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As part of a long-term investment strategy, it is important that you get to grips with your portfolio and its diversification. Equities and bonds, for example, can be supplemented with alternative investments. Read also “What are alternative investments?”.

Hedge funds are one type of alternative investment. They aim to exploit potential returns from various asset classes. In the following, we explain what hedge funds are and illustrate their opportunities and risks.

Hedge funds are among the more complex of investment instruments. Their goal is to generate returns not only in rising, but also in falling or sideways financial markets. Despite the name, hedge funds have little in common with traditional investment funds. They are only similar in that the investor entrusts the management of the fund to a manager, who actively manages the investment and the risks.

Unlike traditional investments, hedge fund managers have a variety of financial instruments and strategies at their disposal. Depending on the investment strategy, they aim to achieve returns in one or more asset classes, for example, stocks, commodities or currencies. More unconventional instruments such as insurance-linked securities are also possible. A diversified and more flexible approach is used to try and prevent significant capital losses and to counteract unfavorable market situations.

Compared to “normal” funds, hedge funds can also sell short. Short selling is the sale of, for example, options or securities that you do not own at all, but which are “loaned” by the owner for the transaction. The (short) seller aims to buy back the securities at a later date at a lower price and return them to the owner. The resulting difference is kept as profit. This is an example of how it is possible to benefit from falling prices.

Hedge funds benefit from significantly less stringent regulation than traditional investment funds. This allows a more flexible investment mandate and makes possible investing across several asset classes. A variety of financial instruments such as short selling or derivatives can also be used. Looser regulation and financing often strongly driven by debt capital are the main reasons for the somewhat negative image of hedge funds.

Hedge fund managers can follow very different investment strategies. In general, these can be divided into four groups. The approaches differ in terms of asset classes, investment levels and target returns.

Equity hedge (long-short strategy)

The most common strategy is the “equity hedge approach.” The fund manager invests in the shares of different companies, speculating on their future price movement. Investments that they consider undervalued (long positions) are held and those that are considered overvalued (short positions) are sold. A large proportion of hedge funds focus on the short position and thus on the short selling described above.

Event-driven strategy

With this strategy, one or more markets are closely monitored and certain events that occur within them are used as investment opportunities. The hedge fund manager speculates on company takeovers, mergers, bankruptcies and turnarounds of companies requiring restructuring. The goal is to evaluate potential misjudgments at each event and to generate profit from this uncertainty.

Relative value strategy

In this approach, the fund manager takes advantage of the price differences between securities in different markets. They buy securities on one exchange and make a profit by selling them at a higher price on another.

Global macro strategy

As part of this strategy, the fund manager monitors markets and their development from a macroeconomic perspective. They try to evaluate trends and opportunities in equity, bond or currency and commodity markets, allowing them to systematically exploit potential return opportunities.

As already explained, a large amount of money is usually required to invest in a hedge fund. As direct investments, they are therefore more geared towards institutional investors. Due to their complexity, they are also suitable for experienced investors with broad investment knowledge.

Another type of hedge fund investment is offered by so-called funds of hedge funds. These are funds which, in turn, contain various hedge funds. By diversifying the various investment strategies and types of investment, investment risk can be spread more widely.

It is easier to invest in hedge funds as a diversifying portfolio component under an asset management mandate. The optimal share of the overall portfolio is determined by the selected strategy and managed by the portfolio manager.