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.

Recommended

Shareholder capitalism: the world’s most powerful asset manager wants you to have your say
ESG investing

Shareholder capitalism: the world’s most powerful asset manager wants you to have your say

Under shareholder capitalism, the owners of the companies the big fund managers invest in are us – and our voice is rarely heard. Now one asset manage…
26 Jan 2022
Julian Brigden: markets are at a huge inflexion point
Investment strategy

Julian Brigden: markets are at a huge inflexion point

Merryn talks to Julian Brigden of Macro Intelligence 2 Partners about the unwinding of the US stockmarket's super-bubble, and the risks and opportunit…
25 Jan 2022
Has growth investing had its day? Don’t be so sure
Growth investing

Has growth investing had its day? Don’t be so sure

Markets – and “jam tomorrow” growth stocks in particular – continue to crash, with some analysts forecasting a 50% drop or more. But, says Max King, a…
25 Jan 2022
A cheap investment trust with a good record
Investment trusts

A cheap investment trust with a good record

This cheap investment trust’s yield of almost 9% may look too good to be true, but should be sustainable, says Max King.
25 Jan 2022

Most Popular

Shareholder capitalism: why we must return power to listed companies’ ultimate owners
Investment strategy

Shareholder capitalism: why we must return power to listed companies’ ultimate owners

Under our system of shareholder capitalism it's not fund managers, it‘s the individual investors – the company's ultimate owners – who should be telli…
24 Jan 2022
Three innovative Asian stocks to buy now
Share tips

Three innovative Asian stocks to buy now

Professional investor Fay Ren of the Cerno Pacific Fund highlights three of her favourite Asian stocks to buy now
24 Jan 2022
Ask for a pay rise – everyone else is
Inflation

Ask for a pay rise – everyone else is

As inflation bites and the labour market remains tight, many of the nation's employees are asking for a pay rise. Merryn Somerset Webb explains why yo…
17 Jan 2022