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What Are Hedge Funds ?

17 November 2014 by National Bank
Hedge Funds

Including hedge funds in your investment strategy could be very beneficial, but it also poses some risks. Find out if they could work for your investor profile.

Hedge funds: What are they?

Hedge funds, also known as alternative funds or arbitrage funds, are private companies that pool investors’ money to invest it in different financial products. These funds are very flexible in the investment strategies used.

How do hedge funds work?

Generally, the goal of hedge funds is to minimize risk and maximize return. However, they are not typically linked to the stock market or the state of the economy. This may mean more stability for the investor since hedge funds are less volatile. However, be aware that while these funds aim to produce positive returns no matter what the situation, this does not always happen.

Hedge funds use different strategies that can sometimes be very complex or risky, even to experts. Here are some examples:

Short selling

Hedge funds can sell securities they do not own. The security is borrowed from a broker or another intermediary before being sold. When its value decreases, the hedge fund buys it back at a lower price and returns it. This is how it makes a profit. On the other hand, if the value rises, the fund suffers a loss.

Use of the leverage effect

Hedge funds can borrow in the hope of making larger gains.

Alternative investments

Hedge funds can invest in derivatives (futures, call options, put options, etc.), real estate or raw materials, for example.

Activism

A hedge fund manager could decide to invest in a business that they consider undervalued. To increase its value, the manager adopts different strategies, ranging from exercising the right to vote to modifying the board of directors.

What are “funds of funds”?

Certain hedge funds are called “funds of funds,” meaning they are part of other funds of the same type. In addition to offering a more predictable return, this strategy allows investment diversification, which limits risk: if one fund performs poorly, the others can make up for it. However, don’t forget that too much diversification can affect your investment’s performance. Funds of funds also require the division of management fees. 

Advantages and disadvantages of hedge funds

Regardless of stock and bond market behaviour, different hedge fund strategies can generate returns. Additionally, they are often managed by experienced managers and, when hedge funds perform well, their returns can be spectacular. They have the advantage of diversifying your portfolio. On the other hand, considering the strategies they use, hedge funds are often considered risky: losses can be significant and your capital is not guaranteed. You need to have significant assets to access them, which is why they are usually reserved for wealthier investors. If you choose to invest in a hedge fund, you should know that they are also illiquid. Sometimes you have to give notice and wait before you get your money back.

How are hedge funds different from mutual funds?

Both mutual funds and hedge funds are managed by investment professionals. Both types of funds can be invested in stocks, bonds and money markets.

Mutual funds, however, rely on the portfolio value’s long-term growth. They are also more regulated.

Hedge funds have the advantage of more flexibility in investments made and strategies used. However, volatility and risk are often higher. Information is often disclosed less as well.

Contrary to mutual funds, hedge funds require relatively high fees. The manager usually receives management fees and a percentage of the assets based on their performance.

If you have significant assets, hedge funds could be a part of your investment strategy. To learn more, consult an expert who can analyze your situation and work with you to figure out the best plan of action. They will guide you to the hedge fund best suited to your situation.

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