Importance of hedge funds in modern financial markets Free essay! Download now
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Importance of hedge funds in modern financial markets
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| Words: 2234 | Submitted: 11-Dec-2012
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DescriptionThis essay seeks to explore the importance of hedge funds in the financial world
Explain the importance of hedge funds in modern financial markets. Why are ‘short-selling’ hedge funds criticised for their impact on markets in recent years?
A hedge fund is a term used to describe a private investment fund which uses both long and short equity positions (US Securities and Exchange Commission 2003). Hedge funds have a designated fund manager who decides on investment decisions. The funds are mainly setup as partnerships with private investors investing their money with a view of getting a positive return from which the fund manager will take a previously agreed share from. Partnerships are formed usually with less than a 100 people as it allows the fund to avoid regulations set by the Investment Company Act of 1940 (Ackermann et al. 1999). The majority of hedge funds have certain standards such as a minimum investment amount which restricts potential investors to pension funds, large organisations and individuals with a high net worth (HedgeWorld 2011).
Investments in hedge funds come with a high amount of risk as it is based on speculation, leveraging and short selling of stock as well as other uncertain investment practices. Leveraging is the process of using debt to finance activities (Economist 2012). This is generally a high risk practice with high leveraging seen as unhealthy due to the high debt to equity ratio. It is used widely due to the high rate of returns but at the same time entails a higher risk. Hedge funds are also said to be illiquid and therefore capital cannot be removed from the fund except on previously agreed dates.
In finance, hedge is a term used to reduce the potential loss that may be incurred by individuals or organisations (Financial Dictionary 2012). Individuals or organisations will seek to reduce uncertainty in their investment portfolio by hedging the risk. There are many ways in which risk can be hedged; one common way is by diversifying the investment portfolio. The advantage of doing this is that investors will have a cushion to fall back on should their initial investment not go ahead as planned.
The modern day idea of a hedge fund was created in 1949 by a financial journalist called Alfred W. Jones (Frush, S 2007). His aim was to minimise the amount of risk in investments by short selling stocks. By limiting the fund to a pool of a 100 investors the fund avoided regulations set by Investment Companies Act of 1940 (Ackermann et al. 1999). For official purposes this is seen as a limited partnership therefore the fund is not required to register with the securities and exchange commission of the USA (known as the financial services authority in the UK). By avoiding financial regulation set by the ...
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