Introduction to Hedge Fund

Although there is no universally accepted definition ofsystematic (based upon computer models) or
the term hedge fund, the term has evolved overdiscretionary (ultimately based on a person). A hedge
time to include a multitude of skill-based investmentfund may pursue several strategies at the same
strategies with a broad range of risk and returntime, internally allocating its assets proportionately
objectives. The common element among theseacross different strategies.
strategies is the use of investment and riskHedge funds are often classified according to
management skills to seek positive returns regardlessinvestment style including following categories: relative
of market direction.value, event-driven, equity hedge funds, global asset
Hedge funds are an exciting innovation to the rangeallocators and short selling. Within each style
of professionally managed investment vehicles thatcategory, funds are then classified according to the
have brought sophisticated investment strategies andunderlying markets traded. For example, within the
a new sense of excitement to the investmentrelative value style classification, there are a number
community. They can serve as an important riskof sub-groups, including equity market neutral, fixed
management tool for investors by providing valuableincome arbitrage, convertible arbitrage, credit
portfolio diversification. One might define a hedgearbitrage and statistical arbitrage.
fund as an information-motivated fund that hedgesVarious hedge fund return opportunities stem from
away all or most sources of risk not related to thethe expanded universe of securities available to trade
price-relevant information available for speculation.and the strategies that can be employed. Funds can
Hedge funds use a wide variety of investment stylesaccess both financial and non-financial (commodity)
and strategies. Even among hedge funds that purportmarkets and can easily take long, short, spread, and
to use the same investment strategy or invest withinoption positions in any of these markets. Expanding
the same asset class, there is a wide range ofthe set of investment opportunities results in
investment activities, performance and risk levels.providing diversification benefits to a portfolio that
Because the investment activities of hedge funds arecannot be replicated through traditional stock, bond,
so diverse, the hedge funds assigned to a particularand real estate investment strategies.
investment category are likely to exhibit less similarityFor alternative investments, such as hedge funds, to
than more traditional investment vehicles, such asgrow as an investment alternative, individuals need to
registered investment companies.increase their knowledge and comfort level as to
The investment strategies are typically designed totheir use in investment portfolios. The logical
protect investment principal and engage in a varietyextension of using investment managers with
of investment techniques that include fixed incomespecialized knowledge of traditional markets to obtain
securities, convertible securities, currencies,maximum return/risk tradeoffs is to add specialized
exchange-traded futures, over-the-countermanagers who can obtain the unique returns in
derivatives, futures contracts, commodity optionsmarket conditions and types of securities not
and other non-securities investments in order togenerally available to traditional asset managers; that
generate specific risk-return profiles.is, hedge funds. In addition, investors must compare
Strategies may be designed to be market-neutralthe unique returns available to each of the hedge
(very low correlation to the overall market) orfund styles to insure that the particular style does
directional (a "bet" anticipating a specific marketnot duplicate existing investment opportunities.
movement). Selection decisions may be purely