In the United States, the country where they first appeared and enjoyed the greatest development, there is no exact legal definition of the term “hedge fund” that outlines its operational footprint and gives a direct understanding of its meaning.

Yet, to rely on the literal meaning of hedge fund, i.e. “investment funds that employ hedging techniques”, could be misleading, because it relates merely to just one of the many traits of hedge funds and makes reference to only one of the many investment techniques they deploy. A more fitting definition in our opinion is the following: “A hedge fund is an investment instrument that provides different risk/return profiles compared to traditional stock and bond investments”.

To appreciate the meaning fully, however, it is necessary to remark that hedge funds make use of investment strategies, or management styles, that are by definition alternative, and that they do not have to fulfill special regulatory limitations to pursue their mission: capital protection and generation of a positive return with low volatility and low market correlation. Hedge funds are set up by managers who have decided to take the plunge into selfemployment, and whose backgrounds can be traced to the world of mutual funds or proprietary trading for investment banks.

The differences between hedge funds and mutual funds are manifold. The performance of mutual funds is measured against a benchmark, and as such it is a relative performance. A mutual fund manager considers any tracking error, i.e. any deviation from the benchmark, as a risk, and therefore risk is measured in correlation with the benchmark and not in absolute terms. In contrast, hedge funds seek to guarantee an absolute return under any circumstance, even when market indices are plummeting. This means that hedge funds have no benchmark, but rather different investment strategies.

Mutual funds cannot protect portfolios from descending markets, unless they sell or remain liquid. Hedge funds, however, in the case of declining markets, can find protection by implementing different hedging strategies and can generate positive returns. Short selling gives hedge fund managers a whole new universe of investment opportunities. It is not the general market performance that counts, but rather the relative performance of stocks. The future return of mutual funds depends upon the direction of the markets in which they are invested, whereas the future return of hedge funds tends to have a very low correlation with the direction of financial markets.

Another major difference between hedge funds and mutual funds is that the latter are regulated and supervised by Regulatory Authorities, and are bound by limitations restricting their portfolio makeup and permitted instruments. Moreover, investors are further protected by obligations burdening the management company in terms of capital adequacy, proven robust organization and business processes. On the contrary, the absence of a stringent 2 Investment Strategies of Hedge Funds regulatory framework for hedge funds leaves the manager with greater latitude to set up a fund characterized by unique traits in terms of the financial instruments to be employed, the management style, the organizational structure and the legal form.

Therefore, the hedge fund industry is marked by a great heterogeneity, in that it is characterized by different investment strategies and by funds of a wide variety of sizes. Although hedge funds immediately bring to mind the image of innovative investment strategies within the financial landscape, the first hedge fund came into existence more than half a century ago.

This article is a part of “Investment Strategies of Hedge Funds” ebooks by Filippo Stefanini for closed private educations only. You should buy his books for the best completely informations.