Hedge Fund

What It Means

A hedge fund is a business that pools money together, typically from very wealthy people with experience in the financial world, and invests it in a wider variety of ways than more traditional investment firms do. A traditional investor or investment firm buys a number of different stocks (shares of company ownership) in the hope that, as those companies prosper, their stock shares will gain value; this is called taking a “long” position on those stocks. Such investors or firms might also buy bonds (a loan of money to a government or company, in exchange for which the borrowing government or company makes periodic payments of interest to the bond holder) in the hope that their gains in value will balance out any stock losses. But stock market gains are hard to predict, so a long approach to stocks exposes an investor to losses, and bonds usually do not pay off at a high enough rate to compensate in the event of a drop in stock values.

Hedge funds were initially created to “hedge” the bets of investors by taking a “short” as well as a long approach to stocks, bonds, and other forms of securities (a security is any contract that can be assigned value and can then be bought and sold by investors). To “hedge” an investment simply means taking action to reduce the risk of losing money. The first hedge funds, launched in the United States in the middle of the twentieth century, bet on some stocks to win and others to lose, thereby minimizing the losses of investors during difficult economic times.

Today, the world of investing is more complex, and hedge funds are less uniform in their approach to investing. Hedge funds do generally go long on investments at the same time that they engage in “short selling.” In simple terms, short selling, or “shorting,” is the practice of borrowing stocks (typically from another broker), selling them, then buying the stocks back at a lower price, earning a profit on the difference. While hedge fund managers do engage in short selling, hedging against potential losses is not their main purpose anymore. Instead, hedge funds are loosely united by a few basic characteristics.

Because of the way they are set up, hedge funds are not subject to many government restrictions. Therefore, they can buy a wider variety of investments and take more risks than more heavily regulated investment firms can. They can also make more investments using borrowed money than other firms can, allowing them to invest far more money than they actually collect from individual investors. This flexibility allows them to take advantage of changing conditions in the financial markets that more traditional, slower-moving investors cannot. It also gives them the chance to outperform other investors. Because of the chance for high returns, hedge fund managers charge extremely high fees and make some of the highest salaries in the world.

When Did It Begin

Alfred Winslow Jones, trained as a sociologist, got his introduction to the world of big business while working as a writer for Fortune magazine during World War II. As he researched and wrote a technical piece for the magazine about stock-market forecasting (predicting the future gains and losses of various stocks), Jones came up with the idea that would serve as the foundation for the hedge-fund industry.

Jones did not believe that any forecaster, no matter the degree of his economic or mathematical skills, could reliably predict the future of the stock market. Instead, he began trying to figure out ways of protecting investors from stock-market fluctuations. The investing strategy Jones came up with involved a combination of two techniques: taking a long position on some stocks and paying for these stocks with borrowed money, while simultaneously selling other stocks short. Prior to this time, both of these techniques were considered too risky to be commonly used, but Jones found that in combination they could be employed, paradoxically, for the purpose of protecting an investor from risk.

In 1948 Jones and four friends started what he called a “hedged fund,” a way of investing that appeared to offer something unimaginable: the possibility to make money without any risk of losing it. While Jones’s approach successfully protected investors from risk, it required foregoing the huge gains to be made during economic booms. The tradeoff for financial safety was a modest, but consistent, level of growth.

More Detailed Information

Unlike Jones’s hedged fund, today’s hedge funds generally have a different purpose. Like Jones’s clients, the people who trust hedge funds with their money today expect to profit even when the economy as a whole is struggling, but hedging against the risk of loss is not the primary purpose of today’s funds. Instead, hedge funds attempt to outpace the gains of all other forms of investment. Whereas traditional investment firms and mutual funds (a more highly regulated and more conservative way of pooling money to invest in financial markets) often hope to keep pace with the gains made by the stock market as a whole, hedge funds openly attempt to outperform the market.

