In 2023, the highest-paid financiers on Wall Street were hedge fund managers. The best-performing hedge fund in January 2024 had a market value of $234,317,200,000, according to Forbes.
In the world of finance, hedge funds have established a reputation for their high-risk, high-reward nature. At their core, however, hedge funds are simply pools of money controlled by professional analysts and hedge fund managers who aim to generate higher returns than traditional investment avenues.
With the goal of consistently earning more than index funds, such as the S&P 500, hedge fund managers must use various strategies to maximize their investments, according to the Economist. Hedge fund managers are expected to generate profits irrespective of market conditions, so they use high-risk methods to make more money. Hence, even in a recession, hedge funds still aim to make a profit, not a loss. As a result, hedge fund managers use leveraging, derivatives and arbitrage to amplify the potential of the investors' money. However, these risky tactics can also lose a lot of money.
So, why do investors flock to hedge funds? Investors are attracted by the potential for higher returns, often uncorrelated with the broader market. Additionally, hedge funds offer the promise of diversification, potentially minimizing risk through various investment strategies. If one investment fails, the others can still generate a profit for the investors. However, hedge funds are usually more exclusive to high-net-worth individuals due to the riskier nature of hedge fund investing, according to the Motley Fool.
At the surface, mutual and hedge funds are both portfolios built from pooled funds that focus on achieving returns through investment diversification. However, while mutual funds are more accessible to the general public, hedge funds are more exclusive. Additionally, according to Investopedia, hedge funds are less strictly regulated by the SEC. So, they are managed more aggressively than mutual funds and seek large returns. Mutual funds simply mirror the market while hedge funds aim to outperform the market. Because of this high bar to meet, hedge funds usually employ riskier strategies to return higher profits while other mutual funds invest in safe, shallow stocks. Moreover, hedge funds typically have higher fees and lock-up periods, limiting liquidity compared to mutual funds.
Investopedia categorizes hedge funds into four common types.
Global macro hedge funds are hedge funds that attempt to profit from broad market swings caused by political or economic events, as defined by the Corporate Finance Institute. Due to their flexibility, global macro hedge funds can invest across various asset classes. The success of these funds usually hinges on periods of high uncertainty and volatility, which lead to drastic changes in macroeconomic trends.
In contrast, an equity hedge fund invests in lucrative stocks while hedging against downturns in equity markets. Investopedia lists the main strategies used by equity hedge funds as buying equity in some form, selling overvalued stocks and capitalizing on rising and falling stock prices. Equity hedge funds mainly aim to make profit but also offset losses connected to market risk by hedging and buying options.
Relative value hedge funds seek to profit from price differentials in related securities, such as stocks, bonds and derivatives. To do this, fund managers must predict changes in stock prices or rates, capturing excess returns, according to Oxford Academics. Hence, relative value funds intend to achieve isolated returns across the market by exploiting price discrepancies.
The fourth kind of hedge fund is an activist hedge fund. The European Corporate Governance Institute defines activist hedge funds as specialized funds that seek to invest in businesses and take actions that boost the stock price. In order to do this, these funds buy a significant stake in a public company to influence its operation for profit. These funds may raise the stock value by pressuring for changes, changing the board of directors or restructuring the assets of the company or business.
Hedge funds remain an enticing yet intricate realm of investing, offering potential rewards. However, hedge funds do come with higher risks, fees and entry barriers compared to mutual funds. Investors considering hedge funds must weigh the allure of higher returns against the increased complexity and potential lack of liquidity compared to other investment avenues.
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