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Modern Hedge Funds No Longer Successfully Reduce Risk

2159 words - 9 pages

Examine the view that modern hedge funds are no longer capable of successfully reducing risk, and that they now struggle to provide absolute returns to investors

An economy requires a financial system that moves funds from people who save to people who have productive investment opportunities.
A hedge fund is an actively managed fund that seeks an absolute return, that is, a return whether markets go up or down (Valdez & Molyneux 2013). Hedge funds are often confused of obtaining the same risk pattern as normal investments, hedge funds have a unique scale of risks that make them different to evaluate and analyze.
Hedging is making an investment to reduce the risk of an investment by making an offsetting investment. There are a large number of hedging strategies that one can use. (Farlex 2012.)
An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. (Investment dictionary 2012).
There are many different areas to consider when evaluating whether modern hedge funds are no longer capable of successfully reducing risk, and if they now struggle to provide absolute returns to investors; leverage, short selling, inflation, recession and other aspects that combined provide an answer on hedge funds.

A hedge fund uses various different techniques, investing in a wide range of assets creating maximum returns at lower risks than a normal investment. Hedge funds are tailored to generate returns despite the market fluctuations.

Leverage is a strategy, where hedge funds experience huge losses, as any adverse effect gets multiplied and worsens. Therefore, leverage has been the main reason for businesses such as Amarnth ceasing to exist (Chincarini, L. 2008).
Leverage is the skill to carry out a deal with only a small amount of the investors’ capital. There are many ways of achieving this, one of which is to borrow all or most of the money and another is to put forward a premium. In both cases it produces a percentage profit or loss for the investor. For example if an investor buys $200,000 shares in Apple, using $50,000 of their own capital and borrowing $ 150,000; after four months the share price will go up 20% and the shares will then be worth $240,000. If the investor then sells the shares, he/she will make a $40,000 profit. However, suppose that the price falls by 20%, in this case, the shares will be worth $160,000 which will incur a huge loss, hence, risk is inevitable (Valdez & Molyneux 2013).

Short selling is the best way of making money out of a price fall. In this case, you will sell a security you don’t own, expecting to deliver them in the required timescale; you shall then borrow from a lender to deliver the shares. In hoping that the shares fall, you will buy the shares for a cheaper price making a profit. On the other hand, it will be undeniable if the shares go up as the short seller will receive a loss. ‘For Hedge funds...

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