Different Types Of Hedge Funds

Different Types Of Hedge Funds

A hedge fund is a small scale investment strategy that is characterized mainly by its privatized partnership style as well as having as its essential goal the return of huge gains with as low of a risk to the investor and the fund as possible. Because of the possible large risk involved, hedge fund managers utilize complex sophisticated risk management models to assess and then reduce that risk, and so it can be very difficult to simply advise someone off the street of what type of funds to invest in and which strategy to use with that specific fund. However, hedge funds can be reduced to two basic types, and are called absolute-return funds and directional funds. Below is an investigation into these two types of funds.

Absolute-Return Funds

One type of hedge fund is called the absolute-return fund. This fund is created specifically to give you a consistent return on your investment regardless of any market fluctuations. Thus, the manager of these funds will attempt to eradicate any risk involved with the fund so as to be sure the fund does not reflect what is happening in the marketplace. When all risk is removed, the fund’s behavior is entirely dictated by the experience and skill of the fund manager. There are some attractive advantages to this type of fund. For instance, as noted above, even if the market suddenly declines, an absolute-return fund will not be affected, thus giving you a constant positive return. Also, these funds are quite flexible, with creative techniques such as short-selling and derivatives to provide good, high returns. Also, since these funds are not highly correlated with market behavior, having such funds within your portfolio will decrease your portfolio’s level of risk and instability.

On the other hand, there do exist some disadvantages to absolute-return funds. For instance, because risk is removed from the fund, as noted above, the fund’s performance is entirely based on the level of skill of the manager, thus the dependence level of these funds is high. As a result, it can be very hard to choose which of these funds to use, as opposed to the more classic funds, which follow market trends. Additionally, these funds have increased fees over traditional funds. Furthermore, these funds have very limited access for liquidity, often making you wait to either grab your capital or sell off only at monthly intervals or quarterly intervals.

Finger pointing at a stock market graph.

Directional Funds

In contrast to absolute-return funds, directional funds are exposed, although only somewhat, to the market behavior. However, managers of these funds shoot for above average returns than what was expected, in light of the amount of risk that’s taken. So, one advantage of directional funds is the potential huge gains associated with them. However, as a downside, the returns on such funds are not dependent upon the skill of the manager, but more so on the behavior of the marketplace, and so directional funds have a reputation of being incredibly erratic over time. Then again, because the managerial skill is largely taken out of the equation, fees for investing in these funds tend to be much lower than those associated with absolute-returns. Another disadvantage, and one that again is reflective of the marketplace, is that the returns will not be consistent every year, however as time goes by, you will experience higher than expected returns. One other advantage to directional hedge funds is that they have much better access to liquidity than absolute-return funds, and such access is usually determined through the funds being traded on the stock exchange.

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