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Hedge Funds Demystified

Posted in Finance Articles, Total Reads: 19958 , Published on November 06, 2010

Hedge Funds represent a broad category of investments within the alternative investments asset class.  It is an investment vehicle which pools money from different investors and seek absolute returns uncorrelated to the financial markets through a broad variety of skill-based or speculative strategies.  They seek a positive annual return (the higher the better), limited swings in value, and, above all else, capital preservation. They do so by using the best of what modern financial science can provide—rapid price discovery; massive mathematical and statistical processing; risk measurement and control techniques; and leverage and active trading in corporate equities, bonds, foreign exchange, futures, options, swaps, forwards, and other derivatives.

Currently hedge fund market is of the scale of around $2.3 trillion on the back of high investment by institutional investors like pension funds and insurance firms which are focussed on diversifying their portfolio. These funds mainly focus on absolute returns and in the process use hedging, arbitrage and leverage. They are characterised by few regulations and maximum freedom in terms of use of short sell and derivatives. Hedge funds charge fees under two heads: management fees as fixed percentage of assets under management and performance fees as fixed percent of profits generated on the investments.

Their performance is gauged by the absolute returns they generate without reference to any benchmark index. These funds have generally very low correlation with the market benchmark as they focus on absolute returns.  Hedge funds employ flexible market strategies that generate positive returns in rising or declining market scenario. They can make money in the falling market scenario also.

What is the difference between hedge fund and a mutual fund?
Mutual fund and hedge fund are similar in the aspect that they pool money from different investors and invest in profitable investment opportunities. But there is significant difference in the way they operate. Mutual funds are more regulated than hedge funds and are not allowed to short sell or invest in derivatives taking speculative positions. They can enter into long trades taking long position in equity and debt. Hedge funds, however, can short sell as well as take speculative position in derivatives.
Mutual funds have to report their performance and holdings on a regular basis while there is no such regulation on hedge funds. In case of hedge funds, it is voluntary for them to report because success of hedge funds depends on the ability of the manager to employ profitable strategy which others are not aware of. Displaying the holdings in public would lead to loss of competitive edge thereby leading to loss of profit.
Due to limited reporting, the numbers of investors of are also limited. Since most of institutions are regulated, they are permitted to invest in mutual funds which are more transparent than hedge funds in terms of holdings and strategies.

Risks and Concerns of Hedge funds
• Regulators are concerned about investor’s losing money due to failure of hedge funds because of high risk involved in that. Around 10% of hedge funds fail every year. But there is no evidence that there is any social cause attached to it. Most of the investors in hedge funds are high net worth individuals who totally understand the complex nature of the product. Supervision in this area is not going to help.
• Regulators believe that institutional investment in hedge funds is a potential risk to the overall market. Failure of one hedge fund may lead to collapse of financial institution linked to it which may lead to overall market instability. But there is no evidence to support that.  Financial institutions interested in risky investments will continue to do so even if there is restriction on them to invest in hedge fund. So making them unavailable to financial institutions will not serve any purpose.
• There is general perception that hedge funds tend to create volatility in the market by taking speculative positions moving prices away from their fundamental value. But there have been instances in the history where hedge funds have been major buyers in the falling market bringing stability in the market ex. Market crash of 1987. So concern of excess volatility does not seem to hold any ground.
• Regulators feel that hedge funds trade in huge quantities which create liquidity problems as they tend to maintain large position and sell them in bulk driving down the prices. But there is no evidence to suggest that.

Hedge funds are more risky compared to other avenues of investments but we must understand that only investors who are investing in them are high net individuals and financial institutions who have capability to absorb that kind of risk. With growing number of investors in hedge funds, regulators are feeling the need to regulate activities of hedge funds as security of investors is their prime concern. However, implementation of newer norms and regulations will not affect popularity of hedge funds with the investors.


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