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Money Basics: What is a hedge fund?

Welcome to Money Basics, Yahoo Finance’s new personal finance series offering quick explanations for some of the most important terms involving your money.

A hedge fund is a privately run investment organization that uses pooled assets from participating investors in the fund. Hedge fund managers use diversified methods to try and generate large returns. The purpose of a hedge fund is to eliminate market risk from volatility and maximize investor returns. Hedge fund managers try to make money regardless of current market conditions and look at every upswing and downturn as an opportunity to generate profit.

A hedge fund is most often established as a private institution and incorporated as either a limited partnership or as a limited liability company. Hedge funds are also unique in that they will invest in anything from stocks and bonds to currencies and even real estate. Many hedge funds are specialized in their investment strategies, and most often they rely on a manager’s or group of managers’ expertise in certain securities and investments.

Hedge funds come with a few caveats and risk. For example, they allow only a limited number of accredited investors to join their organization. Many, if not most, require a large initial minimum investment in order to participate. Many hedge funds are not regulated by the SEC. Hedge funds, despite their efforts to reduce the risk of losses, are not immune from losses. Some hedge funds use derivatives (such as futures contracts) and leverage (borrowed money) to maximize the level of returns on investments and protect against downturns in the stock market. These types of strategies can incur heavy losses if an investment goes sour.

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