Hedge funds are one of the most misunderstood investment vehicles out there. People think they're only for the super-rich, that they're risky and secretive, and that you need a Harvard MBA to understand them.
None of that is true. Hedge funds are pretty simple: they're just pooled investments actively managed to generate returns.
Strategies such as leveraging or trading alternative assets give hedge fund managers the potential to generate higher returns than traditional investment vehicles. And while there is certainly risk involved, the idea of "hedging" is to protect against downside risk while still being able to participate in the market upside.
What are the types of hedge funds?
The first step is understanding the different types of hedge fund strategies. There are dozens of different approaches that hedge fund managers can employ, but they can broadly be grouped into four main categories:
- Equity hedge funds
- Macro hedge funds
- Relative value hedge funds
- Activist hedge funds
Equity hedge
Global or country-specific, long or short, large cap or small cap… there are many different equity hedge fund strategies. But at the end of the day, they all share one common goal: to profit from stock price movements.
This can be done by taking long positions in stocks that are expected to rise in price or by taking short positions in stocks that are expected to fall in price.
A recent Goldman Sachs report shows that "the average equity hedge fund has returned -9% year-to-date," relative to, at the time, a nearly 20% decline for the S&P 500 Index.
Macro hedge fund
Macro hedge funds bet on global economic trends. They try to profit from political or economic events causing changes in interest rates, currency exchange rates, commodity prices, etc.
Graham Capital Management LP is an $18.6 billion macro hedge fund firm. Its five most significant funds returned 32.77%, 21.82%, 46.93%, 19.82%, and 29.77% year-to-date.
Those are impressive returns, and they've been buoyed by a volatile year in which the war in Ukraine, red-hot inflation, and Fed rate hikes have fueled market uncertainty.
Relative value hedge fund
Relative value hedge funds aim to exploit temporary differences in the prices of related financial instruments. The strategy is often used in tandem with other strategies, such as event-driven or merger arbitrage.
Arbitrage funds seek to profit from temporary imbalances in the price of related securities. For example, a fund might buy shares of Company A and sell short shares of Company B, betting that the spread between the two will narrow.
Event-driven strategies seek to profit from corporate events, such as mergers, restructurings, or bankruptcies. The idea is to buy shares of a company that is the target of a takeover bid or to purchase a company's debt in bankruptcy proceedings.
Activist hedge fund
These hedge funds focus on taking activist positions in companies to try to generate returns. The strategy can involve anything from campaigning for changes in corporate governance to pushing for the sale of a company.
Hedge funds vs. private equity funds
Both hedge funds and private equity funds are typically only available for accredited investors. To be an accredited investor, one must have a net worth of over $1 million or an annual income of more than $200,000.
Hedge funds seek to generate alpha through the active management of securities, while private equity funds invest directly in private companies.
Hedge funds are more liquid than private equity, meaning investors can access their money more efficiently. Private equity is an illiquid investment, typically requiring a seven to ten-year commitment.
Hedge funds vs. mutual funds
Mutual funds like $UXPSC or $OEPSX are similar to hedge funds in that they are a pool of investments that is actively managed.
The critical difference is that mutual funds are publicly traded on stock exchanges, with daily liquidity. On the other hand, hedge funds are not traded on exchanges and can have much longer investment horizons.
Hedge funds typically have higher fees than mutual funds, but they also have the potential to generate higher returns.
Ultimately, whether or not a hedge fund is right for you depends on your investment goals and risk tolerance. If you're looking for higher returns than traditional investment vehicles can offer, but are comfortable with the added risk, then a hedge fund may be worth considering.