A Comprehensive Guide to Hedge Funds: Definition, Structure & Strategies

Did you stumble upon the term ‘Hedge Funds’ in pursuit of wealth creation? Want to know more details about them, such as their definition, benefits, structure, strategies, etc? We‘ve got you! Firstly, let us define hedge funds as private investment funds that collect money from institutional investors or wealthy individuals with the goal of achieving greater returns. To outperform the broader market, these funds incorporate strategies such as derivatives, leverage and short selling. That’s why only accredited investors can subscribe to hedge funds. This makes it clear that one must meet some financial or professional criteria to be eligible to invest in these. In this article, we will provide an in-depth discussion of hedge funds. Take a look!

The Peculiar Aspect of Hedge Funds

The term ‘hedge fund’ actually is derived from hedging, a trading technique where the gains made from an investment can offset losses in another. A lot of hedge funds implement this principle for wealth creation. However, some look to generate higher returns by placing big, speculative bets, even if it requires taking greater risks.

Hedge Funds vs Mutual Funds - The Differences

You might argue whether hedge funds and mutual funds are similar, given that both collect funds from investors with the same purpose. Yes, on this parameter, they remain the same. However, there are stark differences between the two in terms of other factors such as investment approach, the target audience, regulation, etc. Below, we have compared both hedge funds and mutual funds based on these.

Investment Approach

Hedge funds adopt a more aggressive and complex investment approach, involving strategies such as short selling, leverage and derivatives to earn greater returns. On the other hand, mutual funds involve creating a diversified portfolio of traditional instruments such as stocks and bonds.

Accessibility

This is the major differentiating factor. Only accredited investors meeting a minimum level of assets or income can subscribe to hedge funds. In contrast, anyone can buy mutual funds.

Regulation & Transparency

The regulation on hedge funds is not high, so they do not need to share much information with the public. On the other hand, mutual funds remain highly transparent about fees, holdings and other details.

Liquidity

Hedge fund investors usually witness lock-up periods of a year or more, prohibiting them from accessing their funds for the period. However, most mutual funds allow purchase and sale at any time.

Fees

Hedge fund investments require paying higher fees compared to mutual funds.

Hedge Fund Structure

Hedge funds, especially in the US, are usually represented as Limited Liability Companies (LLCs) or Limited Partnerships (LPs). The fund manager, also known as the General Partner (GP), undertakes fund investment management. On the other hand, outside investors take part as limited partners by contributing capital but stay away from daily operation management. Further, a corporation is created by an asset management company or investor for advisory and investment strategy services. You can thus make out that there are two structures in a hedge fund - the fund and the fund advisor.

What is the Minimum Investment Needed in Hedge Funds?

Most hedge funds come with a minimum investment requirement, which can change based on the funds demand, strategy and target investors. While some funds allow subscription for a starting investment of around $100,000, some larger or more established funds may require investments worth $250,000 or $1 million or more.

Fee Structure

• A management fee accounting for 2% of the net asset value of an investors shares
• A performance fee of 20% charged on profits made above a specific limit.

Note - Some hedge funds may charge lower fees, depending on the overall fund management.

Hedge Fund Strategies Explained

Hedge funds use innovative strategies to outperform the broader market. These strategies revolve around varying risks, investment horizon, asset types such as stocks, bonds, derivatives, currencies, and even real estate. While some hedge funds may follow a single strategy, others use multiple strategies for risk management and diversification. Here are some common hedge fund strategies.

Long/Short Equity Strategy

Long/short equity, one of the most renowned hedge fund strategies, involves purchasing undervalued stocks, which will likely rise. It further uses the short-selling strategy for overvalued stocks expected to decline. Here, the strategy is to ensure profit from both upward and downward price movements while keeping optimal risk management.

Global Macro Strategy

The strategy revolves around taking positions based on major geopolitical or economic trends. Hedge fund managers might assess macroeconomic indicators such as the central bank policy, interest rates or inflation before investing in asset classes that can benefit from price movements.

Event-driven Strategy

This strategy aims at benefiting from price movements occurring before or following major corporate events such as mergers & acquisitions, restructurings, bankruptcies, etc. For instance, a hedge fund might purchase shares of a company to be acquired, anticipating an upward price movement, or short-sell a competitor it believes could be affected by the business deal.

Relative Value Strategy

The strategy seeks to benefit from pricing inefficiencies between related instruments. Hedge fund managers incorporate fundamental, technical or mathematical analysis to identify temporary price misalignments between two assets that usually move together.

Fixed-income Strategy

This strategy focuses on investing in debt instruments such as corporate or government funds, hoping to generate consistent returns while ensuring capital safety. Investors seeking low volatility and a predictable income will likely prefer this strategy.

Conclusion

Hedge funds stand out as sophisticated investment vehicles designed for accredited investors seeking higher returns through innovative and sometimes risky strategies. Unlike mutual funds, hedge funds operate with less regulation, higher entry requirements, and more complex structures, making them suitable only for those who can afford both the financial threshold and the potential risks. From long/short equity to global macro and event-driven strategies, hedge funds continue to play a vital role in global financial markets. However, while the opportunities for wealth creation are significant, investors must weigh the risks, fees, and lock-in periods carefully before committing their capital. In short, hedge funds are powerful tools — but only when handled with the right knowledge, strategy, and risk appetite.

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