What is a Hedge Fund?

Hedge funds are privately held investments that use resources pooled together from investors to capture particular market segment that offers high returns. Investors are therefore required to commit their monies for a minimum period after which they can redeem their investments. These funds are aggressively managed and are only open to the select investors with a minimum set net worth.

The original purpose of creating hedge funds was to capture equity securities investments and to utilize leverage and short selling to monitor the movements of the equity market. This purpose has however been overridden to accommodate other investments that can offer higher returns. The aggressive managers observe the market trends and make speculative investments that at times carry a bigger risk to that of the overall market.

Hedge fund strategies

Their approach to the market structure can take any of the following forms:

• Short selling

Short selling commonly referred to as shorting is a strategy whereby stocks that are not in use are sold and then bought later at a discounted price thereby making real returns. Only a few hedge fund managers can be entrusted with this high-risk venture.

• Equity market neutral

This is an asset stock-picking with the aim of hedging against volatility in the market using the long-short method. The hedge-manager can buy one stock and, on the other hand, short another stock in the same asset class. Regardless of the performance of the individual markets, the investors will still make some money from the investment.

• Market neutral arbitrage

This technique exploits the imbalances in the pricing of different securities. For instance, a manager may short sell a company’s stock and still buy the same companies bond.

• Merger arbitrage

Merger arbitrage focuses on the companies on the verge of an amalgamation. For instance when a corporation Y announces that it is buying company Z at $100 per share, the stock price for company Z will rise by a margin let’s say at $105 by share. The difference between the two stocks is called the spread. A hedge manager can use this chance to make a short term profit from the spread.

• Convertible arbitrage

It’s a corporate bond that is redeemed for a company stock in the future. The price of this bond can fall when the credit ratings fall or when the interest rates shoot up. Profit is achieved from the difference between the price of the bond and the stock it can be redeemed for.

Hedge funds are like a double bladed sword. When you make the right bet, then you are sure to smile all the way to the bank. If you are not lucky, then your lifetime savings can be swept with the speed of the lightning. In the 1990’s, Manhattan investment fund clearing through Bear Stearns lost close to $400 million of their investors assets. The firm, however, collapsed in the 2000s having made $2.4 million and with losses of up to $160 million which the court ordered they should pay.