A hedge fund is simply one of the many types of investment funds where different investors pool money and invest together. Hedge funds refer to specific funds that are allowed to undertake more risky and/or broader investment activities.
Function
Hedge funds are limited to a specific range of investors, those allowed by regulators to undertake wider trading activities. This means that hedge funds are attractive to wealthy investors and can therefore bring together large sums of money into huge purchasing pools.
Types
Hedge funds are named from the 'hedging' that the fund managers engage in to try to eliminate some of the high levels of risk associated with more diverse investments. However, not all types of hedge funds engage in this activity. Each fund has its own strategy and is attractive to different investors.
Considerations
By limiting their availability, typically to wealthy investors, hedge funds become exempt from certain regulations, especially those governing derivative contracts, fee structure, short selling and the liquidity of hedge fund interests. This makes hedge funds more rewarding and also more risky.
Hedging
When a firm 'hedges' their position, they take a position counter to one they own currently. The hedge can either lose money or gain money, based on whether the difference between the price for the hedge and the market price widens or narrows. Hedging can sometimes help to reduce risk but can also be used to increase potential gain and therefore risk.
Significance
The value of hedge funds can run into the billions of dollars, and the purchasing power is even higher than the net asset value because of leveraging. It is no surprise, then, that hedge funds have come to dominate certain markets such as high-yield derivatives and toxic debt. This may be create financial problems in the future, because even though 'hedging' is designed to reduce risk, most hedge funds are riskier than more regulated types of investment funds.
