What are Hedge Funds?

July 22, 2013 Maria Morales In the News

hedge-fundNow that hedge funds are allowed to advertise by the SEC it is probably a good idea to review exactly what is a hedge fund.

According to Wikipedia a hedge fund “is a collective investment, often a limited partnership, which invests private capital speculatively to maximize capital appreciation.”

A good clue to understanding what hedge funds are all about is found in the meaning of the word “hedging,” as in “hedging your bets.” Hedging means to reduce risk, and that is exactly what many hedge funds aim to achieve, a reduction in risk. Yes, we all know that return is usually a function of risk. Those investing in risky enterprises are compensated for their bravery by a higher return. However, hedge fund managers have some strategies available to them which can cut risk while not cutting into return on investment.

An example of what a hedge fund manager can do to reduce risk without reducing return is to take stock market risk out of the fund’s portfolio through the action of selling stock index futures. The flip side of this is increasing return without increasing risk. That can be accomplished by investing in relatively low-risk investments but borrowing money to do it, known as leveraging.

Be warned, however, that there is no way to completely eliminate risk, no matter what the investment strategy. Even stashing your money under your mattress is risky. Imagine someone who put his $100 life savings in a jar in 1900, and that jar with that $100 being passed down through the generations until today. I am sure that the great great great grandchild who eventually acquired the jar with the money would have much preferred if great great great granddad had instead bought $100 in Thomas Edison’s stock. Or how about just putting the $100 in a bank earning a mere 3 percent interest annually? Even under those unfavorable conditions at least the child would get an additional $13 beyond the original $100.

Most of us do not have to worry about whether hedge funds are too risky or not, since the SEC requires that only accredited investors be allowed to invest in hedge funds, meaning people of high net worth.

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