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Created on 19.12.2018

Hedge funds: achieve a return even in declining markets

Over the past few years, hedge funds have gained a slightly dubious reputation in the world of finance. This is primarily because they are complex, high-risk investments. What is the difference between hedge funds and traditional investment funds? How do hedge funds work exactly? And what sort of investor can benefit from them? We will examine this question and more in this article.

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In the world of asset management, hedge funds are classified as alternative investments. They were originally created to “hedge” investors’ money against certain risks on the market, which is where the name comes from. Nowadays, however, these special funds generally do not have much to do with hedging. Quite the opposite, in fact: they frequently involve a risky investment strategy with a degree of speculation, the goal being to achieve a return even in declining markets.

Hedge funds vs traditional funds: more differences than similarities

Even though hedge funds and traditional investment funds are both classed as funds, these two investment instruments are significantly different. One characteristic they both share is that they are managed by a fund manager. This fund manager invests each investor’s money in various assets, such as shares and bonds, or even derivatives and foreign currencies. Those investing in a hedge fund or a traditional fund receive fund units and pay management fees. And that’s about the extent of the similarities between hedge funds and traditional funds – in many respects, they are vastly different.

Alternative investments for qualified investors

Traditional funds are usually open to all investors. This means that as a private individual, you can invest in funds relatively easily, even if you do not have much capital to invest. Hedge funds, meanwhile, are generally not aimed at small-scale investors. Anyone looking to invest in hedge funds will need to be able to invest a great deal of capital. This is why institutional investors such as banks, health insurance companies, pension funds and life insurance companies, or even trusts and very wealthy private investors, make up a large proportion of such investors.

Regulations for hedge funds lag behind traditional funds

Unlike traditional funds, hedge funds are still a fairly recent phenomenon. This means that hedge funds are still lagging behind quite a bit as far as regulation goes. Whereas traditional funds are very well regulated, uniform regulations on hedge funds have only been in place for a few years. These are less restrictive and usually less transparent than for traditional funds. This means hedge funds can also execute short sales. You can find out more about in the next section.

A return regardless of the market situation

There are many hedge fund strategies and investment options. They differ in relation to investment class, industry, region, the amount of capital invested and the target return. Yet they always have the same goal: the idea of hedge funds is not just to make a good return in growing markets, but also in declining and stagnating markets. In other words, the aim of a hedge fund is to generate revenue, regardless of the market situation.

Hedge funds can, for instance, speculate on certain price fluctuations with foreign exchange forward contracts and warrants, or they can sell items they don’t even own. These short sales are controversial, but the advantage for investors is that it is possible to achieve a return even if prices are falling. This is because the short-sold share can later be repurchased at a lower price.

Investing just a small amount of capital can be risky

Another feature that is typical of hedge funds is the small amount of capital invested. Indeed, hedge fund managers keep the share of equity as low as possible and acquire vast quantities of debt capital in the form of loans. If the interest due on these loans is lower than the interest due on the equity, there is potential for more profit. This is known as leverage, a strategy that is particularly popular with hedge funds. If this speculation proves to be wrong, this will often spell the end for the hedge fund due to its meagre equity base.

Not an option for small-scale investors

Even though there are now opportunities for private investors to invest in hedge funds, they are only suitable for small-scale investors to a limited extent. This is partly due to the fact that minimum investment sums for hedge funds are too high for the majority of small-scale investors, and partly because most hedge funds are aimed explicitly at qualified investors. These include the institutional investors mentioned above and wealthy private individuals who are registered as qualified investors. And for good reason: anyone looking to invest directly in hedge funds must acquire specialist knowledge to comprehend the hedge fund strategy and to be fully aware of the risks that hedge funds present.

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