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Basics of Hedge Funds

By Charles Hopkins Published 03/13/2006 | Finance

Alfred Winslow Jones first coined the term hedge fund in 1949.

Jones' innovation was a simultaneously selling and purchase of stocks, thereby hedging some of the market risk.

Even today hedge funds are presumed to undertake a similar hedging, and most of today's hedge funds still trade stocks both long and short. But some do not trade stocks at all.

The term 'hedge fund' now quite often means a partnership dealing a relatively unregulated investment fund, characterized by unusual stock strategies other than investing long only in equity shares, bonds, or money markets. A modern hedge fund basically takes a wide range of P/E ratios and adopts a mixed strategy generating maximum expected and often high actual profits from investing in asset classes such as equity shares, currencies or distressed securities.

Hedge funds have been estimated to be a 875 billion industry, and are growing at about 20% per year, with approximately 8350 active hedge funds in 2004.

The general partner is normally appointed as the hedge fund manager. The vast majority of hedge funds make consistency of return, rather than magnitude, their primary goal. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as volatile, or even more so, than mutual funds.

It makes a pooled stock of funds in the partnership, and the general partner a.k.a hedge fund manager takes all the decisions on investment, based on the strategy s/he has outlined in the offering documents. In return, the hedge fund manager will receive a management fee and an incentive fee.

Typically, the management fee ranges from 1-2% of the assets under management. The incentive fee is usually 20% of the profits of the fund and can include "hurdles" or other items.

Among generally followed strategies, there is the use of leverages and derivatives in a venture for high profit arbitrage. The strategies take the forms of aggressive growth, market neutral securities hedging, market timing, multi strategy, distressed securities etc.

Aggressive Growth consists of investing in stocks expected to experience an accelerating growth of earnings per share, generally in stocks with high P/E ratios and low or no dividends.

In Market-Neutral Securities Hedging, a hedge fund invests generally in the same sectors of the market equally in long and short equity portfolios. This greatly decreases market risk. But this needs effective stock analysis and stock picking for meaningful results. Here leverages may be used to enhance returns. Performances are not usually correlated to the equity market. Sometimes they use market index futures to hedge out systematic (market) risks.

Distressed Securities approach means buying equity, debt, or trade claims of companies in or facing bankruptcy or reorganization at deep discounts. Hedge funds with this strategy often profit from the markets misreading of the true value of the deeply discounted securities. Also as the majority of authorized institutional investors cannot own below-investment-grade securities, there arises a selling pressure resulting in the deep discount. Results generally are not correlated with the markets.

Likewise, in the Multi Strategy approach, investment is diversified by employing various strategies simultaneously to appropriate short- and long-term gains.

Other strategies may include systems trading such as trend following and various diversified technical strategies. This enables the manager to underweight or overweight different strategies in order to earn maximum by capitalizing on current investment opportunities.

Hedge fund managers are extremely able professional people who know their business inside out. Hedge funds heavily interlink managers remuneration with performance incentives, and thus attract the best brains in the investment business.