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HEDGE FUND ARTICLES

Hedge Fund Basics

Author: Dave Inglis (Part 2 of 3)

WHAT IS A HEDGE FUND?

A hedge fund is a private investment partnership run by a money manager who has his own money in the fund. The private aspect of the pooled fund gives the manager more leeway in the securities and the strategies used compared to traditional mutual or segregated fund managers. Hedge funds are usually known for their superior returns.

WHY SHOULD I INVEST IN HEDGE FUNDS?

Hedge funds have generally outperformed all other asset classes. Good hedge funds could generally provide greater diversification, lower volatility, neutral market correlation, risk management, capital protection and appreciation, and greater returns than traditional investments.

WHY ARE THEY CALLED HEDGE FUNDS?

The term hedge fund is actually a misnomer because most of them do not even hedge their positions. The word was first used in the 1940s when Mr. Alfred Jones created the first fund combined of long and short positions. Since that time, private investment vehicles have evolved into a more heterogeneous group of money managers using more complex strategies and offering a greater array of products. Most of these funds might not hedge their positions but the catchy name stayed.

WHAT STRATEGIES DO THEY USE?

Hedge funds are managed by sophisticated money managers who use a great array of strategies. Nothing is left unused. They can use anything from complex arbitrage strategies to simple long positions. Some funds specialize in very distinctive strategies where others may combine more than one strategy. Most use leverage and many may have short positions in their portfolio. For more information on specific Hedge Fund strategies, see the document entitled "Common Hedge Fund Strategies".

HOW LARGE IS THE INDUSTRY?

The census of private investment is never easy to do but it is known to represent approximately 500 to 600 billion $US. Hedge fund services generally track between 3,000 to 4,000 funds, but it said that there might be up to 6,000 funds in the world. The hedge fund industry is relatively small in comparison to the mutual fund or the bond industry, but it is growing rapidly at an estimated rate of 27% per year.


WHAT IS A FUND OF FUNDS?

A "Fund of Funds" is simply an investment vehicle that invests in other hedge funds. By creating a pool of single strategies, the fund of funds manager can create a more diversified fund. By nature, the fund of funds manager will not make direct decisions on investments within each underlying fund, but instead uses expertise in risk management, market direction and investment strategies to decide the composition and direction of his/her particular fund of funds. Using this knowledge and expertise, the fund of funds manager can create a fund that will have very little correlation with other assets, will greatly outperform in all market conditions and will experience lower volatility.

Through a limited partnership, private investors and institutional groups can have access to the best hedge fund managers by styles with daily risk management and a wealth of knowledge from the fund of funds' investment decision team. To the investor, this allows participation in a unique allocation process that could limit some of the downside risks without having to constantly monitor the single managers or having to go through the continuous process of due diligence.

Part 1 of 3 > Part 2 of 3 > Part 3 of 3

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Ivon T. Hughes, The Hughes Trustco Group Ltd.
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Tel: (514) 842-9001 Email: [email protected] Web: http://www.trustco.ca
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