The investment experts at SEI released a survey in January showing that 38 percent of institutional investors (such as those managing pension and retirement funds) plan to increase their investments in hedge funds in the next year. That’s a big increase that can affect the retirement of many individuals across the United States – which makes it important that you understand what a hedge fund is and how it generates a return.

What Is a Hedge Fund?

A hedge fund is an investment similar to a mutual fund in that it pools all investments made into it (minus fees) and then uses those funds to buy underlying assets for the fund. While the mechanics of the two funds are similar, the hedge fund’s focus on investing in hedging strategies makes them very different from the mutual fund, which focuses on going long on individual stocks or bonds. The fact that the hedge fund focuses on sophisticated hedging strategies to reduce the risk of loss makes it suitable for experienced and high-net-worth investors.

Some of the strategies that hedge fund managers employ to hedge against loss include the following:

  • Investing in put options:

    “Put options” are agreements that allow you to sell your positions at a certain price within a certain time frame, even if that price is above market value. A hedge fund may buy put options for a stock that the fund manager thinks will lose market value within the option dates. If the hedge fund owns that stock, this secures a minimum sale price. If not, the manager can buy the stock for the cheaper price in the market and then sell it through the put contract for a profit.

  • Investing in call options:

    Like a put, a “call option” gives investors a guaranteed price at which they can buy a stock within a set time frame – even if the market value exceeds that price. Hedge fund managers buy call options in order to secure what they feel is a low price for a stock whose price, they think, will increase exponentially. This allows them to exercise the call option and obtain the stock for less than market value, then immediately sell it in the open market to realize the gain.

Hedge fund managers may also focus on global economics, emerging markets, market trends and other strategies when making investment decisions. Because of the wide range of underlying investments in a hedge fund, investors are allowed to buy and sell ownership in a fund based on its net asset value (NAV), which is the value of its underlying investments minus its liabilities.

As with mutual funds, the manager is one of the most important tools the hedge fund has. This individual must not only have innovative strategies for investing and hedging but also be able to study the market and accurately anticipate future movements.

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