Definition

Hedge Fund management employs a wide variety of techniques using various types of investment instruments to generate positive returns irrespective of market movements.

Generally speaking, Hedge fund managers use many of the same instruments that traditional asset managers employ, but do so in more diverse ways. However, their approach does not automatically lead to higher risks and in fact, it might even decrease risk.  Typically, hedge fund managers work within the framework of clearly defined investment parameters which include rigorous risk management procedures. By default, some hedge techniques are inherently risk adverse. For example, the ability to short securities to take advantage of a decrease in value is a typical hedge technique since, in the case of equities, it reduces market exposure.

1. Hedge funds generate higher returns without a proportionate increase in risks compared to typical investments in a given asset class,

2. Hedge fund management styles are so diverse that a portfolio of such funds can create a particularly diversified asset allocation,

3. Historically, hedge fund techniques were almost exclusively used by banks to manage risk in their own portfolios. The opening up of this field has prompted many highly talented hedge fund managers to leave banks to pursue opportunities with asset management firms.
 

	THE VALUE OF DIVERSIFICATION. Conventional financial theory suggests that it is possible to reduce global risk by selecting a pool of well diversified investments, reflecting an expected gain equal to the mean of the expected gains of each investment. Therefore, it is beneficial to select assets with the same potential gain but which have different investment styles. The resulting portfolio will generate a similar potential gain but with reduced risks compared to the risk level of each of its components on a stand alone basis (see graph below).
	Portfolio C is made up of half asset A and half asset B yet it retains the same expected value as A and B while reducing the risk, measured by volatility, in half. The use of hedge funds helps diversify a portfolio while maintaining expected performance.