A hedge fund is a pool of securities that are likely to constitute a part of an aggressively managed investment portfolio. Getting involved with a hedge fund is a high-stakes game - the goal is to maximize returns in a way that more traditional assets, like stocks and bonds, do not. The term "hedge" comes from a strategy known as hedging, a practice that seeks to reduce the level of risk associated with an investment. Historically, this was the primary goal of a hedge fund, but today, a hedge fund prioritizes profit maximization above all else, which can actually generate greater risk.
Hedge fund managers may use a variety of strategies to achieve the goal of optimal returns, including leveraging and long-short equity. Leveraging is a technique which relies on debt to drive investments. For example, a firm may only possess $5 million, but by borrowing an additional $15 million, it is now capable of investing in many more financial operations. In order for this to be profitable, however, the interest from the borrowed sum must remain consistently smaller than the dividends from firm's investments. Long-short equities, simply put, involve purchasing "long" stocks that seem likely to appreciate in value over time, and selling "short" stocks that appear to be declining in price.
Hedge funds are generally reserved for investors with a substantial amount of wealth at their disposal. US laws state require that investors in hedge funds be accredited - this means that they must possess a certain minimum annual income, a net worth greater than $1 million, and a thorough knowledge of investments.
Because hedge funds primarily cater to these sorts of experienced investors, the US government leaves them largely unregulated. This opens up a wider range of investment possibilities that have greater impacts, not only on the profits of the fund, but on the market at large.
Hedge funds have a few positive effects on the market. One common strategy of hedge funds is arbitrage, which eliminates unfair pricing through exploitation. If there is variation in price for an identical product, a manager can purchase that product at the lower price and sell at the higher for a profit. This results in a rapid re-adjustment of price. They contribute to greater liquidity due to their willingness to sell securities, and are a reliable source of risk transfer.
However, hedge funds pose a number of threats to the market as well. Because many hedge funds use similar analytical techniques when surveying the market, multiple funds will often come to the same conclusion. If everyone decides that a certain product is highly lucrative, an asset bubble may begin to grow, such as during the housing bubble starting in 2005. Derivatives are another hedge fund tactic that has a significant impact on the market. A derivative is an agreement between multiple parties based on an underlying entity, such as an asset, index, or security. It may have a variety of effects, such as contractually obliging one party to purchase another party's assets at a specific price in the future. This offers a form of insurance - even if the market price of the asset falls, the seller can rest assured of a reasonable profit. However, these derivatives can create enormous swings in the market; if the market price of the underlying entity is drastically different from what was expected, the parties involved may experience tremendous losses. Leverage, although a powerful tool for generating profit, can also have troublesome effects on the market; if the returns on a hedge fund's investments are consistently lower than the interest from their debts, the hedge fund will incur losses and may potentially increase the interest rates of lenders.
The top five performing hedge funds of 2015 with $1 billion or more in assets were as follows: Perceptive Life Sciences, Melvin Capital, Segantii Asian-Pacific Equity Multi-Strategy, Sylebra Capital Partners Master, and Teton Capital Partners. It is worth noting that all but one of these funds rely primarily on the long-short equity strategy.
The top five performing hedge funds of 2015 with assets valued between $250 million and $1 billion were: Ping Exceptional Value, SPQ Asia Opportunities, APS Asia-Pacific Long/Short, Landsdowne European Equity, and TT Long/Short Focus. As was the case with the top five hedge funds possessing $1 billion or more in assets, four of these five funds also relied on the long-short equity strategy.