What Does a Hedge Fund Do? (part 1)

From quora.com, op asked this question:

I don't understand what hedge funds do (their impact on the market and what managers do in the company). Could someone give a layman's explanation?

Andrei Kolodovski, Managing Partner, TRIZ Fund, had this top voted answer:

A Hedge Fund is a type of Investment Partnership.

If you want to co-invest with other people, you need an entity that can combine your capitals. Depending on what this entity invests into, and who is allowed to join it, you get various types of investment partnerships.

The most common type of investment partnerships is Mutual Funds. They invest in publicly traded securities (stocks & bonds), and anyone is allowed to join. To protect general public investors, Mutual Funds are heavily regulated and restricted in what they can invest into.

Hedge Fund is an investment partnership restricted to "sophisticated investors" - people who have enough experience to protect themselves. Hedge Funds are not allowed to accept capital from general public; in exchange, they don't have restrictions on what they can invest into.

This diagram shows the key difference:

Fund managers are the partners designated to make investments and manage the partnership; for their work they receive compensation. Unlike Mutual Fund managers who can take only fixed fees, Hedge Fund managers also receive share of fund profits as a performance incentive. Profit sharing aligns interests of managing partners and investors better, and attracts top talent to Hedge Funds.

Since Hedge Funds don't have any restrictions on the investment side, they use many various strategies, such as:

• Distressed Securities (investing in companies in difficult situations)
• Emerging Markets (investing in developing countries like India, China)
• Market Neutral (making portfolio insensitive to market fluctuations)
• Equity Long/Short (buying good/cheap and shorting bad/expensive stocks)
• Event Driven (exploiting inefficiency around mergers and other events)
• Global Macro (investing in global economic trends)

This is how the world of Hedge Funds looks today:

Hedge Funds impact on the market and economy depends on their strategy. Overall, they perform several useful economic functions:

1. Allocate capital between productive and unproductive companies;
2. Make markets more transparent and efficient via deep research & arbitrage;
3. Improve market liquidity via trading (make it easier to buy & sell for others).

Some famous Hedge Funds:

• Buffett  Partnership: Equity Long/Short Fund managed by Warren Buffett.  Returned 29.5% per year from 1957 to 1969
• Quantum Fund: Global Macro Fund managed by George Soros, famous for "breaking" the Bank of England. Returned 30% per year from 1968 to 2000

https://www.quora.com/Hedge-Funds/What-does-a-hedge-fund-do

See part 2 here
See part 3 here