9.7 Hedge Funds - 9.7 Hedge Funds Explained

Key Concepts

• Hedge Funds
• Investment Strategies
• Leverage
• Performance Fees
• Regulation
• Risk Management

Hedge Funds

Hedge Funds are investment vehicles that use various strategies to generate returns regardless of market conditions. They are typically only accessible to accredited investors and often employ leverage to amplify returns.

Example: A hedge fund manager takes long positions in technology stocks and short positions in energy stocks, aiming to profit from the differential performance of these sectors.

Investment Strategies

Hedge Funds employ a wide range of strategies, including long/short equity, global macro, event-driven, and arbitrage. These strategies are designed to generate alpha, or excess returns, by exploiting market inefficiencies.

Example: A global macro hedge fund might take positions based on economic trends, such as buying currencies expected to appreciate due to interest rate changes in their respective countries.

Leverage

Leverage involves borrowing funds to increase the potential returns of an investment. Hedge Funds often use leverage to amplify their bets, but this also increases risk. Leverage can be obtained through margin accounts, derivatives, or borrowing.

Example: A hedge fund with $100 million in assets might borrow an additional $100 million to invest $200 million in a particular strategy. If the strategy yields a 10% return, the fund's return would be 20% on the original $100 million.

Performance Fees

Hedge Funds typically charge a management fee and a performance fee. The performance fee, often referred to as "2 and 20," includes a 2% management fee on assets under management and a 20% performance fee on the profits generated.

Example: If a hedge fund manages $100 million and generates a 10% return, the management fee would be $2 million, and the performance fee would be $2 million (20% of the $10 million profit).

Regulation

Hedge Funds are generally less regulated than mutual funds. They are subject to the Investment Advisers Act of 1940 and must register with the Securities and Exchange Commission (SEC) if they manage over $150 million. However, they have more flexibility in their investment strategies.

Example: A hedge fund that engages in complex derivatives trading must comply with SEC regulations but has more freedom in choosing its trading strategies compared to a mutual fund.

Risk Management

Risk Management in hedge funds involves strategies to mitigate potential losses. This includes diversification, hedging, and setting stop-loss limits. Hedge funds often use sophisticated risk management tools to monitor and control their exposure.

Example: A hedge fund might use options to hedge against a decline in the value of its equity portfolio. If the market drops, the gains from the options can offset the losses in the equity portfolio.