A hedge fund pools investors’ money and actively invests that money to earn a return. Unlike mutual funds, hedge funds tend to take more risk, are subject to far less regulation, and cannot invest money from small investors. In fact, only institutional investors and wealthy individuals can invest in a hedge fund.
Hedge funds tend to use derivatives and use leverage (in other words, borrowing money to increase the return and, at the same time, the risk), short-selling (betting on certain stocks’ prices to fall) and other speculative practices.
Ironically, hedge funds take their name from the fact that they were created to implement less risky investment strategies. These funds used derivatives to reduce their risks, either by covering each of their positions on the stock market, in particular through put options. Thus, if an investment’s market price fell below a certain threshold, the hedge fund limited its loss, having covered its position with a put option. In fact, a put option enables the holder to profit from the drop in a share.
Through this hedging strategy, hedge funds provide a more consistent return and are less vulnerable to stock market volatility. A fund employing such a strategy reduces its risk, but at the same time, its return. While many hedge funds still have such strategies in place, many of them aim to maximize returns, so many of them, despite their names, are riskier than the market itself.
Unlike mutual funds, hedge funds are not subject to some of the regulations intended to protect small investors. Hedge funds must, however, comply with securities laws, just like other market players, and their managers owe a fiduciary duty to their investors.
Synonyms: arbitrage funds
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