Hedge funds are able to offer this possibility because they take more risks than mutual funds and traditional investors, and they are able to take these risks with the money of others because they are not subject to substantial government regulation. They have avoided regulation primarily because they do not allow just anyone to give them money; they manage the money, generally, of only very wealthy people who are experienced investors. Whereas anyone can contribute money to a mutual fund, and whereas mutual funds are generally not even allowed to sell short, hedge funds collect money privately from the very rich and are allowed to use virtually any investment techniques they want.

To outperform the economy as a whole, an investor must find investment opportunities that others have overlooked. Because of their freedom from regulation, hedge funds can find imbalances in financial markets and exploit them, making large amounts of money in a matter of hours or days, before other investors catch on to the opportunity.

Most of the investing techniques employed by hedge fund managers are complex and difficult for nonexperts to grasp. One common feature of most hedge-fund investments, however, is that they rely on borrowed money. The reason hedge funds borrow money is that this allows them to multiply the effects of a small opportunity, such as a slight change in a stock’s, bond’s, or currency’s value. The risk of this approach is that bad investments mean funds (and their individual clients) could end up owing lenders more money than they possess. Another feature common to hedge-fund investing is that the freedom from oversight allows them to take advantage of time-sensitive investment opportunities to which other investment firms cannot, because of regulatory constraints, react quickly enough.

Because of their relative freedom from regulation, hedge funds are also able to operate in secrecy. They typically do not provide their investors or the general public with detailed information about their strategies, their actions, or the amount of money they have. Hedge funds have therefore developed an aura of mystery in the popular imagination. People who work in the hedge-fund industry generally do not talk to the press, and few ordinary people understand what a hedge fund is.

What many people do know about hedge funds is that they pay their employees enormous sums of money. One reason that those in the hedge-fund industry make so much money is that the funds charge the highest fees of any form of investment. The typical hedge-fund fee structure is known as 2-20: the fund collects two percent of a client’s investment total for managing his or her money, no matter what happens, and then the fund collects 20 percent of all gains made by the fund’s investments. Some hedge funds charge significantly more than this. As of 2007, for example, Renaissance Technologies Corporation, a hedge fund run by James Simons, had a 5-44 fee structure. To encourage managers to invest responsibly, the managers of hedge funds are expected to place their own money in the fund. Thus, in a single year the managers of the largest and most lucrative hedge funds can make hundreds of millions of dollars in fees in addition to increasing their own invested sums by hundreds of millions of dollars. Single-year incomes of $1 billion are not unheard of in the industry.

Recent Trends

The number of hedge funds, and the amount of money under their management, increased dramatically in the early years of the twenty-first century. The number of hedge funds was in the hundreds through the end of the 1990s; by 2007 there were an estimated 9,000 hedge funds. Likewise, the amount of money managed by hedge funds grew from around $2 billion in 1999 to around $2 trillion by 2007.

There were several basic reasons for this explosive growth. One reason was that investors in general had become increasingly comfortable with taking big risks in the financial markets. Whereas high-risk investing in the mid-to-late twentieth century was typically seen as foolish, it was commonplace for investors to put some of their money into riskier forms of investment by the beginning of the twenty-first century. Another reason for the growth of hedge funds was that when the U.S. stock market crashed in 2000 and lost 40 percent of its value by 2002, many hedge funds lost no money, and some even prospered during this time. In the years following this economic downturn, more and more investors looked to hedge funds as though they had a magic formula for wealth creation.

Finally, the growth of hedge funds was a product of the growing participation of institutional investors: organizations such as banks, insurance companies, and retirement funds that invest huge pools of money on behalf of numerous individuals. Only in the early years of the twenty-first century did hedge funds begin to be perceived as legitimate investment opportunities for the most reputable of institutions. Institutions, obviously, are in possession of far larger sums of money than even the very wealthy individuals who were the main investors in early hedge funds. With access to these new pools of money in the twenty-first century, hedge funds were poised to continue growing and gaining influence over world affairs for some time to come.