How Hedge Funds Operate: Investing Ideas for Profitable Traders
If you aren’t exactly sure what a hedge fund does, you aren’t alone. Like mutual funds, hedge funds raise a pool of money to invest and pay out profits, after fees, to the investors. The similarity doesn’t go much further.To begin, hedge funds are only lightly regulated and are only occasionally required to report their holdings. In addition, they employ a number of leveraged trading techniques that mutual funds cannot use due to the regulations. There is really no easy way to price the assets of some of the more illiquid hedge funds, or to verify that the returns are accurate. Knowing this, hedge funds lack the same transparency that mutual funds offer… which can be a huge advantage. You can truly use your own investing ideas to exploit the way that big hedge funds trade!
The basic anatomy of a hedge fund. When a hedge fund is established, it is generally made to pursue a specific strategy that governs the investments the manager makes and how the fund is set up. An example of this is a fund that specializes in merger arbitrage, who will typically concentrate in investments to companies that are involved in a corporate merger or seem likely to be. Hedge funds usually buy shares in a target company and will sell short the shares of an acquiring company. If the deal is completed, there is an equal and opposite position in the acquiring company and the hedge fund can realize a profit on the spread between the two.
While very controversial, there are definitely pros and cons to investing in and operating as a hedge fund. While there is no official count of how many hedge funds there are, or how much they are investing, research companies estimate there are about 8,000 hedge funds with a combined value exceeding $1 trillion dollars. Those that are concerned about hedge funds point to the risk that the funds might pose in capital markets. They maintain, for example, that if a large number of hedge funds made similar bets at the same time, and they were wrong, then they would suffer major losses and roil the entire stock market.
However, many feel that hedge funds pose a necessary role in the economy because they serve the high net worth clients and pension funds, insurance companies, and other institutional investors that aren’t fully served in traditional strategies. Advocates also point out that the large amounts of money that the funds invest provides liquidity that makes the markets less volatile than they might otherwise be.
Hedge funds began in the 1940s as a relatively conservative approach to investing in the stock market. A fund positioned itself to take advantage of the fact that some investments will be losing money while others are gaining, and that you can’t reliably predict which will be which. If the market as a whole becomes profitable, the fund would make much more money on the stocks it held long than it would lose on the ones it had sold short. If the opposite occurred, the fund would lose money on the stock that it owned but could profit on the short sales. The basic goal, as far as investing ideas go, in this long/short strategy is to realize a bit more on the profitable side of the trade than you would lose on the other. That is the concept of “hedging” or playing both sides of the fence to hedge your bets in the stock market.
-Jim Regan
Tags: fees, fund, funds, hedge, how, ideas, investing, investment, investor, mutual, operate, profit, profitable, trading
August 30th, 2008 at 7:23 pm
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