What are hedge funds?

What are hedge funds?

NAV TL;DR

If you don’t have time to read through the whole article, you can check out our short version below.

  • Hedge funds employ investment strategies that go beyond managing a portfolio of stocks and bonds.
  • The strategies often include the use of short selling, leverage, and derivatives.
  • They are limited to institutional investors and high net worth individuals.

Retail investors in the Wallstreetbets community on social media platform Reddit drove up shares of video game retailer GameStop caught the headlines in early 2021.

The incident resulted in frantic short covering by hedge funds who bet against GameStop, believing the retailer’s business was in decline as more were turning to purchasing video games online. A number of these funds and short sellers suffered large losses.

Other heavily shorted stocks, like movie theatre chain AMC Entertainment, also benefited when retail investors started targeting them.

These events signal the rising influence of retail investors since the Covid-19 outbreak, a period when many have also made their first investments.

That said, for many who are new to investing, it may have also been their first time hearing about hedge funds.

intro to hedge funds

What is a hedge fund?

Hedge funds are managed pooled investment funds where money from investors are used to purchase financial instruments in accordance with an investment mandate or strategy.

On the surface, hedge funds sound similar to other pooled investment funds like unit trusts and exchange-traded funds (ETFs). However, that’s where the similarities end.

Hedge funds - considered as alternative investments - employ investment strategies that go beyond managing a portfolio of stocks and bonds like you might see for many unit trusts and ETFs.

Instead, hedge funds employ a variety of complex strategies – usually in relatively illiquid assets - that aim to deliver better than market average returns for investors using short selling, leverage, and derivatives (e.g futures, options).

Furthermore, the use of complex strategies is why these funds typically have higher fees. While fee structures may vary by factors like the type of hedge fund strategy used, they typically charge a 2% annual management fee as well as 20% in fees for profits. This is known as the 2/20 model.

Hedge funds are also limited to institutional investors and high net worth individuals. This contrasts with unit trusts and ETFs, which are regulated investments that are available to retail investors.

Hedge funds vs unit trusts vs ETFs

intro to hedge funds

Hedge funds as part of an investment portfolio

Given that hedge funds often include the use of short selling, leverage, and derivatives, they are considered alternative investments.

Taking DBS’ Chief Investment Office’s balanced portfolio as an example, alternative investments take up 15% of the total portfolio. Of this, 7% of the total portfolio is invested in gold and 8% in hedge funds.

As such, those who are able to invest in hedge funds, often do not have a large proportion of their investable funds in it. That said, the proportion invested in hedge funds tends to rise, the more aggressive a portfolio is.

intro to hedge funds

Hedge fund strategies

There is a variety of strategies that hedge funds use to produce returns for investors that beat the market average.

For example, there are hedge funds that only go long or short on equities and others that concentrate on leveraging investment opportunities when two or more companies merge.

These strategies can focus solely on commodities, real estate, derivatives, or currencies. A hedge fund manager oversees the buying and selling of fund investments and utilizes one or more hedge fund strategies.

Some common hedge fund strategies include:

intro to hedge funds

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Disclaimers and Important Notice

This article is meant for information only and should not be relied upon as financial advice. Before making any decision to buy, sell or hold any investment or insurance product, you should seek advice from a financial adviser regarding its suitability.

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