The hedge fund industry has come under fire since the economic downturn, with many accusing it of exasperating an already strained economy and others blaming it entirely for the financial crisis.

But investing in a hedge fund can provide certain investors the ability to reduce risk as well as add diversification, while providing enhanced returns on their money.

For those of you who are still unsure about what a hedge fund is, we go back to the basics:

What is a hedge fund?

A hedge fund uses a range of investment techniques and invests in an array of assets to generate the highest return possible. But as with any other investment that promises high returns, managers of hedge funds expect their investors to be highly tolerant to risk.

Hedge funds, by their very nature, are aggressive investment vehicles as the manager takes on a lot of risk to generate high returns.

What is hedging?

To understand what a hedge fund does, you need to understand the concept of hedging.

Hedging basically means managing or mitigating risk. Hedge fund managers take on an investment to limit the risk of another investment. (Taking out life insurance is a real world example of a hedge.)

Hedge fund managers try to limit risk by using certain assets while taking on more risk elsewhere. One of the things a hedge fund manager can do to make the highest returns is to leverage, which is essentially borrow money to invest to get higher returns.

Do all hedge funds use hedging?

No. The name is mostly historical from when the first hedge funds were used to hedge against risk in a bear market.

Today, hedge fund managers use various different strategies to get enhanced returns, often investing speculatively and therefore carrying more risk.

What is the difference between a hedge fund and a mutual fund?

Hedge funds are managed far more aggressively than mutual funds. Hedge fund managers can take speculative investment decisions and can also short sell.

Short selling is when an investor borrows (leverages) an asset, such as shares, currencies or oil contracts, from another investor and then sells that asset in the relevant market hoping the price will fall.

The aim is to buy back the asset at a lower price and return it to its owner, pocketing the difference.

Mutual funds are considered less risky as they are far more stringently regulated. Mutual fund managers also cannot borrow to invest, which makes them safer as a result.

Availability is another crucial difference. Thanks to their higher risk nature, hedge funds tend to be targeted at ‘sophisticated investors’ with high net worth.

However, many ordinary investors may have their money in hedge funds through their pension funds.

Mutual funds are far easier to access as small pots of money can be put in to these funds.

How much does it cost to invest in a hedge fund?

Hedge fund managers have a charge rate of 2% of the asset you put into their fund, but then they also get 20% of any profits made on the investment. This is quite a steep charge scale, and often it can made worse by poor performance where the manager has made losses but still charges the 2% flat fee.

What are the pros and cons?

Investors could stand to make a lot of money by investing in a hedge fund, however as mentioned before, there are plenty of risks.

Hedge fund managers can borrow unlimited amounts of money but if they over-leverage at a crucial time and things go wrong in the markets there is a very real danger of the fund being wiped out. This is a risk that investors need to really consider.

Until 2010, there was little transparency in this industry. But since then both the European Union and the US have introduced new measures in a bid to improve the transparency issues in the hedge fund world.

Hedge funds now regularly update their investors, especially institutional investors like pension funds, on their research methodology and strategy.

However, regulation of this industry is still very light so may be appropriate for investors who want vehicles that have more freedom and flexibility to do what they need to do to achieve higher returns.

As it stands the Financial Conduct Authority is in charge of regulating this industry.

How long should your money be in a hedge fund?

Most managers state that money has to be locked into their hedge fund for a minimum of a year. This is typical of most investment funds, and is preferred to even out the day-to-day volatility in the markets and investment world.