Pin Me

What is a Hedge Fund?

written by: ShawnTe•edited by: Rebecca Scudder•updated: 2/23/2010

From the AIG debacle to the Bernard Madoff Ponzi scheme that plagued 2008, hedge funds have been finding their way into the headlines in a negative light. Many are wondering exactly what are hedge funds? This guide will provide an overview as to the nature of a hedge fund.

  • slide 1 of 4

    History of Hedge Funds

    In 1949 the first hedge fund was established by Alfred W. Jones, who was the first to use the combination of leverage and short sales techniques. Hedge funds are similar in nature to mutual funds due to the fact that both investment vehicles pool together investors money and collectively invest these funds. Hedge funds historically lived up to their name by attempting to hedge the downside risk of a bear market via leverage and short sale techniques as its implementor Alfred W. Jones first established. However, today a vast array of techniques are used in hedge funds with the original aspect of hedging most of the time not even entering the picture.

    The ultimate goal of these varying techniques is to generate high returns for its investors. Primarily hedge funds are set up as private partnerships with a limited number of (generally rich) investors. Due to their illiquid and highly unregulated nature, United States law requires for a majority of the investors in a hedge fund to be accredited.

  • slide 2 of 4

    A Virtually Unregulated Investment Vehicle

    Hedge funds escape most the regulations that other funds such as mutual funds are subject to by the Securities Exchange Commission (SEC). If a hedge fund manages fewer than 15 funds it is not mandatory for them to register with the SEC. One regulation that hedge funds are not able to escape are the anti-fraud provisions of United States federal securities laws. Even though hedge funds are similar to mutual funds, they escape many of the regulations that mutual funds have to adhere to such as:

    • liquidity requirements
    • allowing shares to redeemable at any time
    • disclosure regulations
    • limits on the use of leverage

    Though hedge funds in the United States are highly unregulated the case is different in other parts of the world. The nations of Europe for one make an attempt to have regulations in place for hedge funds. European nations often regulate hedge funds either by the type of investors they have or by the minimum subscription level needed to invest in hedge funds.

  • slide 3 of 4
  • slide 4 of 4

    Different Types of Hedge Funds

    A common misconception about hedge funds is that all are volatile. Not all hedge funds rely heavily on leveraging and derivatives in their strategies and some still live up to their name by derivatives for hedging purposes. Which leads to another myth about all hedge funds being the same. Different strategies are used by different hedge funds according to the University of Iowa's Center for International Finance and Development there are 12 classifications of types of hedge funds:

    1. Aggressive Growth – investment in equities that are expected to perform well with accelerated growth. This fund is typically hedged by shorting either equities that are expected to disappoint or stock indices.
    2. Distressed Securities – Purchases equity, debt, or trade claims at huge discounts in companies facing bankruptcy or reorganization.
    3. Emerging Markets – Hedging is difficult for this type of hedge fund due the investment in equity or debt of these less mature emerging markets which tend to experience inflation and volatility in growth.
    4. Fund of Funds – The pooling of various hedge funds together utilizing the various strategies of each fund.
    5. Income – Primary focus is on yield or current income versus solely focusing on capital gains. Uses leveraging and derivatives in its strategies.
    6. Macro – Aim is to profit changes in global economies. Participation in all major markets at different times while using leveraging and derivatives in it s strategies.
    7. Market Neutral - Arbitrage – Hedges out a majority of the market risk via taking offsetting positions with various securities of the same issuer.
    8. Market Neutral – Securities Hedging – Equal investment in long and short equity portfolios in the same sectors of the market.
    9. Market Timing – Allocation of assets amongst different classes based upon the funds manager's view of the economic or market outlook.
    10. Opportunistic – Strategy changes as opportunities arise to maximize profit. May use various investment styles in unison and is not restricted to any single approach or asset class.
    11. Short Selling – selling securities short in order to re-buy them in the future at a lower price.
    12. Value - the investment in securities forecast to sell at deep discounts to their potential worth.

    Hedge funds themselves are not as volatile as many believe. However, the different strategies used by any particular hedge fund is what causes major fluctuations in volatility. Although most investments that offer a high return take major risks in their efforts to make good on their claims of such returns. If your investing needs require more security with regards to liquidity and SEC regulations, then hedge funds may not be the wise investment choice for you. For those with the money to invest and the willingness to venture out at a higher risk than more regulated investment vehicles then hedge funds may be worth the gamble. Just do your research of the hedge fund and its manager to make sure they have a proven track record of appropriately handling investor funds.