How do hedge funds work?
Hedge funds work by taking money from rich investors with a high tolerance for risk and placing that money in high-risk investments that are likely to yield higher returns.
Due to their deregulated environment, hedge funds have the freedom to invest in riskier assets like volatile stocks, structured derivatives, swaps, and options. They can also short stocks and thus hedge their risks. All this investing flexibility allows them to generate higher returns to their investors.
Hedge funds sometimes lose money, and this is a risk that fund investors are willing to take in exchange for higher returns. Sometimes however, things don't work out so well and hedge funds lose a lot of money. Hundreds of hedge funds have closed down over the past few years.
Hedge funds work by channeling investors' capital into risky investments and complex portfolios with the goal of achieving high absolute returns.
The investors typically trust the hedge fund to do all the work to generate profits, and hence the fund usually has leeway in deciding where and how to invest the money. Unlike some other types of funds, hedge funds can be very secretive about their investment strategies.
Some hedge funds use quantitative tools to make investing decisions, others use fundamental analysis, and some even use macroeconomic theory to find investment opportunities.
Hedge funds are not always successful however, and even some famous hedge fund managers have lost money in some years.