Hedge funds are private investment vehicles that raise money from outside investors.

Their managers typically invest that money alongside their own money.

They do so by following a wide variety of strategies, which are often quite sophisticated.

These strategies – which we’ll touch on shortly – are one of the features that set hedge funds apart from traditional funds, such as mutual funds.

Many hedge funds seek returns even when markets generally are falling.

By contrast, many traditional funds seek relative returns or beating a benchmark. When markets are down, such funds typically see making a smaller loss than the benchmark as a good outcome.

Hedge funds may also use some borrowed money – or “leverage” – when investing and may use techniques frequently not available to traditional funds. 

The ways hedge fund managers charge clients differs from most traditional funds too.

Typically, they charge a larger annual fee as well as a share of any profits they make.

For these and other reasons, as we’ll see, hedge funds are riskier investments and are usually restricted to investors with a high net worth and sufficient understanding of the risks involved. 

Collectively, hedge funds are considered an “alternative” asset class alongside private equity and real estate.

Most hedge funds invest in the same assets as many traditional funds.

There are funds that specialize in equities, fixed income, commodities or foreign exchange. Some invest a combination of these.

The strategies they use to do so can vary a lot, however. Here are just a couple of examples.

Some seek to buy the shares of companies they believe may rise while simultaneously betting on price falls in shares in other companies.

Others focus on situations where one company is trying to take over another, perhaps buying the target and short selling (or betting against) the acquirer.

There are also funds that make a complicated combination of trades involving different kinds of securities issued by the same company. 

This might involve buying one class of a company’s bonds, selling another class of its bonds, and buying its shares while also doing a derivative trade.

A further possibility is trying to anticipate big events that others are not expecting. Big bets against a country’s currency or bonds or speculating that a certain industry might experience widespread difficulties (think US housing ahead of the 2007-09 crisis.)

Funds-of-hedge-funds are hedge funds that invest in other hedge funds. These can provide exposure to a variety of strategies with a single investment, but tend to be more expensive as there are two layers of fees to pay.

Many hedge funds deploy borrowed money or “leverage” in these strategies. The aim here is to amplify profits if their view is correct, albeit with the risk of amplified losses if they are wrong.

Just as hedge funds strategies are varied, so can be their contribution to portfolios. But some hedge fund strategies can perform well or badly at different times to equities and bonds.

So, adding such strategies to a portfolio may potentially help improve its diversification.

Other hedge fund strategies may emphasize seeking positive returns.

Hedge funds are risky investments and only suitable for qualified investors.

If a hedge fund strategy does badly, investors can lose all the money they put in, especially where leverage and/or concentrated bets are involved.

Most hedge funds are less liquid than traditional funds, with investors required to lock up their money for a length of time. And they can only reclaim it within limited windows.

As well as investment risks, hedge funds come with operational risks.

These include issues arising from how a fund is run. If it doesn’t have suitable technology, personnel or processes, investors can end up losing money for reasons that aren’t to do with investing.

Less transparency is another issue that hedge fund investors typically face. 

Whereas mutual funds are obliged to share regular information about their pricing and holdings, hedge funds typically do so much less often.

For suitable investors only, a carefully considered allocation to hedge funds could help seek returns and diversification within a portfolio.

However, rigorous research is vital before entering into any hedge fund investment. 

Thereafter, investors should continue monitoring the risks. Specialist knowledge and resources are needed here.