A Beginner’s Primer on Hedge Funds

I would have liked to call this post Hedge Funds De-Mystified, but that’s not really possible. The beauty, and danger, of hedge funds lies partly in their veil of secrecy. The rest is risk. Hedge funds are the bad boy of investments

What is a Hedge Fund?

As if the complexities of the investment itself weren’t confusing enough, even the name hedge fund is misleading. While many funds make investments that are designed to hedge, or protect against, risk, this is actually a very risky investment. Here are the common characteristics of a the class of investments known as hedge funds:

• An investment fund open to a limited pool of investors, who are wealthy and/or extremely sophisticated investors.
• Because of their investor profile, hedge funds are allowed to invest in a wider range of activities than other investment funds.
• Investments often include short selling and derivative contracts.
• They are often highly leveraged.
• These investments may free from regulations that normally govern leverage, fee structures and liquidity requirements.
• Hedge funds pay a performance fee to its investment manager.
• Hedge usually don’t have daily liquidity, or price. Invested funds are locked in for specific periods of time.
• Due to favorable regulatory or tax treatment, many hedge funds will be set up in the Cayman Islands, Dublin, Luxembourg, British Virgin Islands and Bermuda.

Why Were Hedge Funds Created?

In 1949 sociologist and financial journalist Alfred W. Jones created what is thought to be the first hedge fund to exploit what his understanding of financial markets. Jones believed that stock prices moved partly because of the overall market and partly because of the asset itself. He created the hedge fund from these two components:

• Purchasing stocks he expected to beat the market.
• Selling short stocks he expected to be weaker than the market.

In doing so he effectively neutralized price changes due to the overall market. He ‘hedged’ his bets. But who wants to come out even? No one. That’s why hedge fund managers typically engage in very risky, highly leveraged transactions that they expect to generate a high rate of return.

For this the hedge fund manager is rewarded, usually with a percentage of  the profits. However, when the fund loses money, there is no way for the fund manager to share in those losses.

The Problems With Hedge Funds

Some critics believe that large hedge funds pose systemic risk, that due to their size and interrelated nature they have the capacity to disrupt entire financial systems. For the individual investor too, the problems are all about risk.

Two big issues contributing to the risk of hedge fund investing are leverage and short selling. Hedge funds typically borrow money, many times more than was initially invested. Very small losses can erode the value of the initial investment quickly if creditors call in their loans. Losses incurred through short selling are theoretically limitless, unless hedged with a corresponding long position. Any time you try to profit from short selling rather than using the strategy to hedge, losses can be substantial.

Then there’s the lack of regulation and transparency. It’s easy to see why these investments are restricted to savvy investors. What can get regular folks into trouble is when these types of investments are not presented for what they truly are.

Image Credit: fedcomite, Flickr