A hedge fund is an investment vehicle which is only open to a limited range of investors, and is considered riskier than your average mutual fund. Unlike a mutual fund, which tends to limit itself to buying stocks and bonds, hedge funds tend to diversify over a broader range of investments including shares, buying debt, commodities, securities, options and futures. They may also employ riskier strategies such as short selling and leveraging – essentially betting against the market – in order to return large dividends to their investors.
Because hedge funds are private investment funds that are open to only a limited range of investors – generally very wealthy private investors who can afford to stake 2.5 million or more on the market – hedge funds are permitted to undertake a wider range of activities by the SEC, and are not subject to regulation. Hedge funds typically also pay a performance fee to the investment manager, as an incentive to make money for the investment pool.
As the name might imply, hedge funds tend to try to offset any potential losses by “hedging” their investments. To do this they employ a variety of investment strategies, most commonly short selling. The term “hedge fund” has also come to apply to funds that use short selling and other “hedging” methods to increase risk, rather than reduce it – on the assumption that increased risk means increasing dividends. Leveraging is a hallmark of this type of investment strategy.
Typically, only very wealthy professional investors are able to participate in this type of fund. Each hedge fund generally has a particular investment strategy for which it is known, and may dominate a certain specialty market, such as trading in distressed debt. Many funds require 90 days notice before a planned withdrawal, or only permit investors to take out a percentage of their funds.