You’ve probably heard a lot about hedge funds if you pay much attention to the business news, but the chances are that you’re not entirely sure what a hedge fund actually is, and you haven’t got round to looking it up because it sounds like it might be complicated. Don’t worry, it’s actually quite simple…
In an ordinary investment fund (a ‘mutual fund’ to US readers), the fund manager usually takes all of the money given to him by the investors and uses it to buy shares in companies that are expected to deliver the best returns. With us so far? Good. The difference with a hedge fund is that the fund manager doesn’t just use the investor’s money to buy shares, he can also use more sophisticated trading mechanisms like short-selling, leverage, futures, derivatives, etc…
While these options are much more complex than simply buying and selling shares in companies, they also offer much higher potential rewards. The original idea of a hedge fund was that it would continue to make money for investors whether the overall market was rising or falling, although these days the focus of a hedge fund is usually to achieve much higher than market returns using aggressive trading/investing strategies.
Who can invest in hedge funds?
Because of the high risk and complexity associated with hedge funds, they are considered to be specialist investments which are not normally available to retail investors, and are not subject to the same level of regulation as retail investment products that are available to the general public. Hedge funds are normally only available to specially qualified investors, which usually means organisations or very wealthy individuals.
Hedge fund performance
According to an October 2007 survey (PDF) into the performance of the top 50 hedge funds by financial news service, Barrons, the leading hedge fund in 2007 achieved an average annual increase of 48% over the previous three years. This clearly shows that some hedge funds have the ability to provide extremely high growth. But at the bottom end of the chart, the 50th best performing hedge fund in the world delivered an average of 21% growth per year.
The problem with hedge funds…
Hedge funds are controversial for a number of reasons. Firstly, because they are not heavily regulated, the way in which they operate is not very transparent. This can be a problem because they often employ risky trading strategies with very large amounts of money, which has the potential to cause serious and catastrophic disruption to international markets. The lack of transparency and large sums of money at stake can also encourage some hedge fund managers to behave, shall we say, in ways that might not be entirely legal, especially since their vast salaries are usually linked directly to the performance of the funds they manage.
Where did hedge funds come from?
The invention of the hedge fund is usually credited to Alfred Winslow Jones in 1949. The first part of his idea was to look for two kinds of stocks:
- Strong shares which would rise quicker and fall slower than the rest of the market.
- Weak shares which would rise slower and fall quicker than the rest of the market.
Jones held long positions on the strong shares (i.e. he profited if their value increased) and short positions on the weak shares (i.e. he profited if their value decreased). In theory, if the right shares were chosen, this strategy would deliver profits whether the overall market went up or down. Jones also came up with the idea of placing limits on who could invest in his fund, in order to avoid the fund being heavily regulated.
