Hedge funds are now available to the retail market at entry levels far below their original UHNW (Ultra High Net Worth) clientele, even being available via a $200 a month offshore savings plan.

A hedge fund is an investment in which a fund manager invests money with the twin goals of maximizing returns and minimizing risk. Hedge fund managers attempt to make money in both good and bad stock market conditions, sometimes by using aggressive trading strategies.

To “hedge”, an investor or fund manager essentially makes two investments that react in opposite ways — if one investment goes down, the other goes up, which reduces overall risk.

This can be baffling: on the face of it they are riskier than a straight-forward equity fund because of the strategies used, but when used as part of a wider portfolio, hedge funds can demonstrably reduce the volatility of the overall portfolio.

Let us compare a hedge fund with a more common investment, a straight-forward long equity fund. This also invest pools of investor money. But it is quite different. Like an equity fund, many hedge funds hold stocks and/or bonds. But they’re also allowed to invest in more speculative fare, such as private equity, bankrupt companies, art, currency and (especially) derivatives. Whereas the goal of a regular fund is to beat the returns of the overall stock market or some portion of it, hedge funds aim to deliver absolute positive returns - meaning gains that aren’t tied to any particular benchmark - over time.

Riskier trading strategies:   Hedge fund managers have latitude to use more aggressive trading strategies than their mutual fund counterparts. They can make highly concentrated bets by investing the fund’s capital in just a few assets, and they often use leverage, which involves borrowing money to make trades. Leverage can amplify returns and losses.

Performance-based fees:   Both the equity fund and a hedge fund charge an annual asset-based management fee — also known as an expense ratio or advisory fee. For the equity fund, that fee is usually between 0.25% and 1.5% of your investment in the fund per year.

Hedge fund investors also pay an additional performance-based incentive fee. A well-known setup is called “2 and 20,” in which shareholders pay an annual fee of 2% of their investment in the fund and 20% of any year’s profit above a preset percentage. In recent years, fees have come down and are now closer to 1.5% and 16%.

Hedge fund strategies

• Equity long/short strategy: Hedge funds may short a stock if they think the price is going to fall in the near future, and continue to hold stocks they think will keep performing well.
• Global Macro strategy: Bases on an analysis of macroeconomic events on a huge scale.
• Distressed securities. Buys stock in bankrupt or financially struggling companies.
• Merger arbitrage. Takes advantage of price differences before and after a merger.
• Fixed-income arbitrage. Capitalizes on price changes in fixed-income securities.
• Equity: Uses fundamental analysis of individual stocks to find specific companies in which to invest, either long or short.
• Relative value: Fundamental analysis is used to uncover relative value of various types of securities.
• Event-driven: Employ relative value or arbitrage strategies to buy and sell securities before or after a corporate event, such as a merger or bankruptcy filing.
• Arbitrage: Seeks pricing anomalies among securities.

Hedge funds offer the potential for attractive returns, diversification benefits and upside regardless of market conditions, sometimes allowing investors to profit even when the market is declining. They can also offer variable market exposure, and can assume significant short positions, which means the fund can profit from a security’s declining value. This can help the fund add value to a portfolio regardless of market conditions. Hedge funds also offer diversification benefits for investors since their returns may not track traditional investments such as stocks and bonds.