If you’re learning about finance and finding yourself interested in wealth accumulation, you may want to know what a hedge fund is. This type of investment package is a pooled collection of stocks, bonds, commodities, real estate, derivatives or debt, and it’s similar in structure to a mutual fund. However, in contrast to mutual funds, hedge funds are given a great deal of flexibility by the Securities and Exchange Commission in terms of investment strategies, according to Investment Law Group.
How Hedge Funds Make Money
Hedge funds are able to invest millions of dollars of their clients’ money in securities using an investment strategy called leverage, which allows them to invest several times the amount of the fund’s available assets. Leverage is sort of like taking out a mortgage on a piece of property that you want to buy and then resell for a profit. Many alternative markets, such as the Foreign Exchange markets, allow traders to enter positions using leverage to give themselves greater exposure than they could have as small-scale individual investors. However, hedge funds are by no means small-scale; recent estimates put the total size of the hedge fund industry at around $2 trillion.
With this kind of investing power, hedge funds are able to earn massive returns by leveraging their initial capital investments. The down side of these huge earnings is that investors’ money is put at greater risk than the money invested in more regulated types of funds. In general, though, hedge funds make a lot more money than they lose, and there is a good reason for this success. Although hedge funds are largely unregulated and given the freedom to take big risks, the managers of these funds earn part of their money through investments in the funds they manage. As a result, they have a vested interest in making money for their investors. While a mutual fund manager has a job similar to that of a hedge fund manager, investors in mutual funds often feel cheated when part of their investment pays the salary of a poorly performing fund manager.
Who Can Invest in Hedge Funds?
Another big difference between hedge funds and mutual funds is that only accredited investors can buy shares in a hedge fund, according to U.S. law. The SEC defines an accredited investor as someone with at least $1 million in assets as well as advanced financial knowledge. The investor’s net assets don’t include his or her property, in this case. Because only the financial elite are allowed to invest in hedge funds, most investors are large organizations with considerable resources. They’re drawn to this type of investment vehicle because it’s professionally managed and offers relatively high returns.
Due to inflation and the opportunity cost of saving, a corporation will actually lose money if it doesn’t invest its assets. Conventional investments such as stocks, bonds and real estate require financial managers to plan asset allocation and ensure that investments make money. Whether they manage investments internally or outsource this job to a hedge fund, the cost is the same.
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There is nothing unusual about the way hedge funds earn money by trading securities, but the financial wizards who run them have more knowledge than the average investor. Over the years, they’ve gained and lost billions of dollars of investors’ money. If you’re interested in a career in finance, it’s good to understand what a hedge fund is.
