Candlestick Trading Blog

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What exactly is hedge fund investing?

A hedge fund is a managed pool of capital for wealthy individual investors or institutions that employs one of various trading strategies in bonds, equities, or derivatives, attempting to gain from market inefficiencies and, to some extent hedge underlying risks using fundamental and technical analysis.

Hedge funds are usually loosely regulated and often are much less transparent than traditional investment funds. That allows them to trade a little more "under the radar". Typically funds have minimum investments periods, and charge fees based both on performance and funds under management.

According to many experts, it is a mistake to classify hedge funds as an asset class, rather the industry embraces a collection of trading strategies. The right choice of hedging strategy for a particular investor depends mostly on its existing portfolio and money management techniques; if for example, it is heavily invested in equities, it might seek a hedging strategy to offset equity risk. Because of this, discussion of relative returns between hedge-funds strategies can be misleading.

Hedge fund investing uses stock investing concepts that are not usually allowed for more traditional funds, including "short selling: stock - that is borrowing shares to sell them in the hope of buying them back later at a lower price - and using big leverage through borrowing.

Stock market strategies tend to change. In the past the hedge-fund industry seems to have been equity driven but currently in 2006 there is less long/short. Lately, the picture has been more diverse with less of a concentrated exposure format.

Here are some of the more common strategies:

Market neutral: In this hedge fund investing strategy, equal amounts of capital are invested long and short in the market, attempting to neutralize risk by taking short positions in overvalued securities and purchasing undervalued securities, otherwise known as "value stock investing".

Fund of funds: In this hedge fund investing strategy, investments are made in an assortment of hedge funds to enhance risk reward ratios. Some funds of funds pursue multiple strategies and others focus on single strategies. An added layer of fees is a characteristic of these funds.

Convertible arbitrage: This strategy involves going long in the convertible securities, usually bonds or shares, that are exchangeable for a certain number of another form (usually common shares) at a preset price, and simultaneously shorting the underlying equities. Stop loss strategies were often incorporated into the process. Although previously this strategy was considered a very effective a standard, it now seems to have lost effectiveness and crowd favor.

Global Macro: This strategy involves hedge fund investing in shifts between global economies, usually using derivatives to speculate on currency trading or interest rate moves.

Emerging markets: This strategy involves hedge fund investing in securities of companies in the ever emerging economies through the purchase of corporate or sovereign shares and/or debt.

As demonstrated here, you can see the terminology in dealing with hedge fund investing is both ever changing and confusing, even to successful traders.

You should be familiar with both the stock investing concepts and the language to make intelligent rather than confused choices in your investments.

Keep in mind that it will be you and not your advisor or broker that will pay the costs of negligent investment planning and comprehension.