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Finance: What is a hedge fund? 41 Views

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How does a hedge fund work? Hedge funds, which deploy an array of strategies that include high risk leverage and derivatives, are private investment companies that are subject to less supervision from the SEC than mutual funds or ETFs. They are usually only open to accredited investors (as defined by the SEC). Asset classes are wide open and can include real estate, currencies, gemstones, or anything that can generate a trading profit, in addition to negotiable securities. The hedge fund is also compensated by both charging fees as well as taking a sizable percentage of profits as performance compensation.

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00:00
finance a la shmoop. how does a hedge fund work? so you've probably heard a lot
00:08
about the huge fees that hedge funds charge for the privilege of managing [woman looks shocked as hedge fund is advertised]
00:12
your money. that hedge funds are only investing vehicles for the wealthy and
00:17
how mathy their employees are. but the actual workings of a hedge fund are a
00:23
lot like driving down a road in wartime. there are hills and there are valleys

00:27
your car will Traverse wanting it to speed up and slow down but as long as
00:32
you continue to drive 37 miles an hour the enemy radar can't detect you so you
00:38
drive theoretically, safely down the road. alright so how does this translate to
00:42
financial investments in a hedge fund well essentially every investment made
00:47
on an entity going up in value is usually offset by making a bet on a
00:52
different entity going down in value. that's called hedging got it? the economy
01:02
is coming out of the doldrums and you believe the entire stock market is gonna
01:06
recover but you believe the worst companies which have been down some 90% [chart showing decline]
01:10
in this bad bear market environment will actually do better over the next period
01:16
of time than high quality companies like Coca Cola which didn't decline as much.
01:21
that is yes Coca Cola stock will improve and you think it has Headroom to run
01:26
upwards some 30% in the next year and a half but you believe crap burgers
01:30
dot-com which went from $100 a share at its peak to only $2 today could
01:36
quadruple to 8 bucks in value over that same 18 months. like you get a much
01:41
better percentage return on crap burgers than you do on coke. so as a hedge fund
01:45
manager one quote easy unquote trade that you'll make is too short coca-cola
01:50
betting essentially that it will go down, and then putting the same amount of
01:55
money to being long crap burger com betting essentially that it'll go up. in
02:00
essence the bet that you are making is that crap burger will go up a lot more [Coca-Cola and crap burger stocks in two separate baskets]
02:05
than coca-cola will go up but if the overall market goes down
02:09
well you'll be hedged in that you're short Coca Cola position will cushion
02:13
the blow of crap burgers further demise and it's likely you're looking at crap
02:18
burgers balance sheet and thinking well they have $2 a share in cash and no debt
02:22
how much lower can they go .got it? hedge funds use stock options
02:26
aggressively to manage risk in their portfolios the promise hedge funds make
02:31
to investors is that their performance will be up and/or good whether the
02:37
market goes up down or stay sideways. so another common hedge trade involves the
02:42
use of put options on the market to protect the long trades the fund is
02:47
making. specifically a hedge fund might find 3 S&P 500 stocks it really likes [ put option explained]
02:52
and believes that they will be up significantly over the next two to three
02:55
quarters earnings reports. but it's also nervous about nukes in North Korea in
03:00
order to protect against a bomb going off and the whole market going down and
03:04
ruining its investment performance, and yes there are bigger things to worry
03:08
about then but that doesn't matter to hedge funds not their job. the hedge fund
03:12
goes long the three stocks it likes but it buys put options on the market
03:16
betting with those options that the market itself will go down. it's
03:21
essentially playing both sides of the fiddle so that hopefully it wins in any
03:26
set of circumstances. and yeah it's a lot more complicated than that in practice
03:29
we're just given the idea here. in the case of a put option the market might be
03:32
trading at ten thousand and a put option might have a strike price of nine
03:36
thousand such that if the market declines below nine thousand the put [strike price illustrated]
03:39
option goes quote in the money unquote and pays the investor handsomely for
03:44
making the bet that the market would go from ten thousand and well somewhere
03:47
below nine thousand. if that happened the three long stock bets that the hedge
03:51
fund made would go down but their decline would be hopefully more than
03:55
offset by the gains from the put options the hedge fund bought that were
04:00
portfolio life insurance in the case the market puked. and if that happens well
04:05
all you can really do is offer the market a breath mint and a moist
04:08
towelette and then be sure to collect your fee. [person representing stock market offered towelette]
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