Hedge funds pool investor money and actively invest that money with the goal of earning a return. Unlike mutual funds, however, hedge funds tend to take more risk, are subject to much less regulation, and cannot invest the money of small investors. In fact, only institutional investors and high net worth individuals can invest in a hedge fund.
Hedge funds tend to use derivatives and resort to leverage (in other words, borrowing money to increase return and, at the same time, risk), short-selling (betting that certain stock prices will fall) and other speculative practices.
Ironically, hedge funds get their name from the fact that they have emerged to implement less risky investment strategies. These funds used derivatives to reduce their risk, either by hedging each of their positions on the stock market, in particular through put options. Thus, if the stock price of an investment fell below a certain threshold, the hedge fund limited its loss, having taken care to hedge its position with a put option. In fact, a put option allows its holder to benefit from the fall of a share.
This hedging strategy enabled hedge funds to offer more consistent returns, 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 employ such strategies, many hedge funds aim to maximize return, so many of them, despite their names, are riskier than the market itself.
Unlike mutual funds, hedge funds are exempt from some of the regulations designed to protect small investors. However, hedge funds must comply with securities laws, just like other market participants, and their managers have a fiduciary duty to their investors.
Synonyms: Hedge funds, speculative funds, arbitrage funds