What Does a Hedge Fund Do? (part 3)

See part 1 here
See part 2 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?

Balaji Viswanathan, Cofounder Fin/Tech startup has the third most voted answer:

Andrei Kolodovski and Bob Rice have already given great answers. I will add a few more points to give a little more background.

What are funds?
You must have already heard of a number of funds - Mutual Funds, Exchanged Traded Funds, Money Market Funds, Pension Funds etc.

A fund is a pool of investor money that is managed by a professional. The professional is responsible for finding investments that suit the funds objective. The profits from the investments are shared among those who have contributed to the pool of money. The professional fund manager is then compensated with a share of the money for his/her time & efforts.

The advantages of funds are:

1. Individuals don't have to worry about the various intricacies of investing. The finer details and executions are handled by the fund managers, while you can focus on the broad level direction of your portfolio.
2. They are quite efficient. For instance, if you want to have diverse range of investments you will pay a lot in trading fees for buying and selling each thing. The fund manager however can do this in "wholesale" and get cheaper rates.

Read more about: Collective investment scheme

What are hedge funds?
Due to various scams in 1920s and 1930s, US fund industry is strong regulated (Investment Company Act of 1940). Since, common people invest their life savings in these funds, US government acts like a nanny to protect these small investors interests. There are various safety measures, such as better disclosure on the type of investments made and restrictions on the use of advanced trading tools such as short selling, the use of derivatives.

Although these restrictions protect the common investors, these also limit the potential returns for investors with a high tolerance for risk. In 1950s, a new type of fund was introduced (and become quite popular since 1980s) that were suited for the wealthy investors with a high level of risk tolerance. These are the hedge funds.

Hedge funds working
Hedge funds have utmost flexibility when it comes to what they will invest in and how they will manage the disclosure. However, these funds are restricted on the number and type of investors they could take, so that these funds don't become a tool for scammers.

The investors in an hedge fund need to be accredited (ones with $200K or more in annual income) and the total number of investors have to be less than 500. The hedge fund managers are typically top of the crop and use a wide array of technical tools. Thus, these people are better compensated. The industry standard is 2 & 20 - 2% of the total fund value and 20% of the annual profits go to the fund manager as fees. This is extremely generous compared to the compensations of a regular mutual fund manager whose life goes like the one in "Groundhog's day".

Hedge funds typically take unorthodox positions that a mutual fund manager would not typically take. These include:

1. Arbitrage: Identifying patterns that result in temporary mispricing in the market and get on to it before somebody else could find.
2. High speed trading during events. They use very advanced data analysis tools to make a trade milliseconds after the occurrence of an important event such as an interest rate change or a merger announcement.
3. Distressed investments. They work like vultures identifying the dead carcasses and find an investment that no mainstream investor would touch.
4. Short selling a stock. This way you could benefit in a market that is falling. There are plenty of advanced strategies one could construct with this.
5. Use of derivatives. This allows a more fine grained management of risk.
6. Alternative investments. These could include oil, precious metals, silver mines, small-cap in BRIC markets and so on.
7. Strong focus on timing. Hedge funds use lot of quantitative tools to precisely time their entry and exit.

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