Hedge funds refer to funds that can use one or more alternative investment strategies, including hedging against market downturns, investing in asset classes such as currencies or distressed securities, and utilizing return-enhancing tools such as leverage, derivatives, and arbitrage.
At a time when world stock markets appear to have reached excessive valuations and may be due for further correction, hedge funds provide a viable alternative to investors seeking capital appreciation as well as capital preservation in bear markets. The vast majority of hedge funds make consistency of return, rather than magnitude, their primary goal.
It is important to understand the differences between the various hedge fund strategies because all hedge funds are not the same -- investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds.
Key characteristics of hedge funds
Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded. Hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as puts, calls, options, futures, etc.). Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards performance incentives, thus attracting the best brains in the investment business.
Facts about hedge funds
- Estimated to be a $2 trillion industry and growing every year, with approximately 10,000 active hedge funds.
- Includes a variety of investment strategies, some of which use leverage and derivatives while others are more conservative and employ little or no leverage. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or derivatives.
- Most hedge funds are highly specialized, relying on the specific expertise of the manager or management team.
- Performance of many hedge fund strategies, particularly relative value strategies, is not dependent on the direction of the bond or equity markets -- unlike conventional equity or mutual funds (unit trusts), which are generally 100% exposed to market risk.
- Many hedge fund strategies, particularly arbitrage strategies, are limited as to how much capital they can successfully employ before returns diminish. As a result, many successful hedge fund managers limit the amount of capital they will accept.
- Hedge fund managers are generally highly professional, disciplined and diligent.
- Their returns over a sustained period of time have outperformed standard equity and bond indexes with less volatility and less risk of loss than equities.
- Beyond the averages, there are some truly outstanding performers.
- Investing in hedge funds tends to be favored by more sophisticated investors, including many Swiss and other private banks, who have lived through, and understand the consequences of, major stock market corrections. Many endowments and pension funds allocate assets to hedge funds.
Sources: Taken from Hedge funds Association