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The “hedge” in hedge funds: Just what are hedge funds?

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Protection against market volatility

When investors hear “hedge fund”, they think of all the stories that include volatility and risk. This is completely wide of the mark.

Hedge funds were created to minimize volatility and risk. No one can completely eliminate market volatility. If you hold stocks, you will experience some volatility even if you are a conservative investor.

A hedge what ... ?

A hedge fund takes positions to reduce the risk of adverse price movements in certain securities by taking offsetting positions in related securities. It is the relationship between the securities that creates the “hedge”. Accordingly, if an investor is holding long stock positions, he can eliminate some market volatility by short-selling other stocks. This strategy has become very popular over the years.

Institutional investors use hedging. Affluent investors have also embraced hedging. These two groups have driven the approach, which in turn has driven demand for hedge funds. The demand for hedge funds has grown to the point where at its peak in 2008 the industry managed about $2.5 trillion.

Hedge fund risk

There are some typical risks to owning a hedge fund.

Leverage

Many hedge funds will borrow money or trade on margin. Some funds borrow many times the amount of the original investment.

Short selling

Short selling, in theory, can incur limitless losses, unless, of course, a short position directly hedges a long position. Naked short selling is the practice of shorting a financial instrument without borrowing the security as is usually done. Naked short selling fundamentally increases risk.

Other forms of risk include risk appetite since hedge funds are more likely than other funds to take on investments with high degrees of risk. Because hedge funds are largely private entities and they don’t have the same disclosure requirements, critics point to this lack of transparency. In turn, in some jurisdictions, hedge funds are not exposed to much oversight and may carry undisclosed structural risks due to lack of regulation.

What are the advantages of hedge funds?

Better returns. Less risk.

These days, there are a lot of different hedge funds available to the sophisticated investor. Some are more risky than others. However, hedge funds offer an opportunity that most sophisticated investors really should not miss.

The bottom line is that real hedge funds seek to provide investors with superior returns year after year. Hedge funds accomplish this holding a percentage of the portfolio in long investments and a percentage of the portfolio in short investments. While traditionally, investors have used bonds to hedge losses in their portfolio, hedge funds allow for a more efficient use of hedging products.

Real hedge funds have provided investors with superior returns while at the same time incorporating less risk to the overall investor portfolio than equities.

There is one caveat. Hedge funds are often products for high net worth investors — and they can have very high initial minimum investment amounts as well as other restricitions.

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