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Hedge Funds actually provide an economic benefit to markets, in particular they aid price discovery. It has been argued that hedge funds do not engage in “herd-mentality” trading. Instead they take contrarian positions, unlike mutual funds, and they buy/sell assets according to an asset’s perceived fair value.
A second economic benefit of hedge funds is that they aid competition and the economic concept of the “invisible hand”. Hedge funds thrive on market inefficiencies. As traders do not have instantaneous and costless access to market information, asset mispricing or an arbitrage opportunities must occur e.g. an asset trading in 2 different markets may have different prices. Hedge Funds take advantage of such arbitrage opportunities and so push prices to their no-arbitrage price.
Another important economic benefit of hedge is liquidity provision. Hedge funds typically investing in risky assets provide the much needed capital for investments that many investors would not consider. Hedge funds rather than increasing risk can instead reduce overall risk. Firstly, hedge funds take on more risky investments, thereby absorbing or sharing some of the risk that would otherwise be absorbed by other funds. Additionally they’re more willing to invest in volatile markets, thereby absorbing the effects of market shocks.
Hedge funds are important as an investment product in itself. They provide sophisticated investors with another vehicle for high returns that would not be available in traditional mutual funds. They also provide diversification as they represent a new investment group. A second benefit from an investor’s perspective is that hedge funds can provide “absolute” returns. Hedge funds can achieve this because they pursue a variety of sophisticated investment strategies. Traditional mutual funds are limited in trading strategies due to heavy regulation.
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