Hedge fund is a term, which in reality has no legal definition, at least in the country of its origin – the United States. This is the place that witnessed the birth of hedge funds, as well as its flourishing. This place specifies no restrictions on the scope of hedge fund operations or any direct and specific definition for that matter.
However, if you were to look for the literal implication of the term hedge fund, the answer is nothing but, “funds for investment that are used for indulging in hedging techniques”. However, this literal meaning obscures the overall picture of hedge funds. This is because it focuses on just one characteristic of hedge funds. Hedging in reality is just one among the several investment strategies executed by hedge funds.
A definition of hedge funds that is closer to reality can be stated as follows: “A hedge fund can be defined as an instrument for investment that offers a variety of risk-return profiles, in comparison with conventional investments in shares or bonds.” To get a full picture of the meaning of this definition, you must know that hedge funds employ alternative methods of investment and management tactics. Besides, there are no compulsions to meet the constraints of positive returns, as emphasized by their core mission.
Hedge funds are basically run by managers, who have taken the decision of self employment, as a way of leaving. They may come from varied working backgrounds, ranging from mutual funds, to as diverse a field as, investment banking. However, hedge funds are very different from mutual funds in general. Some instances of differences between hedge funds and mutual funds can be summarized as follows:
Mutual funds are measured in relative performance with respect to a benchmark, deviation from which is a risk. Thus, this risk is measured in correlation with the benchmark. Mutual funds are subject to market risks. Hedge funds, on the other hand, strive to generate positive returns unconditionally, irrespective of market declines. So what is more important with hedge funds is not a certain benchmark, but the most efficient investment strategy in deployment.
Protection against falling markets
Mutual funds offer no protection to portfolios from falling markets, with the exception of selling, or remaining liquid. On the contrary, hedge funds can provide positive returns on falling markets, by using hedging strategies, such as short selling. With hedge funds, what is important is not the rise or fall in markets, but the relative stock performance.
With mutual funds, the future returns depend on the market direction, in which the investment has taken place. Future returns in hedge funds can almost be said to be independent of market direction, at the time of investment.
Mutual funds are stringently regulated by authorities, and restricted in terms of portfolio composition, and instruments that are permitted to be a part of it. Besides, investors remain protected by staunch eligibility requirements on the part of the company management, liquidity, reliability, and business processes. In contrast to this, hedge funds lack tight restrictions, thereby rendering them unique characteristics, in terms of instruments used, style of management, company structure, and legal implications.
Thus, we can conclude that the hedge fund industry tends to be very diverse in nature. The industry is heavily dotted with diverse investment strategies and funds of drastically different sizes. The first of the hedge funds surfaced over a century back in time.