When an investor is researching where to place their money they are often attracted to a hedge fund over other investment vehicles, such as a mutual fund, because they have the ability to yield a higher return. Nonetheless, it is important to comprehend the nature of a hedge fund before becoming involved. Even for investors that do not qualify for a hedge fund can benefit from an awareness in order to know how their pension funds function.
A good starting place is to know the difference between an investor and a speculator. An investor contributes his dollars to support a certain company. The corporation takes investment funds and purchases assets for development. After the investor picks the corporation he does so believing that good use will be made of the dollars he invests. He believes that his investment will grow as the company does. A speculator only looks to the profit on his investment. His involvement is not necessarily for the support of the continued growth of the chosen organization. If he believes a company is in trouble he might decide to sell short instead of purchase stock. Put simply, sometimes he bets that a business will lose.
Being an investor is at times regarded as more for a moral person who feels responsible to society and in general financial gain. With regards to his investment, his return will fail if the company fails. If he hedges his investment by purchasing stocks in many companies, say all in the technology market, and the technology market takes a general downturn, then he will lose again. If his stock portfolio is diversified outside of one market and a economic downturn hits, he is still set to lose. The only way that he will make money when a company, a market segment, or the entire economy crashes is if he allows a strategy of short sales. At this point, he turns into a speculator.
One kind of investment fund is often a mutual fund. An investor joins a group of other investors to pool their resources to buy shares in a fund, then a fund manager is used to manage and grow the fund by selling and buying stocks. On the speculation fund aspect you have what is called a hedge fund. Frequently you will find such institutions as pension funds plus the very wealth purchasing shares as part of a hedge fund. If a hedge fund is effectively managed it can continue to grow and even produce greater than average returns, even if the economy is down. However, the risk of a hedge fund is significantly higher. This is a good reason that the ability to participate in a hedge fund is limited to high-dollar investors who presumably are aware of the risk.
A second thing to understand about hedge funds is leverage. When you purchase stocks or other instruments for less cash than the value, this is leverage. For example, your brokerage firm might allow you to purchase $10,000 of a company’s stock for a deposit of only $5,000. This leverage is 2:1. It means that if the stock doubles for a 100% increase, you will realize a return on investment of 200%. On the other hand, if the value of the stock decreases by half, you receive a margin call, you have the possibility to lose the whole investment and the stocks can be resold. If the business does happen to fail, this safety measure would prevent you from owing $5,000. A hedge fund manager however, will be managing much higher leverages for much higher risks. This is how he acknowledges a higher return. As a participant in a hedge fund, you would be receiving a higher return at the expense of the higher risk. For that reason, choosing the proper hedge fund management for your funds is crucial.
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