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An introduction to hedge funds

Hedge funds are alternative investment vehicles that explicitly pursue absolute returns on their underlying investments. The term "hedge fund" has come to incorporate any absolute return fund investing within the financial markets (stocks, bonds, commodities, currencies, derivatives, etc) and/or applying non-traditional portfolio management techniques including, but not restricted to, short selling, leveraging, arbitrage, swaps, etc.

Initially devised in the US in 1949, hedge funds really took off in the late eighties, and now form a key part of both institutional and private client portfolios. They are normally used in a portfolio context rather than being considered as stand-alone investments.

Hedge funds are usually included as a medium to long-term investment in a traditional portfolio of stocks and bonds. As the performance of hedge funds in general are lowly correlated to traditional investments - especially in declining markets when correlations tend to be low - they offer a good source of diversification for most investment portfolios. By blending a variety of skill-based approaches to investing in a diverse range of financial instruments and markets, hedge fund portfolio construction process aims to achieve a specific return/risk profile, as well as proper diversification and balance in the overall portfolio.

Key features of hedge funds

  • Absolute returns: Hedge fund managers pursue absolute returns rather than returns relative to an index or benchmark, allowing them to generate gains even when the traditional markets are failing or range bound.
  • Skill-based strategies: Returns of hedge funds are derived mostly from the skill of the hedge fund manager in executing their chosen strategy rather than exclusively relying on asset appreciation in rising markets.
  • Flexibility: Hedge funds have the ability to trade on the long and short side of various financial instruments.
  • Diversity: Hedge fund managers trade across a spectrum of markets and exchanges, investing in a diverse array of financial instruments including equities, bonds, currencies and derivatives.
  • Alignment of interest: Hedge fund managers often invest their own money, which aligns their interests with those of their investors.
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