What Does a Hedge Fund Do?
When considering a career in finance, people have quite a few options to choose from and while investment banking is perhaps the flashiest one, there are some other lucrative alternatives also worth a try. One, of them, however, has an air of vagueness about it, and that is working in a hedge fund. So, before venturing that particular career option, it’s good to have at least an idea what a hedge fund is and what it does.
What does a hedge fund do? Very simply put, a hedge fund is a type of investment partnership which pools capital from a number of investors and then invests that capital in a variety of instruments, such as securities.
By this measure, hedge funds are very similar to mutual funds which also entail the pooling of funds for the purpose of investing in securities, including stocks, bonds, money instruments and other similar assets. Unlike mutual funds, however, hedge funds are not subject to the same regulations which are designed to protect investors, and that is where the mystery surrounding those investment vehicles comes from.
Not for Every Investor
Continuing with the differences between hedge funds and mutual funds, while pretty much everyone is allowed to invest in a mutual fund, hedge funds are limited to “sophisticated investors” or accredited investors, namely people or organizations who have enough experience in the field so that they can protect themselves. Examples of hedge fund investors are institutional investors such as pension funds and insurance companies, as well as wealthy individuals with a minimum level of income or assets.
This restriction exists because hedge funds are subject to fewer regulations than mutual funds and have virtually no restrictions on the assets they can invest into, which in turn carries a variety of risks which the average retail investor might not be accustomed to. Or in other words, hedge funds don’t have restrictions when it comes to investments, which is why they have restrictions when it comes to investors. With mutual funds, it’s the other way round.
What a Hedge Fund Does
To understand what a hedge fund actually does (beyond the rather broad concept of “investing”), it is essential to know what hedging is. Hedging means reducing risk, and since the risk is usually co-related with the amount of return on an investment, the purpose of the fund is to reduce the risk without reducing the investment income.
While this is a tricky job, the relative lack of restrictions with investments means greater flexibility and enables hedge funds to use a variety of strategies such as investing in distressed securities (i.e. companies in a difficult situation), alternative assets, applying long and short strategies and so on. A hedge fund might be diversified among many strategies or might concentrate of just a couple or even a single strategy.
Hedge funds are also known to impact the market with their activity such as allocating capital to a given company, buying shares in an upcoming initial public offering and then quickly selling them for profit and so on.
Working at a Hedge Fund
All the strategies and decisions are in the hands of the fund manager who has to decide which risks are worth taking and which should be dropped. It is a rather challenging job, which is why it is handsomely rewarded.
While it is by no means easy to land a job in a hedge fund (typically, they are less advertised relative to other finance positions), it is not an impossible feat either, provided that one has the right set of skills. In addition to corporate valuation and financial modeling skills, a must for an entry-level analyst position, one should also have a broad knowledge of financial markets, as well as understanding of the global financial ecosystem to have a future in a hedge fund. Going forward, decision-making skills, the ability to make the right calls and the guts to stick to them are what it takes to move up the career ladder in a hedge fund.