What is a Hedge Fund, Anyway? (Part I)

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By Jeff Stoffer, CFA, CFP

Learn more about Jeff on NerdWallet’s Ask an Advisor

When a friend recently asked me this question, I realized the answer was complicated! In a way, hedge funds are similar to mutual funds – baskets of securities (stocks, bonds, cash) managed by professionals – but there the comparison faltered. A hedge fund is an alternative investment (to stocks and bonds) that can utilize a broad range of strategies and financial tools to reach its objectives. Hedge funds have greater latitude (than mutual funds) to invest in any and all markets across the globe.

What does this really mean, you may wonder. Here is a sample of self-descriptive language from a hedge fund website:

“Hedge funds are alternative investment vehicles that explicitly pursue absolute returns on their underlying investments. The term ‘hedge fund’ has come to incorporate any absolute return fund investing within the financial markets (stocks, bonds, commodities, currencies, derivatives, etc.) and/or applying non-traditional portfolio management techniques including, but not restricted to, short selling, leveraging, arbitrage, swaps, etc. …”

Perfectly clear, right?

In the second installment of this article, I will provide a more thorough, and I hope clearer, explanation of what hedge funds are and how they work. Perhaps at this point, you begin to get the picture that hedge funds operate somewhere “out there” in what may be a bit analogous to the Wild West during the gold rush days. Wide open territory, few rules or laws. Vast opportunity to seek wealth in an unconstrained atmosphere! There is some of that mentality at work in the operation of a hedge fund.

Why, then, do people invest in them, especially when they are so opaque? One very attractive feature of hedge funds is their objective of making money in all types of markets – up, down and otherwise. Thus, they are an effective diversification tool when added to a more traditional portfolio of stocks and bonds. Another benefit is that the portfolio managers usually have large personal stakes in their funds, aligning their interests with yours.

Finally, I suspect that many wealthy individuals are drawn to hedge funds because they have a certain “cache” – the price of admission is a minimum million dollar net worth to be invited to the table. In the vernacular, you must be an “accredited investor” – which presumes you are “smarter than the average bear” when it come to investing. Maybe it just means you are more capable of absorbing potential losses. More in Part II!