The term “hedge fund” was originally coined due the fact that managers would try to hedge the funds against risk in the market by taking both long and short positions. However, risk is almost impossible to avoid in today’s volatile economy, though hedge fund managers do try to use various risk control tactics.
There are so many different strategies employed by by hedge fund managers, that the term “hedge” does not always apply. While some hedge funds are more risky than others, managers try to purvey the risks to investors, so they are fully aware what they are getting into.
There are many cases, however, where investors feel like managers weren’t being upfront with them about the inherent risks, like in the Bear Stearns case for example.
According to the Hedge Fund Association, there are 14 different common hedge-fund strategies, each with varying degrees of risk. The riskiest funds rely on market timing, investment in emerging markets with volatile growth, and short selling, which anticipates the future decline of a price of stock. Taking long/short positions and betting on both sides of events such as mergers, acquisitions and buyouts is thought to be a much more conservative strategy, along with investments in funds of funds.
Another popular hedge fund strategy that has increased dramatically in popularity due to its complete lack of correlation to the market, is asset-based lending. Since hedge funds that employ this type of strategy make their money off high interest payments from borrowers of their loans, the risk is more associated with defaulting by the borrowers, as opposed to volatility in the marketplace.
According to Citigroup, 93% of the return variance of equity non-hedge strategies could be explained by specific market factors. As for bond strategies, 24% of the performance moves among fixed-income arbitrage managers came from long-only market factors.
One of the riskiest strategies used by hedge fund managers that has caused a handful of funds to implode is the use of heavy leverage backed by subprime mortgages. Many hedge fund managers did not predict that a number of these homeowners who had these types of mortgages would default, causing the bonds backed by them to plummet in value. Hedge funds like ones run by Bear Stearns and Drake Management lost billions of dollars resulting from the subprime mortgage crisis.
Let’s face it. If hedge funds had no risk attached to them, everybody would be throwing their money in. And you can’t reap rewards without taking a risk. This is why there are strict guidelines in place as to who may invest in hedge funds. Only accredited investors and qualified clients can place their money in hedge funds, since they are thought to be more educated than the typical investor and more aware of the risks involved.
These investors also must have a high net worth because there is a chance they may lose their entire investment. For investors who choose to pursue high returns in a short period of time, generally, there is more risk involved because the bets are higher. This is one of the staples of hedge funds, however. If investors wanted to take a more long-term approach, they may choose to invest in private equity or a mutual fund.