Hedge Funds 101 : Understanding Current Concepts and Lingo

Posted by Nick Niesen on November 8th, 2010

What exactly is a "hedge fund " ?

In essence , it is a managed pool of capital for institutions or wealthy individual investors that employes one of various trading strategies in equities, bonds or derivatives , attemting to gain from market inefficiencies and , to some extent hege underlying risks.

Hedge funds are often loosely regulated and usually are much less transparent than traditional investment funds. That helps them to trade more stealthilyt. Funds typically have minimum investments periods, and charge fees based both on funds under management and on performance.

Many experts contend it is a mistake to talk about hedge funds as an assett class : rather the industry embraces a collection of trading strategies. The appropriate choice of hedging strategy for a particular investor depends largely on its existing portfolio; if for example , it is heavily invested in equities, it might seek a hedging strategy to offsett equity risk. Because of this, discussion of relative returns between hedge-funds strategies can be misleading.

Hedge funds use investment techniques that are usually forbidden 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 rhrough borrowing.

The favoured strategies tend to change. It has been said that the hedge-fund industry was equity driven but that now in 2006 there is less long/short. It seems to be a much more diverse picture in 2006 with less of a concentrated exposure format.

Some of the most common strategies include

Convertible arbritrage : This involves going long in the convetible securities ( that is usually shares or bonds) that are exchangeable for a certain number of another form ( usually common shares) at a preset price , and simultaneously shorting the underlying equities. This strategy previously was very effective and was a standard. However this type of action seems to have lost effectiveness and seems to have lost favour in the crowd.

Emerging markets : Investing in securities of companies in the ever emerging economies through the purchase of sovereign or coporate debt and /or shares.

Fund of funds : Inveting in a "basket" of hedge funds. Some funds of funds focus on single strategies and other pursue multiple strategies These funds have an added layerof fees.

Global Macro - Investing in shifts between global economies , often using derivatives to speculate on interest-rate or currency moves.

Market neutral : Typically , equal amounts of capital are invested long and short in the market, attempting to neutralize risk by purchasing undervalued securities and taking short positions in ovevalued securities.

As you can see the terminolgy in dealing with "hedge funds " is both everchanging and confusing.

You should be fluent in both the language and the concepts in order that you can discuss and make intelligent rather than confused choices in your investments.

Remember it is you and not your broker / adviser who will pay the ultimate costs of negligent comprehension and investment planning.