You have probably heard of hedge funds, but what exactly are they? Unfortunately, there's no simple answer to this question, but as you read on hopefully you'll be left with a much better idea. Hedging in the case of investment means to reduce risk. Therefore, hedge funds are meant to reduce the risk of investments by promising a greater return. To explain it basically, a hedge fund uses a variety of investment methods and invests in numerous assets in order to deliver a greater return than usual investments. If managed well-enough, these hedge funds can deliver a consistent level of return, despite how the market is behaving. Make no mistake, the job of hedge fund managers is not easy, but when they are successfully, they are generously rewarded for their efforts.
Hedge funds follow the philosophy that higher risks provide greater returns. As mentioned earlier, hedge fund managers can use a variety of methods to reduce the risk of investment, but to do this they take much greater risks. One way they can do this is by leveraging, which involves borrowing money to increase the return of a lower-risk investment. Essentially it's like playing poker with money you borrowed from your parents. And yes, it's all completely legal. Hedge funds are not regulated by the U.S. Securities and Exchange Commission like mutual funds are. However, they are harder to sell than mutual funds since there are periods of lockup during which investment shares cannot be sold.
Equity market neutral is another hedge fund strategy used that combines long and short equity positions in related markets to pinpoint overvalued and undervalued equity securities to neutralize investment risk. Overvalued stocks in this situation can be much more difficult to correct than undervalued stocks. This strategy aims for an absolute return and therefore comes at a much lower risk. Hedged equity strategies also pinpoint overvalued and undervalued equity securities, but portfolios are not structured and may be highly concentrated.
Investing in distressed securities is a strategy in which portfolios are invested in the debt or equity of a company on the verge of bankruptcy. Distressed securities include bank debt, shares, trade claims and corporate bonds. The logic behind investing in a company that the market will not survive, is that they can be purchased for a reduced cost, and if the company's state is not as bad as the market predicts and it survives or upon liquidation the investment will be covered.
Merger arbitrage aims to seize prices among current market prices of corporate securities and their value after a takeover or merging of two or more companies. The stock is purchased after the company makes the announcement of a merger, and a certain amount is shorted. Another form of arbitrage called fixed-income arbitrage targets undervalued and overvalued bonds with expected changes in structure and credit quality for an array of related issues and market sectors.
Other hedge fund strategies exploit certain areas of the market to reduce risk. Global macro exploits systematic moves in the market through futures and option. Convertible arbitrage exploits mispriced corporate convertible securities like bonds warrants and preferred stock, buying or selling them and reducing all risk.