Understanding How Hedge Funds Work

The primary goal of hedge funds is to obtain positive growth for the investors. Hedge funds can accomplish this in a number of ways. Usually, different strategies are employed to take advantage of the broad range of financial instruments available for hedge fund investment. By using these strategies in conjunction with various aspects both within and outside of the financial sector, successful hedge fund managers bring in a steady, positive return rate, despite how the market is performing at any given time. In order to understand how hedge funds work, you need to understand the main types of strategies, the types of investments possible, and the numerous ways this type of fund may be managed.

Basic Hedge Fund Strategies

While it would be impossible to supply an exhaustive list of the types of strategies a manager may employ, there are some broad categories with regards to styles in hedge fund management. Many times, more than one type of strategy will be used, based upon the type of investment that is being hedged. It’s important to realize that no one strategy is better than another – it’s how the strategies are applied that will obtain the best results.

  • Direct Hedge – just as the name implies, this links one type of asset with a similar asset that can be expected to provide similar gains or losses. Ideally, any movement up or down in price will be so closely matched as to eliminate risk.
  • Dynamic Hedge – used when ongoing change is necessary to provide protection in other long-term investments in the fund.
  • Cross Hedge – this involved linking assets that are directly opposed. In this way, the loss in one area can be made up with gains in another area.

Hedge funds may also invest in options outside the stock market. Business ventures, artwork, or other investment opportunities may be used to provide a potential for growth that has no direct ties to the stock market or foreign exchange markets. These types of investments require a savvy hedge fund manager in order to ensure that the deal has been thoroughly evaluated for profit potential. If your manager has a particular specialization, these types of off the market investments may be a standard part of the hedge fund.

When you are first starting out with hedge fund investment, or are looking for a new fund in which to invest, it is important to recognize that no two funds will work in exactly the same way. You must perform all due diligence to make certain that the investment opportunity matches your level of risk tolerance and that it is geared towards the types of investments that you understand. Be certain to have all of your questions answered before you make the final decision, and choose the investment manager that has the best fit with your overall investment style. Understanding the intricacies of any hedge fund investment can’t guarantee success, but it can help you to minimize any unnecessary risks and ensure that you understand the true potential for positive returns in both the short term and over time.

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