A hedge fund is a business structure and investment vehicle that pools capital from many investors and invests in many instruments such as securities. It is different from a mutual fund because regulators do not cap their use of leverage and from an equity fund because most hedge funds invest in relatively liquid assets. A hedge fund is administered by professional management firms that use distinct investment instruments and trading strategies with the specific goal of diminishing market risks to generate risk-adjusted returns. They produce returns relatively uncorrelated with the prevailing market indices. Like all other investment types, hedge funds are not immune to risks and, therefore, should be administered exclusively by professional and highly experienced management firms.
Hedge fund investors should be aware of the investment risks and be willing to accept them due to the potential returns to the risks. The funds’ administrators always need to employ extensive risk management strategies to secure the interest of the investors and the fund. The Financial Times recently reported that huge hedge funds possess some of the most refined and demanding risk management practices in asset management.
Hedge fund managers may have a specific all-inclusive risk management system in place and hold many investment positions for short duration. Funds may also have risk officers whose primary responsibility is to access and manage risks, but have no role to play in trading. Fund managers can employ numerous strategies such as formal portfolio risk models and a variety of measuring techniques to calculate the risk incurred by any hedge fund activities.
Also, hedge fund managers can choose to use different techniques depending on their fund’s structure and investment strategy. Conventional risk measurement methodologies do not count some factors such as normality of return. Hedge funds that use value at risk as a measure of risk in most cases employ more models including “time under water” and draw-down as a compensation to ensure all risks are captured.
Apart from assessing the market-related risks, investors use operational due diligence to evaluate the risk that fraud or error at hedge fund might cause them. Factors that must be put into consideration include management operations at the fund manager, the ability of the fund to develop a company, and whether the investment strategy is sustainable. Experienced hedge fund management firms understand the risks and have demonstrated that it is possible to reduce the risks. Citadel, a diverse financial institution based in Chicago, is an industry-leading alternative asset manager and leading liquidity providers in the United States’ capital market. The global financial institution was founded by Ken Griffin and has demonstrated that hedge fund management is viable.
Kenneth C. Griffin Started investing during his freshman year at Harvard University and during his second year at the same university he started a hedge fund focused on convertible bond arbitrage. He graduated with a degree in Economics from Harvard University in 1989. A year later, Griffin founded Citadel with $4.6 million. The firm has been in existence for over two decades.