Hedge Funds are investment partnerships that strive for above average returns through active portfolio management and whose primary compensation is a percentage of the profits. Hedge Funds are capable of maintaining both long and short positions in the market. They can also use arbitrage or buy and sell the undervalued securities or deal in options or bonds. They can invest in almost any type of opportunity in any market where they expect to receive handsome returns at lower risk levels. Interestingly, protecting capital and producing good returns in all kinds of the market conditions while attempting to minimize the risk is the main motive of most of the Hedge Funds. The strategies adopted by Hedge Funds vary enormously. Several Hedge Funds want to protect the value of the Funds against downturns in the markets, which is very important today.
Hedge Funds can use approximately 14 different types of strategies. All possible strategies reflect different kinds of risk and return trade-off. For example, a macro Hedge Fund devotes its funds to both stock and bond markets. It can also invest in other investment avenues such as currencies, in anticipation of getting benefited from the major shifts in some market scenarios such as global interest rates and nations' economic policies. Again, an equity Hedge Fund can invest in international markets or may concentrate on a particular domestic market. This helps the fund to invest to Hedge against fluctuations in equity markets which can be possible by selling overvalued stocks or stock indices and buying the undervalued stock or stock indices. A relative value Hedge Fund tries to achieve a high return by exploiting the price difference or spread. It is important to understand the characteristics of various different Hedge Fund strategies to profit from a large amount of high-yielding investment avenues. Since all the Hedge Funds are not similar, their future returns, volatility, and risk can vary greatly among the different types of Hedge Fund strategies. It is quite possible that some strategies, which are not correlated to equity markets, can also produce steady returns with very low-risk of loss. It is also equally possible that with the same characteristics, other funds can show almost equal volatility similar to the mutual funds. A popular misconception about Hedge Funds is that they are volatile, use global macro strategies and place large bets on stocks, currencies, bonds, commodities or gold, while using lots of leverage. In reality, less than five percent of Hedge Funds are global macro funds. Moreover, most Hedge Funds use derivatives only for hedging purposes. Sometimes they neither use the derivatives instruments, nor any other leverage.
The Hedge Fund industry is approximately worth $300-$400 billion and contains around 4,000-5,000 active Hedge Funds, and is growing at a rate of about 20 percent per year. Most Hedge Funds are highly focused on a particular sector and heavily rely upon the specific expertise of the manager or management team. Performance of many Hedge Fund strategies is not dependent on the direction of the conventional stock and bond markets. This ensures that they are capable of performing well in a declining market scenario and not fully exposed to market risks. Many Hedge Fund strategies like arbitraging strategies, limit the amount of the capital that can be productively applied to get minimum returns.