Hedge Fund

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Introducing Hedging Fund

Hedge fund is a profit-oriented financial fund that integrates financial derivatives such as financial futures and financial options with financial organizations.The original function of hedge fund is toavoid losses through hedging.

Financial futures and financial options are called financial derivatives, and they are often used as a means of hedging and risk avoidance in the financial markets. Over time, in the financial market, some fund organizations use financial derivatives to adopt a variety of profit-oriented investment strategies. These fund organizations are then called hedge funds. At present, hedge funds have long lost the meaning of risk hedging. On the contrary, it is now widely believed that hedge funds are actually an investment model based on the latest investment theory and extremely complicated financial market operation skills, making full use of the leveraged effects of various financial derivatives, taking high risks and seeking high yield.

 

In the original hedging operations, the fund manager would buy put options at a certain price and duration of a share after he buys the share. The put option allows the fund manager to sell the shares at the price preset by the options when the share's market value falls below the set price, so as to hedge the risks of share price falling.In other operations, fund manager would first select an industry with a rising prospect and buy some quality stocks in that industry, and at the same time short sell some inferior stocks in the industry with a certain ratio. The result of such a portfolio is that, if the industry reaches its expectations, the increase of the quality shares will surely go beyond shares of other industries and the benefit of buying quality stocks will exceed the loss of selling out inferior stocks. If the expectations are wrong, and share price in this industry falls instead of rising, the stocks of inferior companies will drop even more. The profit earned from short selling will be greater than the loss of price decline of quality stocks. Hedge funds were originally a fund management form used for risk avoidance and hedging right because of the above operations. However, with people's understanding of the financial derivatives getting deeper and deeper, hedge funds gain popularity in the market as they are capable of making profit even in a bear market.There is a reason behind hedge fund's excellent results and they profits are not aseasily made as the public perceived, managers of almost all hedge funds are outstanding financial brokers.

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Hedging Fund Highlights

Complexity of Investment Activities

In recent years, various increasingly complicated and novel financial derivatives such as futures, options and swaps gradually become the main operation tools for hedge funds. These products were designed for risk hedging, yet they have become powerful tools for many modern hedge funds' speculative behaviors for their low cost, high risk and high return. With complicated portfolios and designs, hedge funds are able to use these tools for investment based on their market predications, making supernormal profits when their predications are accurate or designing investment strategies based on the imbalance resulted from midsession fluctuations in the short-term to earn price difference when the market returns to its normal status.

The Concealment And Flexibility Of The Operation

Hedge funds differ greatly from securities investment funds offered to the normal investors not only in type of fund investors, capital raising method, information disclosure requirements and level of regulation, but also in the fairness and flexibility of the investment activities. Asset portfolios for securities investment funds are often clearly defined. The selection and proportions of investment tools are predetermined in respective plans. For example, balanced fund refers to a fund portfolio with 50% shares and 50% bonds whereas growth fund places more emphasis on investing in high-growth shares. Meanwhile, mutual funds are forbidden from using credit funds for investment, while hedge funds are completely free from such restrictions, which allows hedge funds to utilize all possible financial tools and portfolios, and use the credit funds to the largest extent possible to earn supernormal profits higher than the market average. Due to the highly concealed and flexible operations and leveraged financing effects, hedge funds play a very important role in the speculative behaviors in modern global financial market.

Private Placement of Financing Methods

Partnership is the most common organizational structure of a hedge fund. The fund investors join in the partnership with most of the capitals, but they don’t involve in the investment activities. The fund managers join in with capitals and skills and they are in charge of the investment decisions of the fund. Due to the highly concealed and flexible operations of hedge funds, the number of partners for a US hedge fund is normally controlled within 100, with each partner contributing more than $1 million.

High Leverage of Investment Effects

A typical hedge fund often uses bank credit to maximize its return on investment by adopting extremely high leverage to enlarge its investment fund several times or even dozens of times of its original size. The high liquidity of hedge funds' securities assets allows hedge funds to use the fund assets to conveniently make mortgages. A hedge fund with a capital of only $100 million can lend up to billions of dollars through repeated mortgages of its securities assets. The existence of this leverage effect makes it possible to deduct loan interest after a transaction, and the net profit is far greater than the possible benefit generated by $100 million in capital operation. However, it is precisely because of this leverage effect, hedge funds often face huge risks of excessive losses in the event of improper operation.

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Hedging Fund Comparisons

In a broad sense, hedge fund is also a type of mutual fund. However, it is different from common mutual funds in many ways, such as investorqualification, operation and regulation.

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Investor Qualification

Investors have to meet strict qualification requirements to invest in hedge funds. According to the US Securities Act, individual investors must maintain an annual income of at least $200,000 for the last two years. Household investors (wife and husband) must maintain an annual income of at least $300,000 for the last two years. Institutional investors must have a net asset of at least $1,00,000. New regulations were made in1996, the maximum number of investors of a hedge fund was raised from100to500. And the individual investors must own at least $5,000,000+ of investment securities to invest in a hedge fund. Common mutual funds don't have any of these restrictions.
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Investment Operation

The operations of hedge funds are unrestricted. There are few restrictions on investment portfolios and transactions, which allow the main partners and managers to adopt various investment technologies including short selling, transaction and leverage of derivatives freely and flexibly.
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Investment Supervision

Currently, the hedge funds are unregulated. The 1933 US Securities Act, 1994 US Securities Exchange Act and 1940 US Investment Company Act prescribed that institutions with less than 100 investors are exempted from registration at financial authorities such as Securities and Exchange Commission (SEC) and are thus freely from regulation. The reason behind this is that these investors are in small number and they are experienced and rich individuals with strong self-protection capability. In comparison, mutual funds are under strict regulations as most investors are common people, many of whom lack necessary understanding of the market. Strict regulations are thus necessary to help the public avoid risk, protect the weak and safeguard the social stability.

Differences Between Hedge Funds And General Funds

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