A “Hedge Fund” is a general term that was originally used to describe a type of private, unregistered investment pool that utilized sophisticated hedging and arbitrage techniques to trade in the corporate equity markets.
In English: this type of fund is a pooled fund, similar to a mutual fund, that uses more sophisticated – and often riskier – techniques in the hopes of getting bigger rewards.
The first hedge fund was set up by Alfred W. Jones in 1949. Jones was the first to use short sales and leverage techniques in combination. In the mid-1950′s other funds began selling shares short, although the hedging of market risk was not their primary investment strategy.
Today, hedge funds have evolved to represent private, unregistered investment pools that implement both traditional and advanced investment strategies to produce impressive gains either in an absolute sense or over a specified market benchmark.
Advanced investment strategies include taking short positions, using arbitrage, buying and selling undervalued securities, trading derivatives or bonds, and investing in almost any opportunity in any market, domestic or international.
Hedge funds normally aim to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions. Ironically, though the use of risky strategies often results in the loss of capital for these funds.
Many hedge fund strategies tend to hedge against downturns in the markets being traded. The hedge fund market is estimated to be a trillion dollar industry, with about 8,350 active hedge funds; most hedge funds are highly specialized, relying on the specific expertise of the manager or management team.
One of the most common questions investors have is, “What is the difference between a hedge fund and a mutual fund?” Both are managed pools of investments; however, hedge funds are managed much more aggressively in that hedge fund managers can take more speculative positions in derivative securities and have the ability to short sell stocks.
This will typically increase the leverage and, therefore, the risk. Additionally, for the most part, hedge funds, unlike mutual funds, are unregulated (not under the auspices of the Securities and Exchange Commission).
Accordingly, In the United States, laws require that the majority of investors in hedge funds be accredited, which means they they must earn a certain minimum amount of income annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge.
Normally, hedge funds are open to a minimum amount of investors and require a large minimum investment, as such funds take large positions (the bigger the risk, the bigger the reward). Hedge funds are usually established as limited partnerships.
Investments in hedge funds are relatively illiquid, and investors normally face withdrawal restrictions. This means that their money is “locked up” for a certain length of time and having to give sufficient notice if they want to liquidate funds.
There are a variety of hedge fund strategies. A few of the more popular strategies include:
- Distressed Securities – These hedge funds buy equity, debt, or trade claims of companies facing bankruptcy or reorganization at deep discounts. The expected volatility of this strategy is low to moderate.
- Emerging Markets – These hedge funds invest in equity or debt of emerging (less mature) markets, which tend to have higher inflation and more volatile growth. This hedge fund strategy is very high volatility.
- Fund of Funds - Fund of funds is a hedge fund strategy that invests in other hedge funds and other pooled investment vehicles. The blending of different strategies aims to provide more diversification and a smoothing out of volatility and returns versus any of the individual funds. Capital preservation is generally an important consideration in the fund of funds strategy and accordingly, expected volatility is low to moderate.
One of the most successful hedge fund managers is George Soros, who managed the Quantum Fund. A $100,000 investment in his fund when he started in 1969 would’ve been worth $150 million by 1994.
Another very successful hedge fund manager is John Paulson of Paulson & Company. Although Paulson’s fund, Paulson Advantage, declined in performance this past year, it did correctly bet that housing prices would fall three years ago.
Some notable hedge fund losers include the Palomino Fund LTD managed at Appaloosa Management by David Tepper as well as the QVT Overseas LTD Funds A and B at QVT Management.
Many investors have been extremely lucky and unlucky investing in hedge funds. It is important to understand the underlying investment strategy as well as the experience of the managers. Doing one’s due diligence on a prospective hedge fund investment is mandatory unless you can afford to lose a big chunk of money.
Published or updated April 4, 2013.