Normally when you invest in the stock market, you can invest in single stocks of specific companies. However, this can be quite risky and will consume a lot of your time to manage your investments. You could hire an investment manager to do this work for you, but this is costly and isn’t really feasible for the majority of private investors. Investment funds, then, are basically a collection of managed stocks and assets that you can invest in as a whole. In essence, you and many others share a common investment manager (represented by the fund) who manages a diverse portfolio of stocks and assets for you. This way you gain access to risk management, diversification, and economies of scale you would never have access to as an individual investor.

Mutually Non-exclusive

A hedge fund is very similar to a mutual fund, except that it’s closed to the public. The attraction of a hedge fund—as compared to a mutual fund—is that you’re entrusting your investment with experts who can potentially earn you better returns. Without getting too technical, hedge funds, unlike other funds, often use “short” positions and “derivatives” to “hedge” away certain risks.

A short position is just a form of investment where you profit if the price of the stock goes down. So an overly simplified example: a hedge fund might buy $1 million worth of a mining company whose entire production yield equates to a fifty/fifty split between copper and nickel. However, the hedge fund only thinks copper prices will improve, and don’t have an opinion on what will happen with nickel. In response, they might short $500k of stock of a nickel mining company. This way if nickel prices go up or down, they won’t have any effect on the hedge funds profits. They will only be exposed to copper price movements.

Without Restraint

Another important aspect of hedge funds as compared to a mutual fund—or an actively managed ETF—is that there are significantly fewer restrictions on investing. As such, a hedge fund can short sell a stock (betting that the stock price will go down), take on huge positions in a company (mutual funds typically can’t have one stock be over 10% of the total fund), which allows the fund to make concentrated bets and, in special cases, drive change at the company, and invest in any asset class—including derivatives. Derivatives are a little more complex, mainly because there are many different types and combinations. One of the more simple derivatives is a “call option,” where you buy the option to buy a certain stock in the future for a predetermined price. For example, I can pay you $2 now, to have the option to buy copper stock from you for only 100 dollars, three months from now—regardless of where copper stock is trading in three months. Derivatives are also used to hedge.

Is a Hedge Fund Right For You?

Hedge funds enable you to invest in nearly any asset class—-many more than you’d be able to if you were just using your own money. If one asset performs poorly, all the other assets can ensure the safety of your investments as a whole. “Hedging” is usually an intelligent process of determining that, “this asset is going down in value, so this other asset will increase in value, so let’s invest in both. This limits your potential growth, but also protects you against significant downswings, ideally. Call Mercato today for financial consultation, and consider making us your investment partner.