Hedge Funds

Characteristics of a Hedge Fund

The two most common characteristics of hedge funds are the following: (1) the ability to “go long or short” and (2) the use of “leverage.” Going long is the traditional method of buying a security (e.g., stock) at what is hoped to be an undervalued price and later selling it at a higher amount. This strategy profits by the amount the security rises in value. Going short is the process of first selling a security and incurring the obligation to buy it back at a later date. The strategy profits when the price of the security declines and the repurchase price is lower than the price for which the security was originally sold.

Hedge funds often implement strategies using a considerable amount of borrowing or leveraging of funds. Leverage is the straightforward borrowing of funds to increase the returns to an investment strategy. In the case of going long, a typical investor can only purchase a limited number of shares with their own money and the rate of return on the investment equals the rate of return on the security. A hedge can potentially earn a much higher return on an investment in the same security if they borrow money and purchase additional shares. If the cost of the borrowed money is lower than the rate of return on the security, this extra profit boosts the return on the fund's investment. In the case of going short, the fund is only required to deposit a fraction of the dollar amount of security value that has been sold to cover potential losses. In this sense, the fund stands to profit from the decline in the total value of the shares sold short with only a modest investment of the fund's money. However, the fund will incur the risk of substantial loss if the price of the security sold short does not move as expected because the fund must buy the security back at a higher price. This is the key element of leverage: The profits and losses associated with full security value are controlled by a fractional investment.

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