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What is a Hedge Funds?

Hedge Funds: High Risk, High Reward

Only twenty years ago, hedge funds were virtually unheard of by the general public. Within the past decade, however, they have become well known. This is, in part, due to the wealth of the funds. There are now thousands of funds that, by some estimates, manage around two trillion dollars among them. It is also due to the influence hedge funds are rumored to have on the global markets. Events that affect all of us, such as fluctuations in the price of oil, have been rumored to be attributable to the actions of hedge fund managers. Despite all of this influence, however, most people still aren't very clear on what exactly a hedge fund is. Thus, for the average investor or just interested citizen, we'll answer the question: what is a hedge funds?

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Hedge funds are collective investment programs that in some ways resemble mutual funds. Investors turn their money over to a fund manager, who then invests it in a variety of different securities. Hedge funds will deal with both highly liquid and relatively illiquid securities. While the idea behind hedge funds and mutual funds is the same, the structure and results tend to be very different.

Perhaps the most striking difference between mutual funds and hedge funds is the return. Mutual funds are marketed on how reliable their returns end up being. Hedge funds make no such claims. Part of the reason for this is that hedge funds cannot advertise. Hedge funds are organized as private investment partnerships and thus cannot market themselves to the general public. Another reason, however, is that their returns tend to be somewhat irregular. Investors in hedge funds aren't often looking for slow, steady returns. Instead they are looking for a one-time, huge return.

This type of event is exactly what made hedge funds popular in the 1980s. Hedge fund management companies during this decade amassed multi-billion dollar profiles, an amount that was unheard of at the time. Investors began to see hedge funds as a high risk, high reward investment.

This characterization is pretty accurate. Hedge funds are risky and they are not open to investment to the general public. Only accredited investors, big charities, banks, some corporations, or insurance companies (all organizations that can manage the risk) can invest in hedge funds.

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To get these potentially large returns, hedge funds use investment tactics that are legal, yet underused by the mutual fund industry. They include short-selling, leverage, and using derivatives (e.g. options and futures). Most mutual funds will simply buy stocks and bonds, avoiding these more exotic investment options. This makes them a surer bet, but limits their return potential.

The fast and loose nature of hedge fund investing has given the public the idea that hedge funds represent a "wild wild west" realm of investing that only a select few investors get to see. The incredible success stories of some hedge fund investors add to this aura. The truth is that these success stories are the exception, however, not the rule. Still, when thinking about what is a hedge funds it's difficult to ignore the awesome earning potential they represent.