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Hedge Funds Decoded

…and Once again Mystery girl (✿◠‿◠) is here to make us aware with a new Banking Concept. This time it is “Hedge Funds”. This magnificent post has 750 words to make you fully aware with this term. In Case you do not get anything regarding the Topic you can ask her on Comment Section below.

Read her previous post on “Various Accounts Maintained by NRI” 

UNDERSTANDING HEDGE FUNDS

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Before explaining hedge funds, one must understand the key terms used in the explanation, which are as follows:

Leverage:  Leverage is an investment technique in which you use a small amount of your own money to make an investment of much larger value.

It basically means Investing with borrowed money as a way to amplify potential gains. For example, if you borrow 90% of the cost of a home, you are using the leverage to buy a much more expensive property than you could have afforded by paying cash.In that way, leverage gives you significant financial power.If you sell the property for more than you borrowed, the profit is entirely yours. The reverse is also true. If you sell at a loss, the amount you borrowed is still due and the entire loss is yours. Therefore, while leverage magnifies profits when the returns from the asset more than offset the costs of borrowing, losses are magnified when the opposite is true.

Hedge funds may also leverage their assets by financing a portion of their portfolios with the money from the short sale of other positions.

Derivative: Derivatives are often used as an instrument to hedge risk for one party of a contract arrangement or product (such as a future, option, or warrant) whose value derives from and is dependent on the value of an underlying asset, such as a commodity, currency, or security. watch this short video if you want to learn more about derivatives. 

Now what are Hedge Funds?

Dictionary meaning of Hedge is to “Enclose or bound in with hedges”. The “hedging” here means the practice of attempting to reduce risk (or to hedge the risk factor involved).

The name “hedge fund” came into being because the aim of these vehicles was to make money regardless of whether the market climbed higher or declined. This was made possible because the managers could “hedge” themselves by going long or short stocks (shorting is a way to make money when a stock drops).

Hedge funds are alternative investments using pooled funds(funds from different investors) that may use a number of different strategies in order to earn active returns, for their investors. Hedge funds may be aggressively managed or make use of derivatives  and leverage in both domestic and international markets with the goal of generating high returns.

Hedge funds mostly cater to sophisticated investors. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.
Various strategies which the Hedge funds manager employs are Equity market neutral, convertible arbitrage, Fixed-income arbitrage etc but they are out of the scope of banking exams

Key Characteristics

  1. They are only open to “accredited” or qualified investors. Investors in hedge funds have to meet certain net worth requirements to invest in them – net worth exceeding $1 million excluding their primary residence.
  2. Wider investment latitude: A hedge fund’s investment universe is only limited by its mandate. A hedge fund can basically invest in anything – land, real estate, stocks, derivatives, currencies. Mutual funds, by contrast, have to basically stick to stocks or bonds.
  3. Often employ leverage: Hedge funds will often use borrowed money to amplify their returns. As we saw during the financial crisis of 2008, leverage can also wipe out hedge funds.


Similarities between hedge funds and mutual funds:

Both mutual funds and hedge funds are managed portfolios. This means that a manager (or a group of managers) picks securities that he or she feels will perform well and groups them into a single portfolio. Portions of the fund are then sold to investors who can participate in the gains/losses of the holdings. The main advantage to investors is that they get instant diversification and professional management of their money.

Now, the differences: 

  • Hedge funds are managed much more aggressively than their mutual fund counterparts. They are able to take speculative positions in derivative securities such as options and have the ability to short sell stocks. This will typically increase the leverage – and thus the risk – of the fund. This also means that it’s possible for hedge funds to make money when the market is falling. Mutual funds, on the other hand, are not permitted to take these highly leveraged positions and are typically safer as a result.
  • Second is their availability. Hedge funds are only available to a specific group of sophisticated investors with high net worth. The U.S. government deems them as “accredited investors”, and the criteria for becoming one are lengthy and restrictive. This isn’t the case for mutual funds, which are very easy to purchase with minimal amounts of money.

Author-
Mystery Girl (@DISQUS)

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