The term hedge fund covers a very wide range of types and styles of fund, from high risk to low risk and from very complex to simple.
The basic principle is that the managers usually have a very high degree of autonomy and discretion concerning investment decisions.
They have a wide range of powers for making investment decisions including, for example, borrowing ('gearing') or creating completely new companies to buy and run, and hopefully later sell at a profit. It is absolutely essential that you read and fully understand the documentation concerning the specific fund in which you invest.
The term hedge fund is historic – a hedge is a financial device that allows you to protect a position if the market falls, (as in to hedge your bets). For example a UK company agreeing to pay $1,000,000 (for the sake of argument equivalent to £500,000) on a certain date next year for supplies might be worried that the pound might fall, making the supplies more expensive. So they use a hedge, they pay a small fee that allows them to buy their million dollars for no more than £550,000. They are said to have hedged their exchange rate exposure.
The original hedge funds realised that they could use various financial instruments to make money in a falling market, as well as in a rising one (so long as they made the right decisions).
Hedge funds have a degree of glamour associated with them because for many years only the very rich could invest in them, and in the days of easy credit they developed a reputation for making huge profits for their managers, and for having the financial clout to move markets.
But as with all investment – ignore the glamour, make sure you understand their record, their methods, and the risks.
The value of investments can fall as well as rise and you may not get back the amount you originally invested. Past performance is not a guide to future performance.
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