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Hedge funds are pools of investor money that use a large range of different strategies to both generate returns for investors and manage risk. Hedge funds are typically only available to sophisticated investors with large amounts of assets to invest (often over $1 million).  The term hedge fund comes from the practice of "hedging", which is the practice of reducing risk in an asset by taking a position in a related security to offset any downward price movements. These related securities often take the form of derivatives like futures, options, and forward contracts. Essentially, this strategy is intended to protect capital in the event of a negative event that causes an asset to lose value.  Hedge funds often use a wide range of complex strategies to maximize returns like using leverage (or borrowed money), using derivatives to profit from global economic trends, trading currencies, and investing in stock and bonds in markets all around the globe. Mutual funds and hedge funds are similar in that they are both pools of money managed by a fund manager. Other than this, however, there are several key differences. These differences are important to consider when starting one.  Firstly, hedge funds are not as regulated as mutual funds, and so they can invest in a more diverse and risky range of securities, as well as use strategies that mutual funds cannot use. Hedge funds can use large amounts of leverage (or borrowed money), short sell, and perform riskier trades on behalf of their investors, whereas mutual funds cannot. Note that the strategies available to the hedge fund manager must be identified in the private placement memorandum that must be available to the investor before purchase.  Secondly, hedge funds and mutual funds have different levels of availability. Mutual funds are publicly-registered securities with SEC-approved prospectuses and are available to all investors. Hedge funds are funded through private placements to accredited investors, who must have a net worth of over $1 million (not including the value of your home) or an annual income of over $200,000 (now and going forward). Thirdly, hedge fund investors are typically "locked-in" for a period. Whereas a mutual fund investor can sell their shares whenever they want, a hedge fund shareholder may be restricted for a certain period of time. Finally, hedge fund managers are compensated differently from mutual fund managers. Mutual fund managers receive a set percentage of total assets managed each year, whereas hedge fund managers typically receive a set percentage of total assets (usually about 2%), plus a percentage of profits that are earned. This percentage is usually about 20%. Manager compensation is defined in the hedge fund's prospectus and is agreed to by the investor. Hedge funds managers usually get their start by achieving a successful investing track record throughout years of industry experience. This is how they attract their first clients and build out their funds. But even with the requisite experience, you'll also need an overall vision for your fund, including an idea of how it will generate returns for investors. Hedge funds can follow a number of different strategies, including:  Market Neutral Strategy: This is a popular strategy that involves purchasing a group of investments that are expected to go up, and then offsetting these investments dollar-for-dollar by short-selling the overall market (one of the S&P 500 Index ETFs, for example). If the portion that is expected to go up does better than the short-sold portion, the fund would make money. This can be a useful strategy to market to investors who are concerned about market crashes. Hedged equity strategy: This strategy is similar to the market neutral strategy, except instead of shorting the entire portion of the portfolio that you expect to rise on a dollar-for-dollar basis, only a portion would be shorted. For example, if you had a $1 million portfolio, $300,000 may be shorted. This means if the market were to collapse there would be some protection, but generally speaking your fund would be structured to make money from markets rising. Global Macro strategy: This type of strategy seeks to make money from large economic trends. If you have extensive knowledge of economics, global economic trends, global economies, and how these pieces fit together, this may be a good strategy to pursue. Global Macro strategies make money by forming an idea of what will happen to a particular country's (or multiple countries), stock index, interest rate, currency, or inflation/deflation levels. Hedge fund managers typically pursue a strategy to reduce the volatility of a portfolio while maximizing the upside profit potential. In times of expected market declines, this may mean buying low velocity stocks while shorting high velocity security. In this way, the decline in the former would be offset by greater gains in the latter.
Learn the basics of a hedge fund. Distinguish between hedge funds and mutual funds. Select a hedge fund strategy.