Hedge Fund Definition

Hedge Funds are a frequently misunderstood area of finance, yet they are one of the main movers of global markets and one of the key influencers of global liquidity. In order to join a hedge fund it is usually necessary to have experience in either trading, equity research or investment banking experience, although some hedge funds do recruit directly out of graduate school. It is less necessary to have obtained an MBA to get into hedge funds than it is for private equity firms, but a CFA may be of some use. Some recommended reading material on the lifestyle and general activities within a hedge fund are Money Mavericks, The Big Short and When Genius Failed.

What is a Hedge Fund?

A hedge fund is a pool of money from investors which is used to invest in wide-ranging areas of finance, i.e. in different asset classes, different regions etc and is part of the buy-side. Hedge funds are largely unregulated and have the ability to invest in many different ways, one of the most important being to short assets either through borrowing or through derivatives. Traditionally they were called hedge funds because they used derivatives and securities to hedge all their positions, but nowadays hedge funds do not do that to such an extent and are more speculative. Hedge funds will invest in all kinds of assets, including:

  • Bonds
  • Equities
  • Derivatives
  • Real Estate

Hedge funds typically invest aggressively and will be quick to move their money around to adapt to market conditions. They frequently borrow money and leverage up their capital in order to enhance returns, but this will also magnify losses so it is a double-edged sword which must be treated carefully. Hedge funds cater to ultra-high net worth individuals and institutions managing funds on behalf of clients (mutual funds, pension funds, insurance companies etc.). The typical amount required to deposit in a hedge fund is $1-5mm ($1 million to $5 million) and there is often some sort of lock-up agreement saying you have to keep your money in the hedge fund for a designated minimum period.

Some of the most well-known hedge funds are:

Types of Hedge Funds

There are 4 main kinds of hedge fund:

  • Directional
  • Global Macro
  • Event Driven
  • Relative Value

Below is a brief description of each kind of hedge fund.

Directional Hedge Fund
These are probably the most algorithmic orientated hedge funds. Their basic aim is to determine current market trends and to trade on them, i.e. if the market is going up, they will go long etc. If the hedge fund is large enough it can actually influence the market to continue to trend, and this gives it a lot of power. Directional hedge funds have the most exposure to the global markets and can either be immensely profitable or hit very hard by sudden volatile fluctuations in the markets. These types of hedge funds will usually invest in any kind of asset, as long as it is trending strongly and they can make a profit out of it.

Global Macro Hedge Fund
Hedge funds which operate on a global macro strategy will trade according to events in the global economy, usually in currency, bond and equity markets. They will trade on information such as government fiscal & monetary policy, geopolitical events and much more. Global macro funds attempt to seek out global imbalances and investment opportunities and to take advantage of these inefficiencies. Due to the fact that their investments are spread throughout the world, they are susceptible to events in localities such as banking collapses, political risk etc, exchange rates etc. A famous example of a global macro fund is the Quantum Fund (run by George Soros) which forced the devaluation of the British Pound in 1992 and made over $10 billion in profit.

Event Driven Hedge Fund
Event Driven funds invest based on the likelihood of some given event occurring and then profiting out of it. For example, an event driven fund speculating on the future of the Eurozone would invest in European government bonds and a currency pair involving the Euro. A well known example of Event driven hedge funds are those which did not buy into the hype over CDOs in the mid 2000s and instead bought CDS's on those CDOs and profited massively when they defaulted, i.e. Paulson & Co. Event driven funds will invest in all kinds of events such as IPOs, scandals, mergers, wars, political turmoil etc.

Relative Value Hedge Fund
Relative Value funds are perhaps the easiest to understand and the least risky to operate. They essential engage in value investing based on fundamental analysis, i.e. buying securities which are valued incorrectly in the market and then taking their profit when the prices correct themselves. The difference between hedge funds and mutual funds when it comes to value investing is that hedge funds can also short assets that are overvalued and be more speculative through the use of derivatives, as well as investing in a far broader range of assets (i.e. real estate).

Working in Hedge Funds

Hedge funds employ a great range of different people, from equity researchers to asset managers to prop traders. Any background in finance can be used to get into a hedge fund, although experience with the markets is obviously preferred. The most common route into a hedge fund is to complete 2-3 years in an investment bank (either in IBD, trading, asset management or equity research) and then to be recruited via a headhunter into a hedge fund. Typically, trading and equity research is preferred over IBD and asset management, although it is not impossible to move.

The work you will do in a hedge fund is extremely variable and will depend entirely on the role you do. You will typically work a few hours either side of market hours (i.e. 8am to 6pm). The compensation in hedge funds also varies, with a large portion of it being based on performance bonuses (more so than in private equity or investment banking).

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