What Does a Hedge Fund Do? (part 2)

See part 1 here

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?

Bob Rice, Managing Partner, Tangent Capital, had the second most most voted answer:

Ok, a plain English overview of hedge funds and how they impact the market:.

First, what are they? Hedge funds are collective investment pools run by an investment manager-- but with radically fewer restrictions and less regulatory oversight than, say, a traditional mutual fund. There are over a dozen major strategies/styles, but all hedge funds share two traits: they invest in relatively liquid securities (unlike private equity or venture funds, for example), and they practice very active risk management, deploying assets in a way designed to protect the overall fund against big losses... the "hedge" that provides the name.  Of course, all investment managers try to avoid losing money through diversfication and wise security selection, but hedge funds go farther, often allocating some portion of their assets to "insurance" positions that will pay off if the fund's main bets are wrong. (That is a big reason why "average" hedge fund returns often lag the stock market when it's on a tear, but almost always outperform it during down periods.)

A good example to illustrate the core idea of hedge fund style investing is this.  Assume you think Apple is the best tech stock out there, but you're woried about how the overall market will perform.  If you buy AAPL and short an equal amount of HP, you'll profit regardless of how the general stock market moves -- so long as you're right that Apple is a better choice than HP. If the overall market advances, you'll make money on your long, and lose it on your short-- but so long as Apple goes up more than HP, you'll come out ahead. The reverse is also true: if the overall market declines, you'll lose money on your long but make it on your short. So long as Apple declines by less that HP does, you'll have a net profit.

There are almost limitless versions of such "pairs" trades in every sort of liquid market (stocks, bonds, futures, currencies, derivatives, etc.) that various funds use;  and there are many other, very different styles of hedged investing that also pursue profits in ways that are intended to simultaneously limit possible losses.

Second, how do they affect the market? Hugely. There are around 8000 hedge funds with maybe $2 trillion under management.  Moreover, most use leverage to magnify the usually smallish gains that "hedged" strategies often generate.  So they're an enormous force in the world of finance.

That said, some styles have much more market impact than others. High frequency trading shops signficantly exacerbate volatility (despite claims to the contrary); global macro and distressed credit funds meaningly impact the ongoing sovereign debt crises, both directly and through the trading of credit default swaps and related derivatives.  Other styles, like activist investing, can have huge effects on specific stocks but almost none on the overall market.

So despite their common characteristics, the real takeaway is that hedge funds can be extremely different from each other, and that generalizations about them are likely to be misleading.

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