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What is a hedge fund?

Hedge funds, many have heard this term before - at the latest now in the context of GameStop and Co. - but what they really are is unclear to most. There are often fuzzy ideas about what exactly a hedge fund does, but people are all the more certain that hedge funds are evil, aggressive and fundamentally bad. Thus, they are often pejoratively referred to as locusts. Are hedge funds rightly afflicted with this extremely negative reputation? We clarify all your questions about hedge funds in this article.

What are hedge funds?

Hedge funds are investment funds with some special features. Because they are only accessible to a clearly defined group of people due to the often extremely high minimum investment volume of 500,000€ and higher, and they are also not publicly traded on the stock exchange, this is also referred to as an alternative investment.

Hedge funds are used today mainly for stock market speculation. It is tried with very speculative and highly risky investment strategies to achieve the highest possible profit. In other words, hedge funds aim to achieve the highest possible returns while taking a correspondingly high risk. Hedge funds "hedge" specifically, i.e. they try to actively manage the said risks. What sets them apart is that they are free to decide how they act, since they are not publicly available and are hardly regulated.

What distinguishes a hedge fund from a normal mutual fund?

Hedge funds and mutual funds differ in many ways. Probably the most important point is regulation; hedge fund managers have free reign over strategy, risk, and choice of products. While hedge funds are only conditionally regulated, conventional investment funds are in a clearly defined regulatory construct. This basically means that there are only a few rules on the part of financial supervisors (such as BaFin) for hedge funds, or that they must be followed. One of these rules is, for example, the prohibition of insider trading, which hedge funds also have to follow. However, several examples, especially from the U.S., suggest that not everyone adheres to the said rule.

Another significant difference lies in the use of derivatives. While this is completely forbidden with respect to investment funds, it is permitted without restriction in the case of hedge funds.

Furthermore, the two investment options also differ with regard to short purchases. In the case of investment funds, only purchases are possible, whereas in the case of hedge funds, uncovered purchases are also an option. But what is short selling anyway?

Short-selling means that the hedge fund sells assets, such as GameStop shares, without actually owning them at the time. The bet is that in this case the stock will lose value, so the hedge fund can complete the sale at a profit. In the case of GameStop, the exact opposite was true. If you want to read more about the issue, here is an article with everything you need to know.

Hedge funds and conventional investment funds also differ in terms of the liquidability of the invested money. If you have invested your assets in hedge funds, this can usually only be liquidated at fixed times and usually only after a few years, while with normal investment funds it is theoretically possible at any time. This is due to the fact that shares of hedge funds are not traded on the stock exchange and they are closed-end funds, which means that the invested money is necessarily tied up for several years.

Who invests in hedge funds?

Since not only a high minimum investment volume is required (in the USA this is even a proud one million USD for some hedge funds), but in some cases even proof of income for fixed amounts must be provided, we are talking here about very wealthy people when it comes to private investors. Finally, it must also be considered that investments in hedge funds are associated with enormous risks, a total loss is not excluded.

In addition to these private individuals, however, institutional investors, such as foundations, life insurance companies and pension funds, are also among the investors.

In Germany, trading in hedge funds has only been possible since 2004, and only to a limited extent in order to protect investors. In Germany, hedge funds belong to the category of "special assets with additional risks". Those who wish to invest in hedge funds can acquire shares in funds of hedge funds. These contain different hedge funds, so that the risk is reduced to a certain extent through diversification. However, these funds of funds are associated with increased costs.

What are the investment strategies of hedge funds?

It is difficult to briefly list the investment strategies of hedge funds, as there are many different approaches. Some hedge fund managers follow the strategy of analyzing economic trends, such as the well-known investor Simon James.

Others use the very popular strategy of "long short equity", whereby hedge funds try to make themselves more independent of developments on the capital market by simultaneously betting on both falling and rising prices. The trend-following strategy, arbitrage trades or an event-driven strategy are also among the popular approaches.

In the event-driven strategy, events such as possible mergers or "turnarounds" are included in the portfolio planning. Translated, the term means something like turns or turnarounds. In this case, investments are made in a company that is characterized by poor performance or one that is in financial difficulties. Often these two characteristics go hand in hand, as the financial well-being can be considered as an indicator of the overall performance of the company.  Hedge funds speculate on a turnaround in terms of sales, or they then profit from the consequent rise in share prices. In the same way, the hedge fund can also bet on an opposite development, namely the bankruptcy of the respective company.

However, there are no limits to the versatility of hedge fund managers' strategies.

Hedge Funds & Start-Ups

While it used to be common for hedge funds to invest in start-ups, today venture capital funds are taking the lead. However, some hedge funds have begun to develop and launch programs focused on taking on and supporting start-ups. Last year, for example, Coatue, a New York-based hedge fund, invested 27.6 million euros in the Berlin-based start-up Choco and nearly 40 million euros in Gorillas.

The intention behind this is to generate massive profits from these investments. Driven by the growing number of unicorns and the reaching of all-time highs of IPOs, hedge funds are always attracted to the private equity sector. Going forward, it will be important to remain curious about how the relationship between hedge funds and start-ups will evolve.

How much does a hedge fund manager earn?

As a rule, the salaries of hedge fund managers are based on their performance or that of the hedge fund, i.e. there is no such thing as THE typical salary. Nevertheless, hedge fund managers are among the best-paid professions of all, which repeatedly triggers discussions.

For example, after a few years on Wall Street, salaries of around USD 300,000 are already possible. Among the best paid hedge fund managers are well-known investors such as James Simons of Renaissance Technologies, Ray Dalio of Bridgewater Associates and Michael Platt of Bluecrest Capital. In good years and when their performance is stellar, they sometimes rake in hefty salaries of more than $1.5 billion. But of course, that's not the typical salary of hedge fund managers. And how does one become a hedge fund manager? In most cases, this prestigious career is preceded by several years in investment banking; direct entry is hardly possible.

Conclusion: Do hedge funds deserve their negative image?

The typical hedge fund does not exist. Thus, the prejudice of evil and aggressive hedge fund managers can certainly be applied to a subset of existing hedge funds, but certainly not to everyone. An investment in hedge funds is associated with particular risks, there is no question about that, but that is no secret. Whether hedge funds are a curse, or a blessing definitely has to be evaluated on a case-by-case basis.