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Hedge Funds
In their original conception, a hedge fund was essentially a fund that sold some stocks
short, and bought other stocks (long). With this technique, the overall value of buying
and selling balances out, thereby eliminating heavy losses due to large market swings;
profit gains in a hedge fund rely on the choosing of appropriate stocks and acting on them
at the most opportune moment.

The first hedge fund was created by stock pioneer Alfred Winslow Jones. Jones also used
borrowed money to inject his funds with additional capital (leverage), and charged an
incentive fee to his customers to place their money in his fund. Hedge funds have evolved
to include a number of strategies, in addition to the balanced short-long strategy of
Jones. For the most part, the term hedge fund now refers to any mostly unregulated fund
using unconventional methods of investing. Some common hedge fund strategies include:
trading stock options and bonds, the purchase or sale of highly undervalued securities,
and arbitrage. Most hedge funds also have the status of partnerships, rather than the
corporate model of other funds.

A common hedge fund strategy is buying shares in a company that is in the midst of a
merger and acquisition – in this case there is a guaranteed profit if the merger does
complete, with the only risk being that the acquisition will fail. This strategy, often
used in tandem with selling shares of the company doing the acquiring, is known as risk
arbitrage.

Unlike mutual funds, hedge funds are very lightly regulated, and so can keep their actions
relatively secret. Most contemporary hedge funds are handled by offshore companies in
places like the Virgin Islands or Cayman Islands, where regulation is minimal. This
secrecy makes it difficult to predict actual numbers for hedge funds, but estimates for
2003 were over US$650 billion under hedge fund management.

In order to keep regulation very low, hedge funds have the status of unregistered
investment companies. This means that only accredited investors and qualified purchasers
may invest in them – those who have incomes of over $200,000 per year or a net worth of
over $1 million, or those who already have at least $5 million in investments.

The term hedge fund comes from the phrase “to hedge one’s bets”, and refers to the
practice of balancing out transactions to ensure that no matter which way the market
turns, a profit can still be made. It is this which distinguishes hedge funds from a spate
of other fund strategies that sprang up at the beginning of the 21st century to capitalize
on unconventional methodologies.

Hedge funds have been proven to correlate very little to traditional asset classes. In
other words, when the stock market drops 10%, it is not at all necessary that hedge funds
will lose as much, or even decline at all. Thus, a portfolio that includes hedge funds or
any asset class whose returns depend less on the market, will benefit greatly from the
added diversification.

Most hedge funds primary objectives are capital preservation. Hedge fund managers have a
number of risk management tools at their disposal that could help reduce downside risk.
This enables them to deliver consistent returns in all market conditions.
Hedge fund managers also employ investment tools that can greatly increase returns. Unlike
mutual funds, hedge funds can use short selling, invest in derivatives, leverage their
portfolios, and hold highly concentrated positions – strategies that can amplify returns
greatly. In fact, composite hedge fund indexes have consistently equaled or beat the
aggregate market indexes (such as DJIA and Russell 2000) in the last five years. The fact
that hedge funds can provide high returns at lower risk is not a contradiction. In
general, hedge funds offer higher risk adjusted returns than traditional investments. As
exemplified by the hedge fund indexes, pooling hedge funds into portfolios can
significantly reduce their total risk. More importantly, the addition of one or more well-
chosen hedge funds to an investment portfolio can add the same benefits to an investor’s
overall financial picture.

ALL ALTERNATIVE INVESTMENT

Hedge funds have been a mystery to some and thought of as an investment device for the
"Rich and Famous." Aside from the exclusive cachet they have enjoyed, Hedge Funds are in
fact the choice of many informed investors and not necessarily the "Rich and Famous."
What makes hedge funds different, and thus the key to their unique ability to succeed, is
their diversity. The variety of hedge fund strategies far exceeds anything offered by a
traditional mutual fund or stock broker. The strategies tend to be more niche-like in
their approach and frequently, much less dependent upon the market for returns. Investors
also prefer to invest in Hedge Funds because the fund managers have a direct interest in
the positive performance of their funds. Hedge fund managers are compensated largely based
upon how well they perform and in many cases the fund manager is also one of the key
investors in the fund. These are two very strong incentives for the fund managers and
possibly why many Hedge Funds will achieve their goals while other investment vehicles may
not.

Hedge funds can take both long and short positions, make concentrated investments, use
leverage, use derivatives, and invest in many markets. This is in sharp contrast to mutual
funds, which are highly regulated and do not have the same breadth of investment
instruments at their disposal.

Hedge funds are defined by their structure rather than any specific investment method.
These pooled investment vehicles are commonly set up as limited partnerships in which the
manager acts as the general partner while the investors act as the limited partners.
Oddly, the term ‘hedge fund’ is a misnomer. Not all hedge funds are hedged. Hedge funds
invest in any number of strategies regardless of the common term that attempts to corral
them. These strategies include investing in asset classes such as stocks, bonds,
commodities, currencies, and return enhancing tools such as leverage, derivatives, and
arbitrage. Some funds, however, are simply 100% long equity securities.