Hedge Funds: Definition, Types, and Risks 

Hedge Fund Definition
Hedge Fund Definition Types, and Risks

Hedge funds are a type of investment that involves private investment partnerships. Hedge funds are managed by professional fund managers who use complex and unconventional strategies to make more than average returns. Hedge funds have higher minimum investment amounts and involve more risk than conventional investment funds. They are usually utilized by large-scale institutions and high-net-worth individuals. Hedge funds work through the trades and investments made in a wide range of financial instruments, including securities, non-securities, and derivatives. As the name suggests, a hedge fund attempts to hedge the risk factor involved in investing and trading by utilizing other approaches to investment. The trading techniques used by a hedge fund depend on the principal securities it invests in. 

There are six main types of hedge funds: emerging market hedge funds, global hedge funds, fund of funds, mortgage arbitrage hedge funds, equity arbitrage hedge funds, and event-driven strategies hedge funds. Hedge funds are classified depending on the manner in which the hedge funds are managed, and the securities invested. 

Hedge funds involve more risk than other funds as hedge funds are not regulated by governmental regulatory bodies such as the Securities and Exchange Commission (SEC) in the United States or the Securities and Exchange Board of India (SEBI). The instruments that hedge funds invest in are also riskier than those commonly used by other funds. Since hedge funds aim for higher returns, the risk involved is also higher. Investments made through hedge funds are also illiquid as most hedge funds require their investors to keep their money in it for a minimum period of one year at a time. Illiquidity refers to the lack of ability of an asset to be sold or exchanged easily for cash. Illiquid assets pose a greater risk of market volatility and involve greater risk for investors. Hedge funds also utilize high leverage, often adding to their risk factor. 

What is a hedge fund? 

A hedge fund is an actively managed private investment partnership. A hedge fund is an investment partnership of private investors, including large institutional investors and high-net-worth individuals whose investments are managed by professional fund managers. Hedge funds offer high returns using complex and sophisticated investment and trading strategies, including leveraging, short selling, and the trading of unconventional assets and non-securities. As they offer high returns, the risks associated with hedge funds are also high. 

Hedge funds are also not legally bound by the regulations placed by regulatory bodies such as the SEC or the SEBI. The minimum investment amount required to invest in a hedge is high, and this type of investment is targeted at high-net-worth individuals and wealthy clients. The fees paid to the hedge fund manager are also higher than those paid to other fund managers, such as a mutual fund manager. The investment strategy for the hedge fund is decided by the hedge fund manager depending on the type of the hedge fund. 

How does a hedge fund work? 

As the name suggests, a hedge fund works by hedging the risk involved in the investment and trading goals. A hedge fund utilizes a complex investment strategy that is aimed at producing returns that are higher than the average. 

How does a hedge fund work
How does Hedge Fund work

In a hedge fund, a part of the investment is made in a direction that is opposite to the fund’s principal focus. This helps to minimize any losses in its principal holdings. The work of a hedge fund manager is, thus, similar to placing a hedged bet. Hedge funds use a combination of investment strategies, including taking both long and short positions, initiating arbitrages, and trading equities, bonds, currencies, commodities, and other derivatives. 

Hedge funds may also invest in non-securities and real estate. 

Hedge funds are known for using riskier investment strategies. Leveraging, where investments in assets are made using borrowed capital, is also a common feature of hedge funds. To invest in a hedge fund, the investor must have a minimum amount of assets or income. The minimum amount that can be invested in a hedge fund is also high, and most hedge funds come with a lock-in period, during which the investor has to keep their capital in the fund. 

What are the different types of hedge funds? 

There are six main types of hedge funds. The type of hedge fund determines its investment strategy.

different types of hedge funds
Different Types of Hedge Funds

The six types of hedge funds are listed below. 

  1. Emerging Markets 

An emerging markets hedge fund is a type of hedge fund that invests the majority portion of its assets in securities from countries with emerging economies. Emerging market hedge funds are focused on the emerging phase of a developing country’s economy. They offer the possibility of high returns. However, the risk factor that is associated with these funds is also high. The principal securities invested in by an emerging market fund can include debt securities, equity securities, or a combination of both from a single country or a diversified group of countries. These hedge funds utilize the growth investing strategy. 

