Can someone explain hedge funds to me?

Question

I'm an A-Level Economics student.

Preferably quite a simple explanation!

Answer 1

I'll try to make it easy, but they are complex by their very nature.

Put simply, a hedge fund takes money from (usually) very wealthy people and tries to make a LOT more profit in 12 months than the Stock Market would have done. It is HIGH RISK for HIGH RETURN - but the risks are very, very carefully assessed.

For that reason, ordinary unit trusts and pension funds are not allowed by law to invest their assets in hedge funds.

How they invest and in what they invest is too complex to explain, really. They do things like 'arbitrage' which is where you look for a situation where a commodity is selling for £x in one place and £x+1 in another and exploit that advantage. The currency markets are a popular area of profit for those who understand what moves the prices of currencies.

They utilise 'leverage' - this is where you can buy shares for just 10% deposit. If you buy £50,000,000 of shares and they go up in value to £55,000,000 in a week (not unusual) then you sell them and take a £5,000,000 profit from an outlay of £5,000,000 deposit. That equals 100% profit on capital employed. Had you paid the full £50 million, you would have made a profit of £5 million but it would only be 10% of capital employed.

Still with me? It's not that bad really, is it? HUGE profits can be made, but HUGE losses can also be made if the market goes the wrong way.

Hedge funds are huge (but carefully calculated) risk for massive rewards.

Answer 2

There is a hedged trade; the old fashioned hedge fund (which is related); and the modern hedge fund (which is only slightly related).

If a seed company buys corn in the fall, adds value by cleaning and drying it in the winter, and sells it in the spring; they can make some money if the market doesn't move against them. So when they buy the real seed in the fall they can immediately short the same amount in the markets. Then when they sell the real seed in the spring, they cover the market short position too. This is a pure hedge, and market fluctuations have no effect on their profits.

You can't make any money on a pure hedge, but you can't lose any either; which is a good thing if your business is not a market trading business.

An old fashioned hedge fund tries to do well in a bull market and not lose any money in a bear market. How? They might do the following: Invest long in McDonalds Corp. and short Wendys Corp. The former is a great corp. and the latter mediocre. This trade will likely make money in either bull or bear markets.

But in a bull market you could make even more by being long McDonalds and forget the Wendys. So you can juice the performance of the hedged long/short trade by trading on margin.

Now you have reduced the risk of a sudden market downturn, but increased the risk magnitude of a general screw-up. For example: Maybe McDonalds has their 10,000 resturants in China confiscated by the government and Wendys hits a home-run by imitating Chipotle's food items. This would be a disaster for the above leveraged long/short trade.

Modern hedge funds are doing the things mentioned by others here, plus rapid computerized trading, statistical arbitrage, etc.

Answer 3

Hedge Fund: a private pooled investment using complex combinations of forwards, futures, warrants, options, forex transactions, various leverages etc. to systematically minimize most types of financial risk and to maximize return.

Answer 4

Essentially, they take your money and place bets on the market going up and down.

For every £ they collect from 'investors' they will borrow one or 2 ££ extra .. and use that to place a few more bets.

When they get it right, they make ££££'s ... when they get it wrong, they loose £££££'s ..

Answer 5

a group of private investors that are able to invest and trade legally without reporting it to the ftc....cant get any easier..