In the United States, an investment fund must be open to a limited number of accredited investors in order to be exempt from direct regulation. While there is no legal definition for "hedge fund" under U.S. securities laws and regulations, typically they include any investment fund that, because of an exemption from certain regulation that otherwise apply to mutual funds, brokerage firms or investment advisors, can invest in more complex and risky investments than a public fund might. Hedge funds managed from other countries have similar relationships with their national regulators. Since a hedge fund's investment activities are limited only by the contracts governing the particular fund, it can make greater use of complex investment strategies such as short selling, entering into futures, swaps and other derivative contracts and leverage.
As the name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging their investments using a variety of methods, most notably short selling. However, the term "hedge fund" has come in modern parlance to be applied to many funds that do not actually hedge their investments, and in particular to funds using short selling and other "hedging" methods to increase risk, and therefore return, rather than reduce it.
Hedge funds have acquired a reputation for secrecy. Being outside the regulatory regime that applies to retail funds greatly reduces the information a hedge fund is legally required to make public. Additionally, divulging trading methods and positions would compromise the business interests of many types of hedge fund, tending to limit the information they want to release.
The assets under management of a hedge fund can run into many billions of dollars, and this will usually be multiplied by leverage. Their sway over markets, whether they succeed or fail, is therefore potentially substantial and there is a continuing debate over whether they should be more thoroughly regulated..
Strategies
Hedge funds employ many different trading strategies, which are classified in many different ways, with no standard system used. Each strategy can be said to be built from a number of different elements:
- Style: global macro, directional, event driven, relative value (arbitrage), managed futures (CTA)
- Market: equity, fixed income, commodity, currency
- Instrument: long/short, futures, options
- Exposure: directional, market neutral
- Sector: emerging market, technology, healthcare etc.
- Method: discretionary/qualitative (where the individual investments are selected by managers), systematic/quantitative (or "quant" - where the investments are selected according to numerical methods using a computerized system)
- Diversification: multi manager, multi strategy, multi fund, multi market
The four main strategy groups are based on the investment style and have their own risk and return characteristics. The most common label for a hedge fund is "long/short equity", meaning that the fund takes both long and short positions in shares traded on public stock exchanges.
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