Equity hedge funds are funds that are created to reduce risk while maximizing returns on investment. Hedge funds have become synonymous with speculation and volatility, but the risk is not without strategy. The legal structure of most hedge funds is private investment partnerships that are open to a limited number of qualified investors and require a very large initial minimum investment which is held for an extended period of time, usually for one year. This hold on the initial investment makes the hedge fund illiquid. The equity hedge fund uses a myriad of financial strategies to reduce risk, such as: short sales, leverage, puts, calls, options, and futures. Because hedge funds have a multitude of strategies to use, the levels of volatility of the funds can vary.
Equity hedge funds are often included in the investment portfolios of pension funds, endowments, insurance companies, private banks, and wealthy individuals because of the high level of return that hedge funds can achieve with proper management. An equity hedge fund may be either global or limited to one or more specific countries, hedging against downturns in equity markets by shorting stocks that are considered overvalued. Short selling a stock is to sell shares of stock without actually owning them with the hopes of buying them back at a later date for a lower price. Equity hedge funds can also use a strategy known as arbitrage, which is when the fund manager seeks to exploit pricing inefficiencies between securities that are related. An example would be a fund that can long convertible bonds and short the equity of the underlying issuers. Equity hedge funds can also participate in speculation, which is investing with the anticipation of favorable results of a specific event like a merger, a split, or an exit from a bankruptcy.
The styles of hedge funds vary according to the level of return desired. Some equity hedge funds are termed aggressive growth, which is investing with the primary goal of accelerated earnings growth, but carry a high rate of volatility. Other high risk styles would include short selling and emerging markets investing. Equity hedge funds that invest in the equity and debt of companies facing bankruptcy at deep discounts carry a low to moderate risk of volatility. Qualified investors have the option of investing in a fund of equity hedge funds. A fund of equity hedge funds may be widely diversified, or they can be sector or country specific. It would provide returns that are more predictable then traditional investment funds, debunking the myth that all equity hedge funds are volatile and unpredictable.