‘Hedge’ is a widely used term in the financial markets. The word is associated with the popular investment vehicle called hedge fund. By definition, it means limiting or qualifying by conditions or exceptions.
If used as a financial lingo, hedge means protecting oneself on a bet or investment. But beyond the semantics, hedge in the context of finance is basically a strategy.
Where does Hedge in Hedge Fund come from?
Hedging is the common practice done by hedge fund managers or ‘visionaries’ in the investment world. It’s regarded as an advanced but simple investing strategy. To the layman, a hedge fund seems difficult to comprehend. Actually, the principle is easy to understand but using it as a strategy is the hardest thing to learn.
In the investment realm, the primary objective of an investor is to bet on an investment that will preserve capital and derive gains. The only way to realize that objective is to prepare for a negative event that will result in losing the money, partly if not all of it.
Thus, when an investor chooses to hedge, it’s ensuring that the money or principal invested will return plus some more. So even if the market condition is unfavorable, the investor is suitably hedged. The effect is bearable and the extent of financial harm is neutralized.
The same principle applies when you obtain auto insurance. Your prized asset is covered by own damage and theft as well as damage to third party property. In essence, hedging is about protection.
Hedge funds are gaining tremendous popularity not only because investments are protected, but also because of the boundless opportunities to build wealth. Many high-net-worth individuals and corporate institutions go to hedge fund managers who possess the gift of spotting profitable opportunities.
Apart from investment protection, investors are particular about investment appreciation. Both equally important to them and hedge fund managers can get the job done.
How hedging works
The educated investor knows that there’s no such thing as a risk-free investment. Market volatility is ever present. A downturn is also a market characteristic. The solution to contain these eventualities is to hedge.
Hedge fund managers are good at picking various investment instruments and combining them in a basket of assets. By mixing them together, investment risks are moderated. A certain investment can falter but another can prosper.
In other words, while the hedge fund manager remains focused on profits, diversification reduces the risk or potential losses. Therefore, hedging is a technique that’s meant to strike a balance between the risk and reward of the investment portfolio.
Hedging can come in many forms. For example, a hedge fund firm will purchase shares of a listed company that’s performing badly. However, the manager foresees a turnaround in the future because the firm’s project is soon to come upstream.
The word hedge can no longer be disjointed from hedge funds. It’s an industry practice that has been proven effective to lessen or adjust the risk. The technique can be used against almost anything, from stocks and commodity prices to interest rate or currency fluctuations. Learning the strategy can be extremely useful in case you need to hedge at one point in the future.