Hedge Funds

Lesson

Hedge funds are private investment funds that pool capital from accredited individuals or institutional investors and invest in various assets, often with complex portfolio construction and risk management techniques. Hedge funds are typically structured as limited partnerships. As a result, they are subject to fewer regulations than other investment vehicles, allowing them to employ many investment strategies to generate high returns.

Practice Question #1

Which of the following best describes a hedge fund?

A) A highly regulated investment vehicle that tracks an index

B) A pooled investment vehicle subject to fewer regulations than mutual funds

C) An individual investment account managed by a professional investment manager

D) A type of bond issued by corporations

Select an option above to see an explanation here.

A) This describes an exchange-traded fund (ETF). B) Hedge funds are pooled investment vehicles with fewer regulations than mutual funds, allowing them to employ various investment strategies. C) This describes a separately managed account (SMA). D) This describes a corporate bond.

Terms

Hedge Fund:: A private investment fund that pools capital from accredited investors and uses a variety of investment strategies to generate returns.
High Water Mark:: A provision in a hedge fund's fee structure ensures the fund manager only earns a performance fee on new profits, not on gains that simply recover previous losses.

Practice Question #2

What type of investor is typically allowed to invest in hedge funds?

A) Retail investors

B) Accredited investors

C) Government entities

D) Non-profit organizations

Select an option above to see an explanation here.

A) Retail investors typically do not meet the income and net worth requirements to invest in hedge funds. B) Accredited investors meet certain income and net worth requirements, allowing them to invest in private investment funds like hedge funds. C) Government entities may invest in certain funds, but this is not specific to hedge funds. D) Non-profit organizations may invest in certain funds, but this is not specific to hedge funds.

Do Not Confuse With

Mutual Funds:: Pooled investment vehicles subject to more regulations than hedge funds and typically invest in a more diversified portfolio of stocks and bonds.
Exchange-Traded Funds (ETFs):: Investment funds that trade on stock exchanges and typically track an index, sector, or commodity.
Separately Managed Accounts (SMAs):: A professional investment manager manages individual investment accounts, with the investor retaining direct ownership of the underlying securities.

Practice Question #3

Which of the following investment strategies is commonly used by hedge funds?

A) Dollar-cost averaging

B) Passive index tracking

C) Short selling

D) Dividend reinvestment

Select an option above to see an explanation here.

A) Dollar-cost averaging is a strategy used by individual investors to invest a fixed amount of money at regular intervals, regardless of market conditions. B) Passive index tracking is a strategy used by exchange-traded funds (ETFs) and some mutual funds. C) Short selling is a common strategy hedge funds use to profit from declining asset prices. D) Dividend reinvestment is a strategy that individual investors and some mutual funds use to reinvest dividends into the investment.

Historical Example

In the late 1990s, a hedge fund called Long-Term Capital Management (LTCM) employed highly leveraged strategies and complex derivatives to generate significant returns. However, the fund ultimately collapsed in 1998 due to market volatility and excessive leverage, leading to a bailout by major financial institutions to prevent a larger market crisis.

Practice Question #4

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Example Series 65 Example Practice Question

Real-World Example

An accredited investor invests in a hedge fund focusing on technology stocks. The hedge fund uses a combination of long and short positions and derivatives to generate returns regardless of market conditions. Over time, the investor's investment in the hedge fund grows, giving them a higher return than they would have achieved through a traditional mutual fund or ETF.