A guide to hedge funds; what are hedge funds – how do they work?

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You may have heard of hedge funds, but how do they work and how are they different to ordinary investment funds? Should you invest in one?

What are hedge funds – how do they work?

A hedge fund is an investment fund but, unlike ‘ordinary’ share or bond-based investment funds, it will use different strategies to generate a return. In simple terms, a share-based fund will invest in companies that it believes will generate a return, either by producing an income (through paying share dividends), through its share price rising or a combination of both.

A hedge fund will buy shares in companies that it believes will rise in value, but it may also do things like ‘short sell’ shares in companies that it believes will fall in value.

SAVVY TIP: As well as investing in company shares and bonds (which are IOUs for loans to companies or governments), hedge funds can buy derivatives such as futures or options.

What are futures and options?

There are different types of derivative that a hedge fund may use, but futures and options are the ones we’re most likely to have heard of.

  • Future: a future is a contract that says you will buy or sell assets, such as shares or commodities (for example, gold, silver, oil or coffee) at a price that you set in advance. So, for example, you could take out a future that says you will sell 2,000 shares in ABC bank at £2 a share in a year’s time. If the shares have fallen to £1.50 by the time 12 months is up, you would make a profit because the person or company you’d entered into the contract with would be bound to buy the shares at £2 each.
  • Option: an option is the right to buy or an asset at a price that you’ve set in advance. There are two types of options: a put option is the right to sell the asset at a given price (in the jargon it’s called the ‘strike’ price), whereas a call option is the right to buy at a specific price.

SAVVY TIP: Hedge fund managers can use derivatives such as futures and options to speculate on the price of an asset, such as shares or commodities.

Strategies used in hedge funds

Hedge funds can use a range of different strategies to generate a return.

Short selling: this means they sell shares they don’t actually own. Short selling is used when you think the price of an asset, such as a company share, will fall. If this happens, with short selling you can buy the shares at the lower price and make a profit.

Gearing: this involves borrowing against the value of assets you already own. It works in a similar way to taking out a mortgage against the value of a house you want to buy.

If you want to buy a property costing £200,000 and you have a deposit of £50,000, if that property goes up in price by £20,000, you’ve made a big profit on your £50,000 investment (although there will be charges and costs involved in taking out the loan). However, if the price the property falls by £20,000, you’ve made a correspondingly bigger loss.

How you can invest in a hedge fund

Hedge funds used to only be available to institutional investors (such as large pension funds etc) but they are available to ‘retail investors’ (individuals who want to invest).

SAVVY TIP: Although hedge funds are designed to make money when the stock market is rising and falling, they can be quite a lot riskier and their fees are often significantly higher.

What to watch for:

As well as the usual risks of investing, there are extra things you need to consider:

  1. Risk: if the hedge fund manager gets it wrong, you could be exposed to a lot more risk than with an ordinary investment fund.
  2. Charges: the charges tend to be much higher than with an ordinary investment fund. Some charge 2% a year as a management charge and 20% of any profits on top. The trading fees may also be higher.
  3. Complexity: it’s often said that you shouldn’t invest in anything you don’t understand, but the derivatives and instruments used by hedge funds can be complicated.
  4. Regulation: some hedge funds are based in the UK but others may be based overseas where there’s a different set of rules and regulations.
  5. Portfolio size: you shouldn’t invest more than a small amount of your money in a hedge fund (that’s assuming you understand the risks and are happy with them), so you’d need to be reasonably wealthy in order to invest.

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