Hedge fund is a corporate term for different types of investment fund. In 1949, the first hedge fund is created in America. Hedge fund can take both short and long positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and also invest in any opportunity in any market that foresees there would be significant gains at reduced risk in the future. Hedge fund is a structure, not a strategy. There are various strategies of hedge fund with differences between them because all hedge funds are not the same.
Hedge funds can be distinguished from mutual funds by a number of key characteristic. Different financial instruments are used by hedge funds to reduce risk, increase returns and minimize the correlation with equity and bond markets. Compare to mutual funds, hedge funds normally have more flexible investment strategies and are more flexible in their investment options, such as using short selling and derivatives which include puts, calls and options etc, and can also decide to have a higher level of leverage. Many hedge funds can deliver returns which are not correlated to any market and aim to have absolute or positive targets that are not correlated to the development of the market while mutual funds aim to have relative return in the results of the fund compared with an index.
The structure of fee in hedge funds and that in mutual funds are also different. Hedge fund managers usually invest their own money in their fund. Mutual funds only have a management fee which is a few per cent of managed capital while hedge funds normally have a fixed fee which is around two per cent of the managed capital and a variable fee which is around 20 per cent of any earnings lower and higher than the return target. When a variable fee is charged only if the value of funds is larger than its previous top value, some hedge funds would set a limit for when the variable fee may be levied. Most hedge funds are primarily intended to be managed by investment professionals who are experienced or financially strong individuals. One of the key characteristics of hedge funds is that it only allows investors to withdraw their money from the fund on a monthly or quarterly basis while mutual funds can provide liquidity on a daily basis. This can improve investments when there are less liquid assets.
There are around 14 unique investment strategies of hedge funds and there are differences between them because all hedge funds are not the same. Many hedge funds protect their investments against losses and downturns in markets, but this does not apply to all of them. For example, some hedge fund strategies which are not related to equity markets can transfer similar returns with a very low risk of loss, while others may be as or more volatile than mutual funds. And the hedge fund strategies are also including selling short, using arbitrage, trading options or derivatives, investing in anticipation of a specific event and investing in deeply discounted securities etc. For example, short selling strategy means selling shares but not holding them and expecting to buy them back at a lower price in the future. Among the various hedge fund strategies, there are huge differences in investment returns, volatility, and risk. Reducing volatility and risk are the targets of most hedge funds when they are trying to keep capital and transfer absolute or positive returns under all market conditions.
Strömqvist (2008) and ECB (2007) show that the hedge fund market has developed dramatically between 1996 and 2007. Around 2000 Hedge funds managed about USD 135 billion dollars in 1996 and the figures were increased to 10000 and USD 2000 billion in the end of 2007 (see Figure 1). In this period, not only hedge funds have grown in size, but also numbers of strategies used has changed.
Hedge funds can affect financial markets positively or negatively and perform two functions on the financial markets. Firstly, liquidity in the financial market can be improved by hedge funds. When there is a higher liquidity in the financial market, pricing should be more effective. Compare to other investors, hedge funds would like to buy or sell more assets and they can invest in markets and instruments with less liquidity while mutual funds cannot. Moreover, hedge funds usually play an important role in new markets. Liquidity in the financial market can therefore be increased. Secondly, hedge fund can use arbitrage strategy to let managers achieve in mispricing. Investors should purchase undervalued assets and then sell overvalued assets out, so that prices can be balanced and also can be shifted closely to fundamental values. As a result, the market can be more effective by improving pricing.
However, there are also some negative effects occurred by hedge funds on financial market. It may occur higher risks due to the flexibility. For example, a higher level of leverage can produce larger profits, but risks can also be increased. If a wrong investment is applied, hedge fund will collapse. And also, the use of borrowing and of derivatives can have effects on financial market.
There are several events happened in financial markets in the period 2007-2009. The financial crisis of 2007-2009 is caused by a liquidity shortfall in the United States banking system and it has resulted in the collapse of large financial institutions, the "bail out" of banks by national governments and downturns in stock markets around the world. For examples, Bear Sterns' hedge funds collapsed in the beginning of 2007 and these funds had highly leveraged portfolios with credit instruments related to the US market for housing bonds; Lehman Brothers Holdings Inc which was a global financial-services firm declared bankruptcy in 2008; the Icelandic banking sector collapsed and hedge funds are accused of speculating against the currency and the economy in Iceland (Affärsvärlden, 31 March 2008) etc.
The financial crisis 2007-2009 has affected hedge funds more than they have affected the crisis while there are still lack of evidences to show that the crisis is caused by hedge funds . Hedge funds had poorer returns due to the financial crisis. According to the changes in regulations to manage the financial market in 2008, hedge funds have been affected. The changes in regulations are about to prevent short selling which affected different hedge fund strategies. Short selling is one of the major strategies of hedge funds. When it was prevented in the falling market, hedge funds would not be able to sell shares and to buy them back at a lower price in the future. And also, it would be much harder to protect long positions through short positions and to use certain arbitrage strategies. Hedge funds then applied a short bias strategy to create back a higher positive return.
In the financial crisis 2007-2009, future movements in values of assets cannot be foreseen easily because the volatility in shares and prices was very high. While the share prices increased and the commodity prices decreased suddenly, many hedge funds were experiencing problems. And also, the problems of banks have affected hedge funds which are in the form of more restrictive lending, higher borrowing costs and assets related to bankruptcies such as Lehman Brothers. The hedge funds were forced to sell assets in a falling market and this affected their returns negatively.
Moreover, the financial crisis 2007-2009 has also affected various types of assets. Hedge funds normally assume different types of risks including credit, duration and liquidity by receiving premiums which usually produce majority of the profits of hedge funds. In the crisis, the higher degree of risk taking did not lead to higher profits because different types of assets has been affected by the downturn and at the same time all the profits that gained from the premiums has been cancelled by the market. The losses made in the crisis could not be covered by the increased risk premiums.
Sometimes, hedge funds may also have both positive and negative effects on the financial crisis. There are many benefits of Hedge funds. For examples, many hedge fund strategies can generate positive or absolute returns in both rising and falling equity and bond markets; in a balanced portfolio, hedge funds comprehension can lower overall risk and volatility of the portfolio and also increases returns; there are huge amount of hedge fund investment styles and many of them are nor correlated to each other, therefore, investors would have a wide range of hedge fund choices in order to meet their different investment purposes; it is proved by some researches that hedge funds usually have higher returns and lower risk comparing to other investment funds and also hedge funds create more stable long-term investment returns than any of the individual funds etc. There are also critiscisms of Hedge funds including Transparency, Systemic risk, Market capacity, U.S. investigations, Performance measurement and Value in mean/variance efficient portfolios etc.
In conclusion, there are many key characteristics of hedge funds comparing to mutual funds, there are vary hedge fund strategies, hedge funds have both positive and negative effects on financial markets but had been affected by the events in financial markets in the period 2007-2009. For examples, most types of asset and markets has been affected by the downturn and it has reduced the diversification's effect; hedge funds had been affected by the changes of regulation and hedge funds which are in the form of more restrictive lending, higher borrowing costs and assets related to bankruptcies such as Lehman Brothers have been affected by the problems of banks etc. Therefore, the performance of hedge funds became worse.
There are around 14 unique investment strategies of hedge funds
