What are hedge funds?

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Hedge funds can offer bigger returns than other types of investments, but they also entail a high risk. Hedge funds are formed as a private limited partnership containing a group of accredited investors. Discover how hedge funds work, what strategies are used by fund managers, and find out about their advantages and disadvantages.

Hedge funds belong to the alternative investment funds. They operate with the money of private investors in the form of a limited partnership. The money of the investors is pooled and managed by professional fund managers, who use a variety of strategies, such as leverage (borrowed money) and asset trading, to earn high investment returns. Hedge funds are not an asset class of their own. Hedge fund investments are often considered very risky.

There are many different types of hedge funds. These are the most common ones:

• Global macro hedge funds: They use a top-down investment approach and often trade in global markets. This means hedge funds take large positions in financial markets based on macroeconomic trends, such as interest rates, currency movements, or geopolitical events.
• Relative value hedge funds: These funds aim to exploit short-term pricing inefficiencies between related securities.
• Activist hedge funds: These funds are used to invest in a business. Investors take actions such as demanding to cut costs, restructure assets, or change the board of directors in order to boost the stock price of the business.
• Equity hedge funds: These funds invest in lucrative stock, while hedging against downturns in equity markets by shorting overvalued stock or stock indices. These funds can be global or specific to one country.

The Maples Group and Dillon Eustace are two specialised hedge fund service providers based in Ireland. They provide structuring, management, and compliance services to international hedge funds looking to domicile in Ireland. The most prominent hedge funds operating in Ireland include:

• AQR Capital Management: This global investment management company has set up multiple funds, including hedge funds, in Ireland through its Irish UCITS fund umbrella.
• Man Group: Globally, this is one of the largest publicly traded hedge fund companies. Man Group has also a significant presence in Ireland, offering different strategies.
• Citadel: They operate several funds out of Ireland, taking advantage of the country’s favourable regulatory environment. Citadel is a well-known U.S.-based hedge fund.

Hedge funds accept money from their clients, including wealthy individuals, companies, and corporate pensions funds. This money is then invested in financial markets. Hedge fund investing is usually linked with a high level of risk. As a result, hedge funds can generate big returns and profits, but also huge losses. One of the reasons why hedge funds are able to take these high risks is that they are not as regulated as other parts of the financial markets.

To receive these higher returns, hedge fund managers use more aggressive investment strategies. These include:

• Derivatives: These are financial contracts whose value is based on the price of an underlying asset, e.g. a share or commodity, and which are used to hedge risks or speculate on price movements.
• Leverage: To increase the size of an investment, investors borrow additional money. The aim of the leverage strategy is to amplify potential returns, however, it also significantly increases the risk of losses.
• Short positions: Using this strategy means borrowing and selling a security that is expected to decrease in price. The goal is to buy it back later at a lower price to make a profit.

Hedge fund strategies differ depending on the type of hedge fund. Generally, they cover a wide range of risk tolerance and investment strategies. They also involve numerous investments, such as debt and equity securities, commodities, currencies, derivatives, and property.

The investment style of the hedge fund manager classifies the hedge fund strategy. The most commonly used strategies by hedge fund managers are:

• Long/short hedge fund strategy: It involves buying stocks expected to go up (long positions) and betting against stocks expected to go down (short positions), aiming to make money whether the market rises or falls.
• Fixed-income hedge fund strategy: Investors try to make money by taking advantage of small differences in the prices of bonds or loans, often betting on changes in interest rates to increase profits.
• Event-driven hedge fund strategy: It takes advantage of short-term stock mispricing and other pricing inefficiencies caused by a corporate event such as a merger, acquisition, or bankruptcy.

Before investing in hedge funds, it is essential to check the advantages and disadvantages:

Not everyone can invest in hedge funds. Hedge funds operate with complex strategies and are connected with a relatively high risk in most cases. This is the reason why hedge funds are limited to accredited investors, qualified purchases, and institutional investors. They must all meet certain criteria to be able to invest in a hedge fund, including a specific income, net worth, or asset thresholds set by regulatory bodies.

A mutual fund is in many regards similar to a hedge fund, for example, both funds operate with money that is pooled together from different investors. However, there are some key differences between hedge funds and mutual funds, which you should consider before investing.

• While hedge funds are only accessible to accredited investors, mutual funds are available to everyone.
• Hedge funds offer more possibilities when it comes to investments. They allow you to invest in a range of assets, such as property, derivatives and currencies, while mutual funds usually only invest in stocks and bonds.
• The applied fees are different. Typically, for a hedge fund, you need to pay a management fee between 1-2% and a 20% performance fee. A mutual fund only charges a fee of around 0.4% instead.
• A hedge fund is often locked up, which means that investors don’t have access to their money at all times. A mutual fund allows investors to withdraw money at any time.

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