A Hedge Fund is a type of fund that invests in various assets across different asset classes to reduce overall portfolio risks. In finance, the word ‘hedge’ means taking positions or investing in assets that can offset the negative movement in existing positions or investments. By its nature, a hedge fund will have a portfolio of assets that do not have a high correlation factor and will move in different directions so that another offsets the loss of one. Hedge funds are available as an investment option most likely to High Net-Worth Individuals (HNIs) as it requires a large sum of investments in one go.
Just like any mutual fund, a hedge fund is also a pool of investors’ money strategically invested in multiple asset classes to maximise returns. The underlying factor among hedge funds is that they invest in assets that can mutually offset the risks. Since hedge funds require different expertise, they are managed by experienced professional managers. A higher fee amount and risk usually characterise hedge funds since they are actively managed by experts who invest in multiple assets.
The following are some major types of hedge funds:
By now, you must have understood how hedging is the guiding principle when it comes to hedge funds. Let us discuss some examples to illustrate ‘hedging’ better.
Let’s take Company A, based out of India, heavily dependent upon exports for sales, and assume that most of these exports are quoted in USD (United States Dollars). Now, if you have to invest in the equity of such a company, a factor of risk for you will be the foreign exchange rate of USD-INR. If the price of 1 USD declines against INR, it simply means less revenue for our company of interest, assuming all other factors are constant. A hedge fund, in this case, will take a position to offset this risk, which can be done by taking short positions in the USD-INR pair. Once the fund takes this short position, they stand to offset the risk of falling revenue of Company A, as now the gain in shorts held of USD-INR will somewhat offset the possible risk of loss or decline in Company A’s stock.
Return on investment is a powerful financial metric showing the ratio between the income earned on an investment and the value or amount of funds invested. The higher the ROI, the better the investment is; hence, it is often used to compare different types of investments, irrespective of their asset class. If at some point, an investor feels the ROI derived from a particular investment does not justify the risk assumed, then a prudent investor will move their money to a different investment avenue.
Wondering how to calculate this powerful metric? Jupiter Money offers an easy-to-use Return on Investment Calculator, which comes with the following features:
The importance of hedging is the underlying principle while building a diversified portfolio. Therefore, you should take positions in asset classes which can potentially offset the risk. Although hedge funds attract a higher fee, management fees and different asset classes make for a lucrative investment vehicle to park your funds in.
It is an investment strategy that involves taking positions to offset the current risk assumed in the portfolio. This typically can also lead to lower profits, given the negative correlation amongst the assets owned but serves as a helpful way to reduce the portfolio’s overall risk.
Absolute return only shows your profit percentage from any investment held for one year or less. However, since the investment period can vary among your investments, you should use the annualized ROI to make an apple-to-apple comparison among various investments, irrespective of your holding period.
