A hedge fund refers to a type of fund that is strictly limited to a certain type of investor, usually only those who have a certain amount of capital and are accredited. Due to the lack of regulation of hedge funds, they can be used to facilitate a greater range of trading strategies than you could with a conventional investment.
As a type of investment, these funds are capable of investing in many different types of assets, such as commodity futures, stocks, and forex.
When they first appeared in the public eye, the term "hedge fund" was a description of a type of fund that would attempt to hedge the exposure of their investments, thereby helping to mitigate portfolio risk. To achieve this, they would profit from both options and short selling. However, as the industry has matured, the term now applies to any fund that attempts to produce returns that are not correlated to major indices. Quite simply, this means that hedge funds are not grossed up against indices and use market timing strategies to produce alpha, which is their value above the index.
However, the fees charged by hedge funds are often quite different than what you will find with mutual funds. The majority of fund managers base their fees on management and performance fees, often on a basis of 2 and 20. The 2 represents an annual management fee of 2% and the 20 represents a performance fee of 20%, which is billed on all net performance gains. This is calculated through the use of a high watermark, which is the highest point achieved by a given account.
Over the past decade, hedge funds have grown considerably. In the summer of 2008, it was speculated that hedge funds now totaled $ 2.5 trillion, but that figure has obviously declined somewhat in the wake of the financial crisis.
As an investor, there are a lot of things to consider before allocating to a hedge fund, such as the investment strategies offered by the fund, lock-in limits, possible fees and the market liquidity.
Despite all the negative headlines in recent months, hedge funds are still a very suitable investment for many people. You just need to make sure that you are doing your due diligence and investing in a broadly sound strategy, rather than one that is likely to fail when the market experiences sudden changes.