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What are hedge funds?

Hedge funds are a special form of investment fund that are based on highly speculative strategies and always aim for maximum returns. In return, however, the investor takes high risks. The funds do not try to beat a certain stock index. Instead, they make use of many different investment instruments such as equities, bonds, currencies, options and futures in order to achieve the highest possible return.

Are hedge funds accessible to everyone?

Basically, hedge funds are alternative investments. The term "alternative" is used because the trading of hedge fund units is not carried out on the stock exchange, as is customary with bonds or shares, but is reserved for a limited circle of people. In most cases, hedge funds require high minimum investment volumes, often exceeding the limit of EUR 500,000. Accordingly, the fund managers mainly target so-called high-net-worth individuals (HNWI) with their issued funds, which means wealthy private investors. In addition to high net-worth individuals, life insurance companies, pension funds and foundations also invest in hedge funds.

How do hedge funds work?

In general, hedge funds function like classic investment funds. In both cases, the fund manager collects money from investors and generally invests in different asset classes, for example in shares, bonds or currencies. The aim for the hedge fund is always to achieve the highest possible return for the investors. This happens regardless of how the market develops, i.e. also when prices are falling. Hedge funds as an investment product were originally developed to protect investors against the risks of falling prices. The term hedge fund is derived from the word "to hedge". In practice, hedging works by adding opposite options to the portfolio, which also lead to increases in value if the price of an asset falls. In this case, one also speaks of short selling, which has made hedge funds famous and is allowed within the framework of this asset class.

What exactly distinguishes hedge funds from simple investment funds?

Hedge funds differ from classic investment funds in various ways:

  • Legal basis: Conventional investment funds are regulated by the BaFin (Bundesanstalt für Finanzdienstleistungsaufsicht). Single hedge funds, on the other hand, are unregulated products that only have to comply with a few rules issued by financial supervisors. Hedge fund managers are thus largely free to choose the financial products for the respective fund and also to determine the level of risk of the investment. Of course, rules also apply to hedge funds. One of these rules is, for example, the ban on insider trading, which is intended to protect investors from price manipulation. This means that hedge fund managers are also prohibited from buying or selling securities if the transaction is motivated by information that is not publicly available. Unfortunately, not all hedge fund managers comply with this ban. This is illustrated by the case of the US American Steven Cohen, the founder of the company S.A.C Capital (SAC). He was sentenced to a fine of USD 1.3 billion for insider trading in 2013.

  • Asset classes: There are no asset class restrictions on hedge funds. Investment funds, on the other hand, are limited to a few assets, depending on the fund strategy.

  • Availability: The availability or in other words the liquidity of the fund, is another difference. Hedge funds are closed-end funds. The fund units are not traded on the stock exchange and the investor's invested capital is usually tied up in the fund for several years.

  • Short selling: Short selling, which means betting on falling prices, is a common strategy with hedge funds. Short sales are prohibited in conventional investment funds. Short sales are the sale of underlying assets that the seller does not own. Instead, he borrows them and returns them at an agreed time. The intention behind this is to buy the underlyings cheaply on the stock exchange at a later date. The difference between the actual purchase price and the selling price to the broker who has borrowed the underlyings is the profit on a short sale. If this principle is applied on a large scale, it can have a significant impact on the market.

How great is the influence of hedge funds?

Although there are only a limited number of people or institutions who can invest in hedge funds, hedge funds manage a huge amount of capital. An estimated $1.9 trillion is currently managed by hedge funds worldwide. From this it can be deduced that hedge funds have a very significant influence on governments, corporations and our economic system.