Investing into a Hedge Fund
What is a Hedge Fund?
It is common for the news we read in the financial media to refer to hedge funds as an investment vehicle and for more than one of us to wonder what characteristics these products share with the investment funds we are all familiar with or, on the contrary, how they differ from them.
Perhaps the expression that best defines hedge fund is surrounding In fact, although they pursue the same objective, to obtain the highest possible return on invested capital, they can use a much wider range of strategies, take on more risk and even leverage.
What are the differences between hedge funds and traditional funds?
Risk. Investments made by hedge funds have a much higher risk profile than those made by mutual funds. Not surprisingly, they are considered to be a high-risk investment, since the flexibility they have to invest increases the risks assumed. For example, while in a traditional fund the weight of a financial asset may be limited to a specific percentage (for example, no security in the portfolio may represent more than 5% of the fund's assets), in hedge funds there is usually no such limitation. Also, some use leverage (they use debt to invest more capital than they actually own in an investment), which can have a multiplier effect on returns, but also on potential losses.
Assets. In addition, they can invest in any asset class, not only in equities or fixed income, but some also invest in currencies, commodities or real estate assets, among others, being able to build a highly diversified portfolio.
Profitability. Evidently, the fact of assuming more risks makes it possible for them to obtain higher potential returns since, in addition, one of their objectives is to obtain positive returns in any market environment, for which they usually use different strategies, which in many cases are decorrelated with the markets.
Minimum investment. While, in a traditional fund, the minimum investment is usually affordable for the individual investor (e.g., one share or 1,000 euros, among others), in the case of hedge funds, significant initial investments are required and they are aimed at qualified investors.
Types of hedge funds
As mentioned above, hedge funds use different investment strategies and are classified in one way or another. Although the divisions we are going to see below can be further classified into sub-types, in general we find:
Directional. In these, the manager invests depending on whether he believes the market is going to go up (and takes a long position) or whether he thinks it is going to go down (and bets on being short).
Global macro. In this case, investment decisions are based on global macroeconomic trends, the evolution of currencies, interest rates or even commodity prices.
Arbitrage. This consists of trying to take advantage of differences in the price of the same asset in different markets. To do this, simultaneous buying and selling operations are carried out and prices are waited for to adjust. In other words, a short (sell) position is taken in the market where the asset is more expensive and a long (buy) position is taken in the market where it is cheaper.
Event driven. In this case, the manager's investment decisions are driven by situations or events that affect companies, such as mergers and acquisitions or debt restructurings, among other events.
Distressed. They invest in companies in financial difficulties, such as having declared bankruptcy or being about to do so.
Long/Short. Consists of investing inversely in two types of correlated securities, waiting for the price difference between them to narrow or widen. This is known as pairs trading. For example, between two energy companies, in one a short position is taken and in the other a long position.
Taking all this into account, it is clear that the diversity and flexibility of hedge funds when it comes to investing makes them very attractive, but also makes them a risky and complex product to understand, which is why they are reserved for qualified investors, leaving traditional funds for other investors.