Hedge funds are difficult to define because they are not a homogeneous group despite this being the common perception. Hedge fund managers use many different approaches to running money and therefore do not fit one definition.

It is possible, however, to highlight certain characteristics, some of which are used by all or many hedge funds. These include the fact that generally hedge funds seek to generate absolute returns rather than try to out-perform an index. Hedge funds typically do not worry about whether the weightings of underlying holdings are close to those of an index.

Most hedge fund managers use short positions. Selling short is where a manager sells an asset he does not own to then hopefully be able to buy it back again at a lower price. He does this through borrowing shares. A hedge fund manager may use short selling to balance long positions he has and therefore reduce risk in a portfolio. Of course, he will also short sell when he believes share prices will fall in the future.

Investors have increasingly turned to hedge funds in recent years because of the potential attractive risk return characteristic. While this is not true for all hedge funds, many can enhance returns and reduce volatility. Some strategies have a low correlation to equities and bonds. This can be achieved through the ability to short stocks as well as take long positions, their investment flexibility and to have significant holdings in cash. Hedge funds usually have few restrictions on their investment approach. This includes being able to borrow money, which is known as gearing, to enhance certain exposures and therefore try to increase returns.

Hedge funds benefit from attracting some of the most talented fund managers in the industry and the potential ability to deliver absolute returns in any market environment.

Hedge funds can also act as a diversifier by providing low correlation to the traditional asset classes of equities and bonds while fund of hedge funds diversify risk across a broad spectrum of strategies.  

Managers traditionally invest in their own funds and may even own the business. This provides an incentive to not only deliver positive returns, but also to protect capital. Another incentive can come through the application of performance fees, which are commonplace among hedge funds. In theory, they provide an incentive for managers to deliver absolute or positive returns and thus benefit from a higher fee. This should align the interests of hedge fund managers with investors as a positive return benefits both parties.

There are potential disadvantages as well as advantages to the use of performance fees, however. Hedge funds usually earn a fee of 10% to 20% of the out-performance of the fund. This should be subject to what is known as a “high water mark” to prevent you having to pay twice for the same gain. Under this system, when a fund falls in value investors do not pay a performance fee again until the price recovers to above the level where a performance fee was last charged. Many have hurdle rates so that merely posting positive returns is not sufficient to earn a performance fee. The problem is that the positive return may be more the result of the market environment than the skill of the manager.

While performance fees should provide an extra incentive to hedge fund managers, it can also encourage more reckless management, however, as they try to attain the performance fee as the end of year approaches. It can lead to successful hedge fund managers accumulating great wealth and therefore losing their internal drive to deliver out-performance. 

Another development in the hedge fund world that has now spread to unit trusts has been limiting the size of funds. It is argued that limiting the amount of assets provides more opportunities for hedge fund managers to out-perform as they only need to invest in their “best ideas”. Too much money can lead to a dilution of the quality of a portfolio.

Factors that have restrained the growth of hedge funds among the wider investment public have included the requirements for high initial investments, the fact that they are usually subject to lighter regulatory controls than onshore unit trusts and the restricted size of hedge funds.