An introduction to hedge funds
Beginner Stock Market Investing, Stock Market Investing Advice
In the past decade or so, hedge funds have been in the limelight and have proliferated in a bewildering fashion. You may have a basic idea of what the hedge fund is and how it operates but you may not be completely familiar with the different types of hedge fund and, more important, the kind of risk which is not always transparent. There are two basic categories of hedge fund is one of which is centered on equities and the other around fixed-income securities.
These categories may be further broken down into the following:
- Long-Short Funds which take both long and short positions in the market and aim to make a profit out of implementing high-quality stock picking techniques
- Market-Neutral Funds are another species of Long-Short Funds where the managers achieve market neutrality by using hedging techniques to guard against unfavorable fluctuations
- Event-Driven Funds are hedge funds that seek to profit from events that can substantially move the markets such as catastrophes, natural disasters, or political instability.
- Macro Funds are funds that take a view of the market as a whole and then go either long or short. Their strategies are determined by their economic research and analysis and the stated investment objectives and philosophies.
- Fund of Funds are funds that do not make direct investments themselves but, instead, invest in other hedge funds. They may be regarded as a species of hedge fund portfolios.
While there are risks that are specific to a particular hedge fund, there are a number of risks that apply to almost all the categories of hedge funds. They may be briefly described as follows:
- Basic investment risk is the risk that you as an investor stand to lose some or all of your investment. Hedge funds are totally unregulated and fund managers generally have a completely free hand in managing their portfolios. For instance, a hedge fund that describes itself as a blue-chip equities fund should normally be considered safe. However, these key strategies can be employed by the managers such as excessive leverage can create far higher levels of risk. As we all know, leverage is a two-edged sword that multiplies the risk of losses especially in highly volatile commodities and forex markets. In addition, there is the risk known as the “style drift” where the manager deviates from the stated objectives of the fund and hence his core investment competence.
- Because hedge funds are not regulated, there is a greater danger of fraud because there are no checks and balances on the hedge fund manager. Hedge fund is to not particularly rigorous reporting standards and this laxity can encourage employees to indulge in unethical practices. The media is full of stories about hedge fund managers who live lavish and expensive lifestyles at the expense of investors. You should ensure that your hedge fund manager has a reputation for reliability and integrity before you venture an investment.
- The operational practices of hedge funds and the techniques that they use can often be faulty or defective. The very nature of the funds leads to a certain degree of inefficiency and operations. As an example, during the financial crisis of 2008, it emerged that hedge funds were tailoring OTC securities to their advantage. The danger of dealing in OTC securities is that they are difficult to value and, in a difficult market, highly illiquid and unsaleable. These make for unsustainable positions and potential losses.
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