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What is a Hedge Fund?

Interested in learning what a hedge fund is? In this article you will find its definition, types, and structure.

From the very days of their appearance, hedge funds became the subject of mythmaking which is easy to explain.

Primarily, this happened due to the eloquence of the name, amplified by the attractiveness of the actions implied by this term.

Financial management interprets hedge as the performance of actions providing the coverage of financial risks; this usually leads to suggestion that this is exactly what a hedge does.

It is hard to say what did more harm to the very idea of using hedge for covering financial risks: ignorance of such fine and complex science as risk management or using the term “hedge fund” as is.

But fact is fact: most people are convinced that hedge funds are started and operate on the market exclusively for the fulfillment of orders made by the clients from the field of financial risk covering: those related to price, interest, currency exchange, etc.

That’s why let us figure out what a hedge fund really means.

What is a hedge fund?

what-is-a-hedge-fund


In reality, understanding hedge funds as organizations involved exclusively in risk management is false.

It might be true for some companies, but for the most part this name doesn’t fully encircle the range of operations a hedge fund fulfils on the market.

Actions on the market that correspond to the concept of hedging are only an additional element of managing assets which is, in fact, obligatory for all financial institutions under modern market conditions.

In America, hedge funds are usually understood as private partnerships investing mostly in publicly sold securities or financial derivatives.

But some funds do not limit their activity to these directions and also work on other platforms – for instance, goods markets.

In fact, these financial institutions focus their interests on such market segment which totally coheres with their goals.

There are two types of partners in hedge funds:

  • Common Partner: a person starting a hedge fund and managing its daily activities.
  • Restricted Partner: a person participating through investments of their own capital, but not through everyday sales or everyday activity of the fund.

Common Partner receives a stimulating payment for all types of service he provides. Its amount is determined by a partner agreement and usually constitutes about 20 % of pure partnership profit.

Besides, an additional administrative payment is set, usually making 2–3 % from the net worth amount.

The outcomes of the hedge fund activity are distributed among all partners proportionally to their participation interest.

Every detail of partnership relations is presented in the respective agreement which constitutes the most important part of any hedge fund.

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Structure of the hedge fund

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  1. Managing company.

    The managing company initiates the formation of the fund.

    It begins to attract investors and make agreements with banks and brokers, unless they create their own funds what happens quite often.

    It is the professionals of the managing company that are the direct performers of all operations concerning buying and selling securities.

  2. Investors.

    The functioning of the fund begins with the interest of investors.

    They bring their capitals, pass them under the fund’s management and receive the greater part of the profit.

  3. Guarantor bank.

    The guarantor bank plays a very important role as it stores capitals of all investors (money, gold, securities).

  4. Administrator or auditor.

    The administrator (auditor) monitors the hedge fund activity.

    Apart from the managing director of the company, he appraises the assets for the sake of lowering the risks.

    Besides, he does accounting, prepares reports including those sent to investors; sometimes communicates regarding the fund’s shares and clears them off.

  5. Primary broker.

    The primary broker’s functions are very diverse.

    While the managing director orders to perform operations, he carries full responsibility for their technical part, beginning with stock transactions
    and ending with depositary activity and credit granting.

    Taking into consideration that hedge funds can operate at any platforms in any countries, the primary broker must be able to perform operations wherever he is needed.

    That’s why this role is often played by large international banks, namely Merrill Lynch, Goldman Sachs, or Morgan Stanley.

Types of hedge funds


There are a large number of classifications, but most use the one offered by IMF.

It determined three main types of hedge funds:

  • Global funds.

    These funds perform their operations on the markets all over the world, but they build their investment strategy on the basis of knowledge about quotes of separate companies.

  • Macro funds work on the market of a certain country.

    They make decisions about opening a position on the basis of the respective macroeconomic situation.

  • Funds of relative prices.

    These are classical hedge funds that operate on national markets and use a standard model of work.

    It is based on the difference between relative prices for interrelated assets.

    It is these funds that use the same principles applied by the very first funds we have mentioned above.

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Regulations of hedge funds activity

According to the global experience, hedge funds are regulated by state authorities to a considerably lesser extent than other investment companies; sometimes hedge funds are even called unregulated investment mechanisms which truly constitutes a problem of the industry.

In mid-2000s, however, some provisions for tightening hedge funds work were adopted.

In 2006, American financial regulator (SEC) published for discussion several projects of the rules that would provide additional protection for hedge funds investors.

On the 21st of July 2010, the act about the US financial reform was signed.

It is also known as Dodd-Frank Act and stipulates the following provisions regarding hedge funds:

  • Obligatory SEC registration after reaching 150 million dollar capital in assets under management.
  • Various events aimed at strengthening both inside and outside control over trade strategies, risk management, and accounts.
  • Upgrading the quality of hedge fund investors – implementing a requirement for an obligatory one million dollar capital in their possession.

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Investments in hedge funds

investments-in-hedge-funds
Hedge funds invest assets in shares and bonds, forwards, futures, and options.

  • In US, the minimal contribution for private investors starts at 5 million dollars and reaches 25 million for institutional ones, the minimal threshold being usually determined by local law.
  • The legislations of some countries, for instance, Canada, are en exception: there you can invest in a hedge fund about 2 thousand Canadian dollars.
  • In Europe, the minimal contribution starts at tens of thousands of dollars, but usually doesn’t exceed $ 100 000.
  • Many funds are registered in off-shore jurisdictions which, on the one hand, diminishes the transparency of investments, and, on the other hand, decreases expenditures on accounting and allows to lower profit tax.

Unfortunately, this is only part of the information, but we still hope to have provided you with the overall picture of what a hedge fund is.

There’s no doubt that starting a hedge fund on condition of establishing it as a full-fledged enterprise is a very promising endeavour, especially when it fits into the general context of your business.

By the way, it is the hedge fund that, as the organization possessing large discretion in choosing principles of management, can provide optimal solutions for issues in the field of financial engineering – a modern driving force on the market of service in the field of assets and obligations management.

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