The term hedge fund dates back to the first such
fund founded by Alfred Winslow Jones in 1949. Jones' innovation
was to sell
short some stocks while buying others, thus some of the market
risk was hedged. While
most of today's hedge funds
still trade stocks both long and short, many do not trade stocks
at all and the term hedge fund has come to mean any fund
that isn't a conventional investment fund - that is, any fund using
strategies other than investing long only in bonds, equities or
In addition to selling short, Jones used leverage (borrowed money
to trade in addition to the capital provided by his investors),
changed an incentive fee (a fee based on a portion of the clients
profits as opposed to a fixed percentage of assets) and had a substantial
portion of his net worth in his investment funds -- all characteristics
common in today's hedge funds.
One common hedge strategy is to buy shares of a company that is
in the process of a merger
and acquisition. The stock of the company has an announced price
that it will be worth on the date of the merger, so if the stock
is currently under that value, its a safe investment to purchase
it and wait. The risk is that the merger will not go through and
the stock will be left at its current value. Frequently, the trader
will also sell the stock of the acquiring company in addition to
buying the stock of the target.
Most of the early hedge funds did just this. They became very
popular as a way of seeing gains better than the investment grade
bond market, while still having low risk.
However the side effect of this popularity was to dramatically
increase the interest in all of the non-standard investment strategies,
and soon other funds were being set up with new strategies aimed
primarily at high growth. Although there is no hedging in these
cases, the term is still used for these funds as well.
A special type of hedge fund is a fund-of-funds, a fund
which invests in other hedge funds rather than trading assets itself.
Hedge funds use alternative strategies such as selling
trading options or derivatives, using leverage, investing in seemingly
undervalued securities, and attempting to take advantage of the
spread between current market price and the ultimate purchase price
in situations such as mergers. They can be extremely risky investments
as illustrated by the example of Long-Term
In the United States, regulations by the Securities
and Exchange Commission do not allow hedge funds to be offered
to the general public and the funds are limited to purchases by
qualified investors, who have total incomes of over US$200,000 per
year or a net worth of over US$1,000,000. For the funds, the trade
off is that they have fewer investors to sell to, but they have
few government imposed restrictions on their investment strategies.
The presumption is, that hedge funds are pursuing more risky strategies,
which may or may not be true depending on the fund, and that the
ability to invest in these funds should be restricted to wealthier
investors who are presumed to be more sophisticated. No evidence
is cited for this assertion.
A further typical characteristic of a hedge fund is secrecy. Being
private, unregulated partnerships, hedge funds can negotiate directly
with their clients as to the content and frequency of disclosure.
This is in contrast to a fully regulated mutual fund (or unit trust)
which will typically have to meet regulatory requirements for disclosure.
In addition, in general hedge funds do not have to report their
assets, clients or positions to any central regulatory authority.
A byproduct of this secrecy and the lack of regulation is that
there are no official hedge fund statistics. An industry consulting
group, HFR (hfr.com), reported with suspicious precision that at
the end of the second quarter 2003 there are 5660 hedge funds world
wide managing $665 billion. To put that in perspective, at the same
time the US mutual fund sector held assets $6,818 billion (according
to the Investment Company Institute).
The combination of secrecy and rich investors means that hedge
funds are a target for criticism whenever markets move against some
See also: Derivatives