1. Glossary > Asset Class
  2. Hedge funds

Since the first hedge fund was created in the US at the end of the 1940s, many experts have been trying to pinpoint exactly what hedge funds are. Despite their efforts, to this day there is still no official definition. At best there is a consensus on the broad features that set them apart from other investment funds.

In financial jargon, the word “hedge” refers to the offsetting of risks, the act of protecting the assets from market risks. Hedge funds are classed as alternative strategies. Their distinctive characteristic is the fact that they aim at an absolute performance, and not a relative performance compared to a benchmark index. Being decorrelated from financial markets, hedge funds’ performances are seen as reflecting the qualities of the manager.

Although regulators on either side of the Atlantic tightened their oversight after the 2008 financial crisis, hedge funds still have more latitude in their investment policies than traditional funds. The asset class has a wide range of different strategies, the best-known ones being long/short, which seeks to capitalise on market overpricing and underpricing simultaneously; multi-strategy, which combines several alternative strategies into one single vehicle; and global macro, which tracks major economic trends.   

Hedge funds have a lot of freedom to choose the assets underlying their strategies, going from the most obvious (such as equities, bonds, currencies, and commodities) to the most illiquid and complex (such as derivatives – options and futures).

Hedge fund managers also have access to financial techniques which traditional managers do not. For example, they can ‘short-sell’, which involves selling assets without owning them, in a bet that the price will have fallen by the time the position needs to be purchased back. Leverage is another common tool in the hedge fund manager’s kit: borrowing money to increase a portfolio’s exposure, leading to higher gains if the bet pays off, and conversely, bigger losses if not.

The last important point about hedge funds is that in many cases they are quite illiquid, largely due to withdrawal restrictions, and the minimum initial investment amount is generally high. However, nowadays some strategies are available in a regulated format which means they offer daily or weekly liquidity and the initial input requirements are at a similar level as for regular collective investment funds.

Given these special attributes, hedge funds are generally considered relatively risky and are therefore reserved for institutional investors and qualified private investors.

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