The growth investing strategy is an investment strategy that focuses on buying securities from companies that have the potential to grow in the near future. The growth investing strategy functions under the assumption that the companies or economies in their growth stage will grow at an above-average rate. 

Hedge funds that focus on emerging markets tend to involve different risks, including political, inflation, currency, and liquidity risks. Investors should ideally consider these risks before investing in an emerging market hedge fund. The amount of risk associated with a hedge fund focused on emerging markets tends to be higher than other types of hedge funds. 

Emerging market funds give investors an excellent chance to broaden their investment portfolio because they invest in equity and debt instruments across developing nations. Additionally, this helps investors to benefit from favorable market circumstances in the emerging market.

Because emerging market funds invest in stock and debt instruments from developing nations, they give investors an ideal option to diversify their investment portfolio. This also allows investors to benefit from the emerging market’s market conditions.

  1. Global Funds 

A global fund hedge fund is a type of hedge fund that focuses on making profits from different countries’ economic and political circumstances. Global funds utilize short and long positions in trading a range of securities, including equities, debts, currencies, commodities, and the futures market. By utilizing a combination of assets, global funds seek to maximize returns. The focus of a global fund is never on a single company or a single country. Instead, a global fund takes positions after viewing the financial circumstances at a macro level. The investments in a global fund are made based on a particular result arising from an international economic or political issue. Global funds are also designed to profit from the general market volatility. Global funds are actively managed funds in which the expertise and knowledge of the fund manager are utilized to the maximum extent. Therefore, the initial investment amount and the fees for global fund hedge funds tend to be higher than that of other types of hedge funds. The main advantage of investing in a global fund is its diversification. The diversification in a global fund is different from other types of investment. Diversification offers investors a certain level of protection from global events and circumstances that could affect the stock market. 

To broaden our base, we should invest a portion of our money in global funds in addition to our normal investments.  The main advantage is that anytime our economy’s growth is hampered, it will be balanced by our foreign investment funds, whose growth may be steady or progressive.

Looking at the world scene in relation to India’s rapid expansion, the American impact has been rather encouraging, and global finances have greatly aided us.

  1. Fund of Funds 

A fund of funds is a type of fund that invests its capital in a number of other hedge funds. Fund funds’ portfolio consists of different portfolios of other hedge funds. Fund of funds hedge funds operates in a manner that is different from other hedge funds. These funds are more passively managed funds. No active trading takes place in these types of funds. Instead, periodic reports of the underlying hedge funds’ performance are provided to the fund of funds. The strategy behind fund of funds is to minimize risks through maximum diversification. The main advantage of a fund of funds is that it offers investors access to a very diversified portfolio. It also directly lowers the risk associated with investing in individual funds or securities and provides less exposure to market fluctuations. The expertise of a professional fund manager also proves extremely beneficial to the investors investing in a fund of funds. However, the principal disadvantage of fund of funds is that the investment fees are higher than other funds. A significant portion of the returns made through fund of funds gets spent as fees for the manager’s services as well as the investment amount. The expense ratio of a fund of funds is so high primarily because the expense ratio has to cover the underlying expense ratio of each fund. 

Rebalancing is crucial when it comes to maintaining your investment portfolio. It could be necessary for you to sell some investments and buy others in order to rebalance your portfolio. If you sell investments in this situation, you can be obliged to pay capital gains tax.

However, when portfolio rebalancing transactions are made by the various funds that make up the FoFs, no capital gains tax is due. So, you can reap the rewards of rebalancing without having to pay taxes.

The main benefit of a fund of funds is that it allows investors to access various mutual funds with various investment goals with just one investment.

  1.  Mortgage Arbitrage 

A mortgage arbitrage is a type of hedge fund that focuses on the arbitrage of mortgage-backed securities from different markets. A mortgage arbitrage hedge fund utilizes the differences in the pricing of mortgage-backed securities in different markets to generate profits. Mortgage-backed securities are purchased from markets where they are selling at a lower price and sold in markets where they are selling at higher prices. The main disadvantage of this type of hedge fund is that, unless there is excessive leveraging, the rate of returns will be very low. However, excessive leverage poses a higher amount of risk to investors. 

  1. Equity Arbitrage 

An equity arbitrage is a type of hedge fund that focuses on the arbitrage of equities from different markets. An equity arbitrage hedge fund’s main strategy is to buy equities from one market where it is selling at a lower price and then sell in another market for a higher price. This type of fund makes use of the small differences in pricing between different markets. Equity arbitrage hedge funds are associated with a lower risk element than other hedge funds. It is only when the fund managers use excessive leveraging that this type of hedge fund becomes dangerous. 

