Investing for Dummies, 4th UK Edition

Part III

Collective Investments and Pension Funds

Defining Hedge Funds

Strictly speaking, the term hedge fund only refers to a specialised legal structure. A hedge fund is a private-partnership contract where the manager has a substantial personal interest in the fund and is free to operate in a variety of markets using a number of strategies. Think of a hedge fund as giving investors’ money to a manager who has unfettered freedom to invest in areas other funds can’t reach. These freedoms include the ability to

• Be flexible. Most hedge-fund managers can do what they like within wide parameters. They’re not restricted by trust deeds to a narrow range of equities or bonds like traditional collectives, although some have stated strategies that limit their scope.
• Go short. Ordinary fund managers only select shares they think will do well and hence go up, a technique known as going long. Hedge-fund managers can also choose equities they think will sink, making money as the shares fall, a technique known as going short or short selling. If hedge-fund managers see a company in serious trouble, they can take a one-way bet on the shares going down to zero. When other investors see hedge funds attacking the company in this way, they sell as well, putting extra pressure on the share price.
• Employ derivatives, such as futures, options and some very exotic bets on interest rates, currencies and even volatility, which is the speed with which an investment moves up or down. Stacks of strategies ...