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Hedge funds are simply funds with high leverage and no regulation. They have come into existence in the past couple of decades or so. However, a lot of fund managers have used different strategies and different asset classes. The result is a proliferation of the types of hedge funds. The modern investor therefore has a wide variety of options to choose from. In this article, we will explain the various choices that are available.
Major corporate events such as mergers, acquisitions and bankruptcies create a lot of movement in the stock market. Hedge funds are known to take advantage of such movements. There are many funds which specialize in such investments. Events produce volatility and making leveraged bets on this volatility can produce exceptional returns.
Hedge funds hire analysts that have been trained to quickly ascertain the value of companies in the middle of crisis. These funds then try to acquire shares which are undervalued whereas selling overvalued companies simultaneously. Hedge funds usually take both long and short positions since they are not averse to risk.
Contrary to being very risky, a significant number of hedge funds employ equity arbitrage. This means that their strategy revolves around making risk free bets to earn money. Equities are traded in many forms such as the spot market, sectoral indices, market indices and derivatives like futures. The hedge funds strategy revolves around finding arbitrage opportunities during the daily trading of such investments and then placing highly leveraged bets. It is the leverage that makes this trading dangerous. Most of the time, traders earn money from such transactions. However, when things go wrong, the loss can be considerable.
Developed markets like the United States have a highly developed market for mortgage related securities as well. There are mortgage backed securities and collateralized debt obligations being sold. Also, over the counter derivative products are available for these securities. This strategy is similar to equity arbitrage. The difference being that mortgage products are used instead of equity products. Once again, different positions are taken in different markets to capture the price difference. The earnings would be relatively small if not for the extreme leverage that is utilized. Leverage ratios of 10:1 are pretty standard in such trades.
A different kind of hedge fund is called “fund of funds”. This fund also accumulates money from investors just like other hedge funds. However, the operations of this fund are not similar to other hedge funds. This is because the investing strategy of this fund is passive. This means that these funds simply give away the money to other hedge funds. Therefore, there is no active trading but instead periodic and passive monitoring of the performance given by other funds. Such funds happy the opportunity to diversify their portfolio to avoid the riskiness inherent in hedge fund positions. The dangers posed by leverage are somewhat offset by this diversification.
Emerging markets are countries with huge upside potential. These countries are usually advancing rapidly. However, their markets are not developed well enough. Hedge funds see this low regulation as an opportunity. Since they have massive amounts of funds at their disposal, hedge funds can literally move these smaller markets single handedly.
This strategy is being followed by a lot of hedge funds. Markets such as Brazil and India have witnessed the application of this strategy. Governments in developed countries have now become aware of the volatility that such funds can cause. There are therefore many restrictions in place that limit the amount of investments that such foreign institutional investors can make.
Many big hedge funds such as George Soross Quantum Fund as well as the massive Tiger Fund define themselves as global funds. This means that they do not take positions on individual companies or even sectors. They view the world of finance at a very macro level and predict those movements. For instance, when outsourcing first began many companies started investing heavily in macro indices of India and China. Similarly prior to the Euro crisis, it was revealed that many funds had short positions against European nations. George Soros made this strategy popular when he broke the Bank of England and propelled hedge fund managers to celebrity status
The usual approach to selecting investments does not work in the hedge fund scenario. This is because usually past returns are analyzed before making investment decisions. However, in the case of hedge funds, data relating to past returns is not available given the short life of such funds. Therefore investors have to make their choice based on other parameters like the reputation of the fund manager, the risk control mechanisms of the fund as well as their investment philosophy.
Selecting a hedge fund is therefore a very challenging task given that there is virtually no regulation to prevent the fund from being reckless and also there is no data to support any kind of decision making,
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