  1. Event-Driven Hedge Funds

As the name suggests, event-driven hedge funds are a type of hedge fund that focuses on the price movements created by corporate events, including financial distress, bankruptcies, takeovers, or mergers and acquisitions. Event-driven hedge funds specialize in utilizing the market volatility produced by corporate events to generate huge profits. These hedge funds buy debts from companies in financial distress due to some corporate event. The fund makes money when the debt gets repaid. The focus of the hedge fund is generally on those debts which will get paid first. Investing in event-driven funds is risky, as corporate events may not always pan out as judged by the fund manager. There is also the risk of the corporate event taking much longer time than expected by the fund manager. Therefore, an investor seeking to invest in an event-driven hedge fund must be patient and willing to take risks. 

Selecting a Fund 

Investors must select a fund based on their investment goals and risk appetite. While selecting a fund, each type of hedge fund’s pros and cons must be kept in mind. While some funds, such as the Fund of Funds, involve very little risk, the investment fees and the expense ratio can be very high. Other funds, such as a global fund, may offer diversification in terms of the hedge fund profile, but the fees may again be very high. Equity Arbitrage funds, on the other hand, are less risky and levy a comparatively less amount of investment fees. However, these returns may be relatively lower than other hedge funds. 

What is the best type of hedge fund to invest in? 

There is no single type of hedge fund which can be decided as the best type of hedge fund to invest in. Each type of hedge fund has its own advantages as well as disadvantages. An investor decides on a type of hedge fund depending on his risk appetite, investment needs, and goals. Some hedge funds, like an event-driven fund, offer the possibility of higher returns, but these also usually encompass a greater risk factor. Other types of hedge funds, such as the fund of funds, may have a very limited risk element but may have a higher investment fee and expense ratio. The expertise and competence of the hedge fund manager also play a crucial role in determining the outcome of the hedge fund. Therefore, investors must choose between the different types of hedge funds, keeping in mind the pros and cons of each type. 

Investing in any type of hedge fund involves varying levels of risk. Since each type of hedge fund utilizes a different investment strategy and invests in different classes of assets, the risks associated with each type of hedge are different. However, the risk of fraudulent schemes, the risk of market illiquidity, and the risk of losing the investment are common to all types of hedge funds. Another factor that adds to the risk factor in hedge funds is that most hedge funds are unregistered and do not come under regulatory bodies like the SEC or the SEBI. While hedge funds are also subject to prohibitions against fraud, hedge fund managers are not required to have the hedge funds registered or provide regular reports to the regulatory authorities. 

Investing in a hedge fund can be profitable if the investor chooses the right hedge. The returns that the investor gets from a hedge fund are much more than what he would get from other types of funds, such as a mutual fund. Hedge funds are also different from index funds in that they are more actively managed and require much higher investment amounts. The expense ratio for hedge funds is also higher than the expense ratios of mutual funds and index funds. 

What is the risk of investing in a hedge fund?

The three main risks which are associated with all types of hedge funds are listed below. 

  1. Investment Risk 

The main risk factor that is associated with all types of hedge funds is the risk of losing a portion or the whole of the investment amount. In a hedge fund, the fund manager has complete control over all the investment strategies and decisions. Investment strategies such as excessive leveraging have the potential of posing unexpected investment risks to investors. Regulatory authorities also have very limited control over the functioning of the hedge funds, which adds to the investment risk involved in a hedge fund.

  1. Fraud Risk 

Another main risk that is associated with hedge funds is the risk of fraudulent hedge fund schemes. Since regulatory bodies like the SEC in the United States  and SEBI in India have limited control over the functioning of hedge funds, the risk of fraudulent schemes is more for hedge funds than other funds. Hedge funds are also exempt from the strict reporting requirements that are imposed by regulators on the other funds. This makes hedge funds less transparent and more involved in unethical practices.

  1. Illiquidity Risk 

The third main risk that is associated with hedge funds is the risk of illiquidity. Illiquidity refers to the difficulty that is experienced in attempting to sell or exchange hedge fund assets for cash. Since most hedge funds function in over-the-counter markets, they cannot be publicly traded and are thus illiquid. This creates operational inefficiencies and subjects hedge fund investors to risks. 

