Hedge funds

Definition

Hedge funds are investment vehicles that pool capital from accredited investors to invest in a wide range of assets and employ various strategies to achieve high returns. They often use leverage, derivatives, and short-selling to manage risk and enhance performance, making them different from traditional mutual funds. Hedge funds can be aggressive in their strategies and often seek to capitalize on market inefficiencies, which ties them closely to themes like activism in corporate governance, the role of buy-side analysts, and the complexities of international investing.

5 Must Know Facts For Your Next Test

1. Hedge funds typically charge a management fee (usually around 2%) and a performance fee (often 20%) on profits generated.
2. They are less regulated than mutual funds, allowing for greater flexibility in investment strategies and the ability to take on higher risk.
3. Many hedge funds engage in activist investing, where they buy significant stakes in companies to influence management decisions and drive changes for higher shareholder value.
4. Hedge funds often employ a wide variety of strategies, including long/short equity, global macroeconomic trading, and event-driven investing.
5. Investors in hedge funds usually face lock-up periods during which they cannot withdraw their capital, reflecting the illiquid nature of many hedge fund investments.

Review Questions

• How do hedge funds differ from traditional mutual funds in terms of investment strategy and regulation?
  • Hedge funds differ from traditional mutual funds primarily in their investment strategies and regulatory environment. While mutual funds are generally limited to a more conservative approach with specific asset allocations, hedge funds have the freedom to employ diverse strategies like leverage, short-selling, and derivatives trading. Additionally, hedge funds are less regulated than mutual funds, which allows them to pursue higher-risk investments but also means they are available only to accredited investors who can handle potential losses.
• Discuss the role of hedge funds as activist investors and how they impact corporate governance through proxy contests.
  • Hedge funds often take on the role of activist investors by acquiring substantial shares in companies with the intention of influencing management decisions. They may initiate proxy contests to challenge existing boards or propose changes that they believe will enhance shareholder value. This activism can lead to significant shifts in corporate governance practices as hedge funds push for operational improvements, strategic realignments, or even changes in leadership when they feel the company is underperforming.
• Evaluate the challenges that hedge funds face when operating in international markets, particularly regarding cross-border regulations.
  • Hedge funds encounter several challenges when operating internationally, mainly due to varying regulatory environments across countries. Each jurisdiction may have distinct rules governing hedge fund operations, investor protections, and disclosure requirements. This complexity can create hurdles for hedge fund managers seeking to attract global capital while complying with diverse regulations. Moreover, geopolitical risks can impact investment strategies as well as the liquidity and performance of their portfolios in foreign markets.

Related terms

Leverage: The use of borrowed funds to amplify potential returns on investment, which can also increase the risk of significant losses.

Short Selling: A trading strategy where an investor borrows shares to sell them, hoping to buy them back at a lower price, profiting from a decline in the stock's price.

Accredited Investor: An individual or entity that meets certain financial criteria set by regulatory agencies, allowing them to invest in hedge funds and other private securities.