The term hedge fund is used to indicate a 'hedge' against investment deterioration. Hedge fund can be defined as a managed portfolio that has targeted a specific return goal regardless of market conditions. Hedge funds specialize in gaining maximum returns for minimum risk. Hedge funds use a wide variety of different investing strategies to achieve this goal and generally these strategies are managed and executed by a portfolio manager.
Strategies that can be used by the portfolio manager of a hedge fund
include short selling, arbitrage, hedging and leverage. The portfolio
manager uses these options to remain flexible and weather the various
storms of the market.
Short selling means borrowing a security (or commodity futures
contract) from a broker and selling it, with the understanding that it
must later be bought back (hopefully at a lower price) and returned to
the broker. Short selling (or "selling short") is a technique
used by investors who try to profit from the falling price of a stock.
Arbitrage means attempting to profit by exploiting price differences of
identical or similar financial instruments, on different markets or in
Hedging is the practice of offsetting the price risk inherent in any
cash market position by taking an equal but opposite position in the
futures market. A long hedge involves buying futures contracts to
protect against possible increase in prices of commodities. A short
hedge involves selling futures contracts to protect against possible
decline in prices of commodities.
Leverage is the use of borrowed funds at a fixed rate of interest in an
effort to boost the rate of return from an investment. Increased
leverage causes the risk and return on an investment to also increase.