Does the SEC regulate hedge funds?

The Securities and Exchange Commission (SEC) does not regulate hedge funds. The SEC is the regulatory body that is responsible for monitoring and regulating all transactions regarding the investment and trading of securities in the United States. However, the SEC plays a very limited role in regulating the functioning of hedge funds. The SEC regulations which are in place to protect the interests of the investors of other types of funds, such as mutual funds, are not applicable to hedge funds. Hedge fund managers are not required to have the hedge funds registered under the SEC as hedge funds are unregistered private partnerships. Hedge funds are also not subject to the SEC’s stringent reporting requirements. This makes hedge fund investors more susceptible to unethical practices from hedge fund managers and employees. 

The SEC prohibitions against fraud are applicable to hedge funds in a very limited manner. However, the lack of reporting requirements makes it difficult for the SEC to closely monitor the functioning of the hedge funds for unethical practices. 

Is investing in a hedge fund profitable? 

Investing in a hedge fund can be profitable depending on the investment strategies employed by the fund manager and the competence of the fund manager. The reputation and level of expertise of the fund manager are deciding factors in how profitable the hedge fund returns are. Hedge fund managers have almost complete control over the manner in which the fund functions and the returns received from it are largely dependent on how the fund manager manages the hedge fund. It is also equally important to carefully consider the pros and cons of the hedge fund scheme before investing in one. All the documents and agreements related to the scheme including the strategies to be employed, the investment goals as well as the risks posed by the hedge fund, have to be analyzed and studied carefully. It is also useful to research the background and expertise of the fund manager, prior to investing in the hedge fund. 

What is the difference between a hedge fund and a mutual fund? 

The four main differences between a hedge fund and a mutual fund are listed below. 

  1. In terms of the expense ratio 

The variation in the expense ratio is one of the main differences between a hedge fund and a mutual fund. The expense ratio refers to the amount of money that is charged for the operation and management of a fund. The expense ratios for hedge funds are significantly higher than that of mutual funds. 

  1. In terms of the role of regulatory authorities

The degree of control exercised by regulatory authorities is another major difference between a hedge fund and a mutual fund. Mutual funds are strictly bound by the regulations that have been passed by the regulatory bodies. Mutual funds also have to be registered. Stringent reporting requirements are also placed on mutual fund managers. Hedge funds, however, do not need to be registered and are not bound by any reporting requirements. The level of control that is exercised by a regulatory body on a hedge fund is very limited. 

  1. In terms of the assets used for investment 

The kind of assets that are used for investment is another key difference between hedge funds and mutual funds. Hedge funds invest in a range of assets including stocks, bonds, derivatives, currencies, land, real estate etc. Mutual funds, on the other hand, stick to stocks and bonds only. 

  1. In terms of the type of investor

The type of investors who invest in both mutual funds and hedge funds is another main difference between the two. Mutual funds are open to the general public. Any average investor can invest in a mutual fund. Hedge funds, on the other hand, are open only to accredited investors and require the investors to have a certain minimum balance to invest in the hedge fund. 

What is the difference between an index fund and a hedge fund? 

The four key differences between an index fund and a hedge fund are listed below. 

  1. In terms of strategy 

One main difference between a hedge fund and an index fund lies in its underlying strategy. Hedge funds are actively managed funds where fund managers take an active role in trading securities and assets to generate maximum returns for their investors. Index funds, on the other hand, follow a passive strategy. The strategy of an index fund is to reproduce the performance of the index and not exceed it. 

  1. In terms of regulations

Another main difference between a hedge fund and an index fund is the degree of control the country’s regulatory bodies have over them. Index funds are strictly regulated by regulatory authorities, whereas regulatory bodies only have very limited control over the functioning of hedge funds. 

  1. In terms of the expense ratio 

The expense ratio that the investor pays for the upkeep of the fund, is another main difference between a hedge fund and an index fund. Hedge funds have very high expense ratios. Index funds, however, have very small expense ratios. 

  1. In terms of the kind of investor

The kind of investors who invest in hedge funds and index funds is also different. Hedge fund investors have accredited investors who have a high net worth. The initial investment amounts for hedge funds are also very high. Index funds, on the other hand, are accessible to the general public and have very small initial investment amounts. 

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