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What do hedge funds do?

Hedge funds are very secretive organisations, and they don’t really let people have a look at what they do. This is mainly because they have a thesis that they build around certain investing sectors. Effectively what they try and do is to ensure that they invest in one product, and another product, so that whatever happens to the market, they will hopefully make money.

Here’s an example: let’s say you want to take a position on oil, and you don’t really know whether or not oil prices will go up or go down, but you think that it will do something.  So, what you might do is to buy shares in Qantas (ASX: QAN).  Now, what would happen, if oil prices were to come down, to Qantas’ profitability?

Qantas’ profits would increase.

Oil will be cheaper, aviation fuel will be cheaper, so therefore Qantas’ profits would go up.  What would happen if oil prices were to go up, though?

It would be more expensive for Qantas to buy oil.

The exact opposite would happen, so Ryanair would make less profits, and the share price would go down.  So the way you would hedge this would be to buy shares in Woodside (ASX: WPL), or Maverick Drilling and Exploration (ASX: MAD), or one of the oil companies.  Now, what would happen to Woodside’s profitability if oil prices were to come down?

Its profits would come down as well (at least to the extent it couldn’t gain volume from it’s LNG business).

But earlier we established that if oil prices came down, Qantas’ profits would go up.  So if you have two shares, Qantas and Woodside, they would work in opposite directions, depending upon what happens to oil prices. So if oil prices were to go up, profits at Qantas would come down, but Woodisde shares, the oil company shares, would go up, and so therefore you’ve balanced one with the other.

So what are you doing? – you are: Hedging your bets.

You are hedging one against the other, and this is what hedge funds try and do all the time.  They sit down, and they think, what would happen to a sector, what would happen to a commodity, what would happen to something, if something else were to happen, and they try to hedge one against the other.

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The Motley Fools purpose is to help the world invest, better. Take Stock is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

A version of this article, a podcast by David Kuo, originally appeared on fool.co.uk

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