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What are hedge funds and what do they do?

Laura Carson Miller is freelance lifestyle writer in Atlanta, writing for magazines and the web. Her favorite subjects include beauty, health/wellness, and financial issues. She is also an avid cook, gardener, fashionista and interior st...

Exclusive investments: high risk and reward

Have you heard of hedge funds but aren’t sure exactly what they are and how they operate? I’ll take you through the basics, so you have a better understanding of how a hedge fund attempts to make money, regardless of how the actual market is performing.

Couple meeting with financial advisors

What is a hedge fund?

A hedge fund is an investment fund that is carefully and assertively managed and uses sophisticated strategies to make money for its investors. Hedge funds are usually open to investment from a small number of participants, and often the minimum investment can be rather steep. They are not a liquid investment, as many require money to be kept in the fund for up to a year. Sometimes the owners and managers put their own money into the fund, which is said to keep it better positioned to protect their interest, with their vast financial knowledge and commitment to success.

What does a hedge fund do?

Hedge funds pool investors' money and use it to -- among other things -- invest in a wide variety of derivatives, trade options, bonds or futures, take both long and short positions and basically look to quell volatility and deliver positive results for their clients no matter what the markets are doing.

As the name suggests, hedge funds seek to protect themselves from higher risk in the daily market fluctuations by hedging their bets, so to speak. Their focus can be quite narrow or quite broad, and lack of regulations on how they perform leaves it up to the people at the top to figure how best to make money for the funds' investors. While the individual investor in a hedge fund is usually someone in a good financial position (you have to meet financial requirements as stated by the fund and provide paperwork), many institutions such as banks, pensions and insurance companies also put money in various hedge funds. Because they can invest in anything they choose (a UK hedge fund focusing on sports gambling folded earlier this year after losing $2.5 million in investments) it pays (no pun intended) to know and trust the people behind the fund you plan to place your money with. Some people are comfortable with the attitude "I give you the money and I trust you to make the investment calls," while others want to know more about where their money is going.

Unfortunately, one way you might have heard of hedge funds is through the news of a few of their more infamous managers, including Raj Rajaratnam, who was convicted of insider trading, received 11 years in prison in New York and was fined $10 million. Another example is Joseph "Chip" Skowron, an orthopedic surgeon turned hedge fund manager. He made a fortune with his medical knowledge, trading health care stocks, then wound up in jail for insider trading involving the confidential results of clinical drug trials.

Hedge funds are a breed of their own and may offer rewards accordingly. Each and every investment involves risk and the level of reward can depend on the news of the day, be it good or bad. Be warned.

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