How does a hedge fund work ?

A hedge fund, or "alternative investment", is a complex form of portfolio management, because it is not clearly defined, and is subject to little or no regulation. However, hedge funds have grown rapidly in recent years, at the risk of destabilizing the markets. That's why it's particularly interesting to get to know them and understand how they work. Would you like to specialize in finance?  Take a look at our Master's degree in Corporate Finance and learn how to master the complexities of financial products, markets and structures.

What is a hedge fund ?

A hedge fund is an investment structure that aims to maximize returns for its investors while minimizing risk through a variety of often complex financial strategies. Unlike traditional mutual funds, hedge funds enjoy greater freedom in terms of asset management, and can invest in a wide range of financial instruments, including equities, bonds, commodities and derivatives. Their flexibility and aggressive approach to markets make them powerful tools for well-trained investors. More than 80% of hedge funds are located in tax havens in order to avoid regulation.

Hedge funds are characterized by their frequent use of leverage (borrowing to increase potential returns), short selling (betting on the downside of assets), and strategies designed to take advantage of market weaknesses. These funds are often reserved for institutional investors or wealthy individuals, as the minimum investment amounts are high and the risks are significant.

There are 5 main types of hedge fund, each with its own management strategies and return objectives:

Type 1: Long/short equity funds

This type of hedge fund invests in both stocks that it expects to rise (long positions) and those that it expects to fall (short positions). It seeks to generate returns irrespective of market conditions.

Type 2: Relative value funds 

These funds exploit valuation inconsistencies between similar assets through arbitrage strategies. While pure arbitrage is risk-free, relative value arbitrage always involves a degree of uncertainty.

Type 3: Directional funds 

Directional funds take positions in the markets, profiting from bullish and bearish trends through short selling. Strategies such as long/short allow you to reduce market risk while betting on the under- or over-valuation of stocks.

Type 4: Event-driven funds 

These funds take advantage of transactional events such as mergers, acquisitions or bankruptcies. They speculate on changes in company valuation linked to these events, notably through merger arbitrage or activist strategies.

Type 5: Global macro funds 

Macro funds speculate on global macroeconomic trends based on national and global economic models. They try to anticipate the effects of major economic or political events on the markets, as George Soros did with sterling.

For students wishing to master the intricacies of hedge funds and corporate finance, we recommend EDC Business School's Master in Corporate Finance. This program combines an in-depth understanding of financial markets, corporate valuation techniques and advanced investment strategies. Thanks to this practical, market-oriented training, graduates are ideally prepared for strategic roles in asset management, investment and corporate finance.

How hedge funds work ?

A hedge fund is made up of several major players who influence its operation. Investors are generally wealthy individuals, institutions or pension funds who invest their money in the hedge fund. Access is generally limited to qualified investors, as the minimum investment amounts are high. Fund managers are responsible for investment decisions, using their skills in financial analysis, risk management and strategy to generate returns. Brokers and banks facilitate transactions for hedge funds, providing the financial instruments and services needed to execute buy and sell orders.

Hedge funds are characterized by the diversity of the strategies they employ. The best-known is undoubtedly leverage, when a hedge fund borrows money to amplify the size of its investments, thereby increasing the potential for gains (but also losses). Hedge funds also engage in short-selling: the manager bets on a stock's decline by selling it before buying it back at a lower price. Finally, there's arbitrage, which involves taking advantage of price differences between two markets or two similar assets by buying at a low price and selling at a higher one.

Another important aspect of hedge fund operations is their remuneration model, often referred to as the "2 and 20" model. This means that the manager receives 2% of assets under management, collected even if the hedge fund doesn't make a profit, and 20% of profits on gains generated, giving the manager an incentive to maximize returns.

Although hedge funds are often perceived as risky instruments, they are also highly attentive to risk management. Managers use sophisticated mathematical models, hedging tools and market analysis to try to reduce exposure to certain market fluctuations. In this way, they seek to avoid major losses while maintaining high potential returns.

How companies use hedge funds in their investment strategies ?

Hedge funds enable companies to diversify their portfolios by investing in assets uncorrelated with traditional financial markets. This reduces their exposure to sector-specific risks. In addition, hedge fund instruments help companies to protect themselves against market fluctuations, by taking inverse positions to offset potential losses.

Hedge funds often specialize in arbitrage, i.e. capturing valuation differences between similar assets. For example, during mergers or acquisitions, companies can take advantage of hedge fund strategies to maximize returns by betting on the price movements of the shares involved in the deal.

Finally, some companies use hedge funds to speculate and maximize returns. By entrusting part of their capital to hedge fund managers specialized in areas such as real estate or currencies, they benefit from cutting-edge expertise and advanced investment strategies, sometimes inaccessible via traditional methods.

List of professions working in or related to hedge funds

Job 1: Portfolio Manager

The portfolio manager is responsible for the hedge fund's investment strategy. He or she makes decisions on buying, selling and asset allocation based on the fund's objectives and market conditions. Their expertise and intuition are essential to generating positive returns.

Job 2: Financial analyst

The financial analyst provides recommendations to the portfolio manager by studying markets, sectors and companies. They use quantitative and qualitative models to assess investment opportunities and identify under- or over-valued assets.

Job 3: Trader

The trader executes the investment decisions of the portfolio manager. They buy and sell equities, bonds, currencies or derivatives according to defined strategies, while monitoring market movements in real time.

Job 4: Risk Manager

The risk manager identifies, assesses and mitigates the financial and operational risks to which the hedge fund is exposed. He or she implements hedging strategies to protect the fund against unexpected losses due to market fluctuations.

Job 5: Compliance Officer

This role is crucial in ensuring that the hedge fund complies with current financial regulations. The compliance officer ensures that the fund's activities comply with laws and regulations, and that there is no fraudulent behavior or market abuse.

Job 6: Quantitative analyst (Quant)

Quantitative analysts use mathematical models and algorithms to create automated investment strategies. Their expertise in mathematics and programming is essential to the development of sophisticated trading strategies.

To master these cutting-edge finance professions and acquire the skills needed to succeed in environments as demanding as hedge funds, EDC Paris Business School's Master in Corporate Finance offers you an excellent training program that will open the doors to the largest financial institutions.