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Everyone has heard of hedge funds, but few people understand how they work and what they are used for. The short answer to the question what are hedge funds? is that they are investment vehicles that use borrowed money to make big bets on stocks, bonds, or other investments. But to really grasp how hedge funds work and why they are used, it helps to take a look at their history and the different kinds of hedge funds that exist today.

What are hedge funds?

Hedge Funds Explained

There are several different types of hedge funds, but they all share one thing in common. Instead of operating like most investment funds that simply buy stocks, bonds or other assets to achieve returns, hedge funds generally use more complex investment strategies and techniques. While many people have heard about these funds—especially in recent years—very few know what they actually are or how they work. Most hedge fund managers will not discuss their trading strategy for competitive reasons, which can make it hard to fully understand what these entities do with your money. For example, it’s not uncommon for a hedge fund manager to only disclose his holdings quarterly; some even report less frequently than that. Some funds even trade based on confidential information before making a move with investors’ money.

To understand more about hedge funds, you need to first understand their history. This innovative investment vehicle was invented in 1949 by Alfred Winslow Jones, who was working at a bank that held both commercial loans and bonds. He figured out how to combine these assets into a single fund that would offer returns on both types of investments without hedging against losses in one part or another of his portfolio. Early investors were not impressed with Mr. Jones’ approach, but after he made some substantial gains over a period from 1949-1951, it became clear that he had identified an untapped market opportunity. By 1955 there were 42 different hedge funds operating around the world; today there are thousands more with trillions of dollars under management overall.

What they do

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A hedge fund is, fundamentally, an investment vehicle. They are designed to pool investors’ money in order to invest in securities (such as stocks, bonds or real estate) or other assets (such as precious metals). That investment pool is then managed by a professional investment manager who’s tasked with doing what’s best for all parties involved. In short, hedge funds provide a lucrative avenue for both private and institutional investors looking to maximize returns. However, they also come with unique risks that investors should be aware of before entering into an agreement with a fund manager.

To attract investment funds, hedge funds typically have to register with financial authorities. Depending on where you’re located, that might be a national agency such as the Securities Exchange Commission in the U.S., or a regional agency such as Central Bank of Ireland. Once registered, investors can easily move their money from one fund to another without any complications.

Understanding a Hedge Fund Manager

Hedge fund management firms are often operated by the managers in charge of the portfolio, meaning that they are entitled to a large amount of the profits that the hedge fund makes. When entering into a hedge fund, investors cover the management fees that cover the operating expenses, as well as performance fees that are usually distributed to the owners as profit. What distinguishes hedge fund managers from other fund managers is the fact that they usually tie their own money and personal worth to the fund.

Those wishing to invest in hedge funds must meet requirements related to their income and net worth. Hedge funds may be considered risky investments, as they are aggressive and unregulated investments.

Top hedge fund managers have some of the highest-paid positions in any industry. Some of the highest-grossing managers earn close to $4 billion a year. Although some hedge fund managers may make more than others depending on their competitiveness and successes, all of them could be highly-paid in the financial industry as long as they do not fail.

Do they benefit investors?

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The answer to that question is hotly debated. Advocates point out that some hedge funds can provide portfolio diversity, act as market makers and spread risk. However, critics note they also add layers of costs, fees and other expenses that cut into net returns, not to mention higher risks (since they’re usually invested in highly volatile securities). To make things more complicated, there are two types of hedge funds — equity-based funds designed for institutional investors (which are sometimes called hedge funds) and those for wealthy individuals (also known as private equity). The bottom line is that both types have had a long history of producing disappointing returns for their investors; if you decide to invest in one, do so with caution.

Even if you don’t choose to invest in a hedge fund, you’ll still have to deal with them. Some firms choose to use them for their alternative investments, like private equity and real estate. Others may create them as subsidiaries, called limited partnerships. And hedge funds sometimes buy corporate bonds or even other stocks. For example, many index funds are owned by hedge funds — about $1 trillion worth worldwide as of late 2015 — but that doesn’t mean these index funds can escape investment risks altogether. Their returns will fluctuate along with those securities they hold; many also struggle when major markets like U.S.

Why should you invest in them?

For investors who are willing to take on additional risk, hedge funds might seem like a viable option. However, not all hedge funds are created equal. Some hedge funds might only invest in safe, large cap stocks and bonds; others are more aggressive with their investment strategies. Some hedge fund managers will buy puts on blue chip companies or even stock options, which is essentially betting against that company’s stock price to go down. Others focus on derivatives (contracts with a future value that derive their value from an underlying asset) such as oil futures or even commodities like gold or silver—which can be very risky investments given their volatility.

Each fund will list its target investments in its documentation. As a result, investors who are interested in hedge funds will need to carefully consider which ones they want to invest in. Once you have figured out which type of hedge fund is right for you, you can start researching specific funds that fit your needs. For example, if one stock goes down, other stocks in its industry might increase or vice versa (leveraging). You might look at different sectors like gold or even Bitcoin—investments that can provide a very high return when sold.

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