Too embarrassed to ask: what is a hedge fund?

Hedge funds are often portrayed as shadowy institutions pulling the strings of the financial markets. But in reality, they are just like any other investment fund.

Hedge funds have a certain mystique about them. No one entirely seems to understand what they do, but the newspapers unfailingly turn to the term “hedge funds” as soon as anything complicated or with geopolitical implications happens in financial markets. They’re the renegades of the financial world. They operate in the shadows. They are the puppet masters of the global economy. 

This reputation is almost entirely nonsense. It’s a carefully curated image whose main function is to help hedge funds to justify the significantly higher fees that they charge their investors.  This is similar to the same way that banks once had opulently decorated branches in order to project a sense of solidity, and thus win the trust of potential customers. It’s a form of branding. 

So what’s the reality? Hedge funds are just like any other fund. A manager pools money from a number of investors, and invests it on their behalf. There are two main differences. The one we’ve already mentioned is that hedge funds charge very high fees. The other is that these funds are not open to your average private investors. They’ll typically require minimum investments of upwards of £100,000 or more. This is because hedge funds tend to use more exotic investment strategies that financial regulators deem too risky for ordinary investors. 

One of the most obvious examples of such a strategy is short-selling. Short-selling involves betting on share prices going down rather than up, which we covered in more detail in an earlier video in this series. Short-selling is a valid strategy and one that can be useful in uncovering fraudulent or badly run companies. But the potential losses are technically unlimited – hence the restrictions on using it in funds that are aimed at small investors.

The other thing that hedge funds have in common with normal actively-managed funds is that most of them struggle to beat the market over time. Hedge fund managers would argue that they are not there to beat any underlying index, but rather to diversify a portfolio by offering protection in bear markets or extreme events. However, there are arguably easier and cheaper ways to secure such diversification for most people. 

To learn more about investing in funds, subscribe to MoneyWeek magazine.

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