In the United States where they were born and have the maximum development, a precise juridical definition is missing, thus their scope looks quite “unbordered” and their true meaning is not suddenly clear.
Just limiting to consider their literal meaning – investment funds that use coverage techniques, would let us miss at least some of the main features they are characterised by, if it wouldn’t make us look at a completely wrong direction.
A definition that would sound appropriate might be – A hedge fund is an investment instrument that offers different characteristics of risk/return with respect to traditional investments like shares and bonds.
To get their true meaning though we must first understand how they operate. Basically they use investment strategies, or management styles, which we can define “alternative” and have not norms or regulations they must comply with. Their only mission is to keep the capital and guarantee a positive return with a low volatility and whatever the direction of the market is.
This is one of the main differences they have with mutual funds. While the mutual funds performance is evaluated with respect to a reference index (benchmark), the hedge funds try to guarantee a return in any given situation or circumstance, that is whether the market indexes are going up or down. Thus we can say that while the mutual funds offer a relative performance in terms of both risk and return, the hedge funds give an absolute return. The hedge funds have not a benchmark, but investment strategies that can and must vary and adapt to any situation.
This is the greatest benefit of investing in hedge funds. In fact from the previous statement we can easily understand that mutual funds can’t well protect their portfolio from falling markets, they can only sell. At the contrary hedge funds can protect their portfolio through various coverage techniques – that in some cases may be truly innovative – and they can obtain positive returns even when shares are falling, through short-selling. Their performance is thus independent from the overall direction of markets and indexes.