Characteristics of Hedge Funds

Hedge Funds are commonly referred to as "absolute return strategies", which means that many are designed to seek positive returns in most market conditions. Compared with traditional portfolios consisting only stocks and bonds, portfolios that have included Hedge Funds have given higher returns at similar levels of risk. They have now emerged as an alternative asset class of investment for investors.

Hedge Funds as separate assets class have many distinctive characteristics compared to other forms of traditional and alternative investment options. They seek to offer attractive returns with low volatility, which are less correlated to market scenario, and provide benefits of portfolio diversification with investment in various financial instruments.

Some of the distinctive characteristics of Hedge Funds are discussed below:

• Generally, a Hedge Fund is organized as a limited partnership. This structure aligns the Hedge Fund manager's interest with those of investors and encourages the former to seek to achieve substantial returns for the investors in order to maximize his own revenue.
• A Hedge Fund generally uses several kinds of financial instruments to reduce risk and to add more returns. It also intends to reduce the correlation with equity and fixed income markets. Because of this reason, many Hedge Funds can use short selling, leverage, derivatives such as puts, calls, options, futures, etc., to accomplish their goal.
• Unlike others, which typically employ ‘buy-and-hold' strategies, Hedge Funds often employ dynamic trading strategies. This involves frequent change of stances in different asset markets i.e., attempt to identify mispricings between securities or take positions based on their ‘view' on the direction of asset price movements or volatility, or have significant asymmetric exposure to several markets at the same time.
• Highly skilled, specialized and experienced Fund managers generally manage Hedge Funds. Typically, Hedge Fund managers' compensation is linked to their overall performance. This stimulates the Fund managers to deliver their best and also attract the best brains in the investment business.
• Performance of many Hedge Fund strategies is independent of the direction of the bond or equity markets unlike conventional equity or mutual Fund schemes, which are generally 100 percent exposed to market risk. Various statistical analyses on Hedge Fund investment styles show that returns from Hedge Fund strategies are less correlated with the returns on major asset classes and mutual Funds.
• Hedge Funds put high investment floor limit on investors to qualify for Fund ownerships. Therefore, most investors of Hedge Funds are institutional investors and high net worth individuals. They invest in Hedge Funds to diversify portfolio, minimize risk and enhance returns.
• Hedge Funds are relatively illiquid investments. Investors have to commit Funds with a specified lockout period on investments, which could range from 12 months to 3 years; after that, they are allowed to redeem according to the terms of redemption.
• Hedge Funds use leverage positions to maximize their returns without employing full capital. Generally, they use derivative instruments that require paying margin or use of bank borrowings to purchase securities. These allow them to avoid full capital investment while still gaining high exposure on the investment.
• Lack of transparency is a major drawback in Hedge Funds. This is due to the legal structure of Hedge Funds (as limited partnership) or registration as offshore funds that barred them from disclosing their information related to fund activities and financial reporting.
• There are hardly any directions on regulating Hedge Funds in the world; so they are under few obligations to disclose information.