Three Types of Hedge Funds

Hedge funds offer higher potential gains in return for significantly higher levels of risk.

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Like holders of mutual funds, hedge fund investors pool their money in a portfolio of holdings managed by investment professionals. They are designed to achieve positive returns on principal, often using sophisticated mathematical trading strategies rather than simply investing in stocks or bonds issued by publicly traded companies. Common hedge fund strategies include income equity long-short, convertible arbitrage and fund of hedge fund.

General Characteristics

"Hedge fund" has no legal or official definition, according the Securities and Exchange Commission. Hedge funds are not required to register with the SEC and thus are unregulated. Typically they are legal partnerships, employ investment strategies that rely heavily on leverage and derivatives and have limited liquidity compared with other types of investments. Hedge fund strategies tend to have higher potential returns than more traditional funds, but the trade-off is significantly higher levels of risk.

Equity Long-Short

This strategy consists of purchasing long positions in stocks expected to appreciate in value while short-selling positions in equities expected to fall. The short position is achieved through use of futures or options, allowing the fund to sell equities it never owned and may never intend to purchase. The fund can take a neutral strategy where long positions balance shorts, or choose a long or short bias. A 120/20 strategy is one where the fund holds 120 percent long positions and 20 percent short (120 minus 20 equals 100 percent of principal), indicating a general expectation of appreciation in the investments.

Convertible Arbitrage

A fund purchases convertible securities of a company and shorts the company's common stock. Convertible securities are equities that pay higher-than-average dividends and that can be traded in for common stock after a mandatory holding period. If the stock price falls, the short position pays off. If the stock price rises, the long position pays off if the conversion price was lower than the eventual sales price. This strategy requires timing the purchase and conversion accurately to maximize return.

Funds of Hedge Funds

A more recent type of fund purchases stakes in a variety of hedge funds to create a more diversified portfolio. The component funds may all be of one strategy or may be a pool of mixed-strategy funds to spread potential risk. The manager takes on the liquidity risk in the event a fund of fund investor wants to redeem his shares, though they generally have limited redemption options, as do the underlying hedge fund investments. They have two layers of management fees: that of the fund of fund and those of the component funds.

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About the Author

Naomi Smith has been writing full-time since 2009, following a career in finance. Her fiction has been published by Loose Id and Dreamspinner Press, among others. She holds a Master of Science in financial economics from the London School of Economics and a Bachelor of Arts in political economy from the University of California, Berkeley.

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