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What Are Hedge Funds?

Understanding the Nature and Risks of Hedge Funds

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Definition:

A hedge fund is an investment type that uses a wide range of strategies designed to protect investors from downturns in the market while still participating in positive market environments. Hedge funds are offered to private investors and are not publicly offered on an exchange or required to follow the same legal rules as publicly traded funds, such as mutual funds.

The Nature and Risks of Hedge Funds:

By design, hedge funds attempt to have positive returns regardless of what is happening in the stock market. To achieve this low correlation with mainstream investments, such as mutual funds, that tend to move in step with the overall stock market, hedge funds use complex and risky strategies.

For example, a hedge fund might use speculative investments, such as futures contracts (a type of derivatives), that are not different than gambling on certain market outcomes. By selling a futures contract, the hedge fund is "betting" that the stock market will fall. Therefore, if the hedge fund's other investments fall with the market, their futures contracts will have positive returns and therefore protect the hedge fund investors from excessive losses. This is where the "hedging your bets" phrase applies.

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