A Hedge fund, usually used by wealthy individuals and institutions, is allowed to use aggressive strategies that are unavailable to mutual funds, including short selling, leverage, swaps, arbitrage, and derivatives. Hedge funds are exempt from many of the rules and regulations governing other mutual funds, which allow them to accomplish aggressive investing goals.
Each fund has its own strategy which determines the type of investments and the methods of investment it undertakes. Hedge funds, as a class, invest in a broad range of investments including shares, debt, commodities and so forth.
As the name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging their investments using a variety of methods, most notably short selling. However, the term “hedge fund” has come to be applied to many funds that do not actually hedge their investments, and in particular to funds using short selling and other “hedging” methods to increase rather than reduce risk, with the expectation of increasing return.
The net asset value of a hedge fund can run into many billions of dollars, and this will usually be multiplied by leverage. Hedge funds dominate certain specialty markets such as trading within derivatives with high-yield ratings and distressed debt.
Risks
Positions in hedge funds may carry financial risks of a special kind and should only be taken up by investors who have sufficient knowledge of the particular hedge fund, substantial liquid resources and are able to carry potential losses.
In addition to the normal investment risks (credit risk, currency risk, interest rate risk), hedge funds carry further risks. These include the size risk (optimum size), operational risks (e. g. human risk, organizational risks) or strategy change risks. It is difficult for the investor to detect assess and control all these different aspects as the information policy of hedge funds is generally rather sparse and lacking in transparency.
The liquidity and tradability of hedge funds can vary a great deal. Hedge fund issues and redemptions are often only monthly, quarterly or annually. Fixed holding periods lasting many years are not unusual. Provisions regarding trading frequency and holding periods may change frequently and rapidly. Liquidations can stretch over many years.
Hedge fund can take countless different forms. Hence we cannot go into detail here about the risks involved in any particular case. Before making any such investments, be sure to seek comprehensive advice about the particular risks involved and to carefully study any offers.
