What is a Hedge Fund?

If you’re reading this article, you probably already know what an investment fund is - a pool of money from many different investors, which is invested in assets like bonds, stock, property, or even diamonds or expensive wine. You probably know that hedge funds are an unusual, risky type of fund – but you might not know much more. 

Here’s our plain English crash course on how hedge funds work and some of the investment techniques hedge fund manager use.

Welcome to Hedge Funds 101

Hedge funds have several differences from most other investment funds.

Designed to make money in falling markets

Most investments are simple. You buy shares, bonds, property or other assets. Then you wait. The market generally increases in value over time so most likely your assets will soon be worth more than you paid for them. There are riskier investments and safer investments - but no matter the risk they all depend on the value of your assets going up.

Hedge funds are different. They don’t depend on assets gaining in value. In fact, if the fund manager invests smartly, hedge funds can make a lot of money when assets go down in value.

Absolute returns

Hedge funds aim to offer investors a consistent return, no matter what the market does. Even if the market crashes, it’s a hedge fund manager’s job to keep making money at the same rate. A hedge fund’s success depends almost entirely on the skill of the manager.

Accredited investors only 

Hedge funds are only open to institutions and accredited individual investors. Investors can be accredited if they’re experienced enough to weigh up the risks of the investment. 

Not so much regulation

Because (in theory) everyone knows what they’re getting into, hedge funds are less regulated than other funds. Hedge fund managers are allowed to use investment strategies that other fund managers can’t.

Why do you need to understand hedge funds?

Hedge fund management has one of the highest potential salaries of all finance careers. If you’re interested in the stock market and looking for a high income, it’s definitely worth looking into.

It’s also important to understand hedge funds if you’re considering other finance careers, particularly investment management or wealth management. Hedge funds are one of the key types of alternative investment and you should be comfortable talking about them at an interview for your job or internship. 

Even if you don’t go into a finance career, you might build your own investment portfolio one day. It helps to know what your financial adviser is talking about!

Five need-to-know hedge fund definitions 

These are some key terms you should be able to discuss.

1. Alpha

While alpha has a specific definition, you can basically think of it as a measure of a fund manager’s performance. If a fund has high alpha, it’s growing in value much faster than the market in general – suggesting that the fund manager is doing the right things. 

2. Short positions

Taking a short position is one of the techniques hedge fund managers use to make money from shares that are losing value. Here’s how it works.

Say a share price is currently £5 per share. You agree to sell 500 shares to a buyer at that price for £2,500 total. The problem is, you don’t have the shares (you’re short of them). So you borrow them from a broker and hand them over to the buyer. A month later, the share price has dropped to £4 per share. You buy 500 shares for £2,000 and give them back to the broker. Now you’re all square and you’ve made a nice £500 profit.

It’s a risky business. If you make the wrong prediction and the shares actually gain in value you’ll make a loss.

3. Long positions

Unsurprisingly, a long position is the opposite of a short position. If you take a long position, you’re investing in the traditional way. Instead of selling the shares before you buy them (as in a short position), you buy shares, keep them while they gain value and sell them later. 

4. Leverage

Leverage, also known as gearing, is another investing technique. It’s a way to multiply the gains (or losses) you make. There are various ways of doing it but one of the simplest involves borrowing money.

Say there’s a stock you think is going to go up in value. You invest all your spare cash - £500. If the stock value doubles you end up with £1,000 (a profit of £500).

Now imagine you don’t just invest your £500. You also borrow another £500 so you can invest £1,000. If the stock value doubles, you end up with £2,000. Once you pay back the money you borrowed, you still have a profit of £1,000. You’ve doubled your profit.

Like most complex investment techniques, leverage is risky. If you make the wrong predictions you can end up losing all your money and even going into debt.

5. Hedge

In finance, hedge has nothing to do with plants. Think of the phrase ‘hedging your bets’. It means doing something to make a bet less risky. In finance, hedging means doing something to make an investment less risky. It’s almost like taking out an insurance policy on your investment.

So how do you hedge? A good example is to take out an ‘option’. Say you bought 100 shares for £50 each. You hope the price will go up but it’s a risky investment and the price could drop. Just in case, you agree with someone that you have the option to sell the shares to them at £45 each any time in the next six months. That way, even if the price plummets to £30 per share you don’t lose too much money. Of course, you have to pay for the option - but it’s better than taking the risk or missing out on the investment.

Initially, hedging was one of the defining characteristics of hedge funds – hence the name. Now, although they do use hedging, they’re defined more by their goal of absolute returns.

Where can you go to learn more?

For more on how hedge funds work, try finance websites like the hedge funds section of Investopedia. If you get overwhelmed with the wealth of information, start with an economics textbook from your university library.

To keep up on current hedge fund news you can try the traditional journals like The Economist or the FT. For the very latest, check for specialist news on the hedge fund section of Reuters. For commentary, try The Motley Fool or other finance blogs.