A complete guide to how hedge funds in the American investment market operate

Hedge funds are alternative investments that take advantage of market opportunities. These funds require a more considerable initial investment than other options and are generally only accessible to accredited investors. This is because hedge funds require much less regulation from supervisory bodies, such as the Securities and Exchange Commission (SEC) in the United States than others, such as mutual funds. Most hedge funds are illiquid, which means investors must keep their money invested for more extended periods, and withdrawals tend to occur only in specific periods.

As such, they use different strategies so that their investors can earn positive returns. In this form of financial investment, potential hedge fund investors need to understand how these funds profit and how much risk they take when placing their money. While no two hedge funds are identical, most use one or more of several specific strategies described below to generate their returns.

• Hedge funds are flexible investment vehicles that can utilize leverage, derivatives, and take short stock positions. 
• Hedge funds use different strategies to try to generate active returns for their investors because of this. 
• Strategies for hedge funds range from share buying/selling operations to neutral market strategies.
• Merger arbitrage is a type of event-driven strategy, which can also involve distressed companies.

Today, one of the pioneers of hedge funds is the Wall Street based American-Lebanese entrepreneur, philanthropist, Marc Hanna Malek. He is also a Lebanese rights advocate and a Wall Street executive specializing in global macro hedge fund strategies. Malek is the Founder of Conquest Capital Group.

Research by Malek has been widely published in scholarly journals and books, including Risk Books and Alternative Investment Journal.

The first hedge fund used a strategy of buying/selling shares in the stock market. Created by Alfred W. Jones in 1949, this strategy is still used in most of the investments in stock market assets made by hedge funds today. The concept is simple: Investment research usually shows potential winners and expected losers, so why not go for both?

Under this concept, the fund takes bullish positions in the investments it considers to be winners as collateral to finance its short positions in the assets it considers to be losers. The combined portfolio creates more idiosyncratic earnings opportunities (i.e., specific to the stocks being invested), reducing market risk while short positions offset bullish market exposure.

Simultaneous short buying/selling of stocks is an extension of stock pair trading. Investors open buy and sell positions in the stocks of two competing companies in the same industry based on their relative valuations. It is a relatively low-risk leveraged trade performed based on the investor's stock selection skill.

For example, if General Motors (GM) stock appears cheap compared to Ford stock in a certain period, a trader may decide to buy $100,000 worth of GM stock and sell Ford stock for equal value. The net market exposure is zero, but the investor will make money no matter what happens to the overall market if GM outperforms Ford.

Now suppose Ford is up 20% and GM is up 27%. The investor sells GM for $127,000, hedges the short Ford position for $120,000, and makes a $7,000 profit. If Ford falls 30% and GM falls 23%, the investor sells GM for $77,000, hedges the short position in Ford for $70,000, and makes $7,000. However, if the investor is wrong and Ford outperforms GM, he will lose money.

Before committing money to any hedge fund, investors should carry out a thorough analysis and research. Knowing which strategies, the fund uses, and its risk profile is an essential first step, particularly considering that they use high-return but high-risk strategies in some cases.