Hedge funds are funds that can use alternative investment strategies, such as hedging against market downturns, investing in asset classes like currencies or distressed securities, and utilizing return-boosting tools like leverage, derivatives, and arbitrage. They can be used as an alternative to the stock market for investors seeking not only capital appreciation but capital preservation. The primary goal of the majority of hedge funds is to make consistency of return, rather than magnitude.
However, not all hedge funds are created equal. Returns, stability, and risk vary between strategies. Many strategies hedge against downturns in the markets, but not all. Hedge funds are flexible in their investment options, and there are multiple strategies, including selling short (selling shares without owning them in hopes that the price will drop and the shares can be purchased at the lower price), investing in anticipation of a specific event (merger transaction, hostile takeover, bankruptcy, etc.), or trading options or derivatives (contracts whose values are based on the performance of any underlying financial asset, index, or other investment). Many strategies benefit from not being correlated to the direction of equity markets. Hedge funds are largely unregulated because they cater to more sophisticated investors. US laws require the majority of investors in a fund to be accredited, meaning they earn a certain amount of money annually and have a net worth of $1 million. Some might call them mutual funds for the Donald Trumps of this world—in other words, the super-rich.
Hedge funds are estimated to be a $2 trillion industry that is growing every year, and there are approximately 10,000 hedge funds in the US. Most are highly specialized, relying heavily on the specific expertise of the managing team. The performance of many hedge funds is not dependant on the state of global markets, especially relative value hedge funds. In contrast, conventional equity or mutual funds are usually totally exposed to market risk.
The common misconception that hedge funds are extremely volatile and unstable is based on the assumption that they all use global macro strategies and place large directional bets on stocks, bonds, commodities, currencies, and gold while using lots of leverage, when in fact most use other strategies. Less than 5% of hedge funds are global macro funds, most hedge funds either don’t use derivatives or use them only for hedging, and many don’t use leverage at all. Benefits of hedge funds include reduction of portfolio risk when added to a balanced portfolio, a wide choice of strategies for investors to meet their investment goals, higher returns and lower risk on average than traditional funds; elimination of the need to watch entrance and exit times on the market, making it a more viable long-term option; and portfolio diversification not possible with traditional investing.
Downsides to hedge funds include management and performance fees from management firms, though high water marks and hurdles help to curb these fees. They also require a large starting investment, which is why they generally are catered more to the wealthy.