What is a hedge fund?

A question from Askville:

Can anyone explain to me, in layperson’s terms, what a hedge fund is?

“Hedge fund” is more of a legal term than anything else.

The first hedge fund was created by A.W. Jones in 1949 and had a strategy that today would be termed “equity market-neutral”; the fund bought stocks it expected to outperform and shorted stocks it expected to underperform. In other words, the fund hedged away its market risk (hence, the term “hedge fund”). The fund was structured as a limited partnership, was available only to accredited investors (high net worth individuals and institutions), and was compensated strictly through performance fees (20% of total return delivered to investors).

Over time, other funds developed other strategies (many of which actually do not involve any hedging), but the name stuck. Additionally, many funds started to charge a base fee (1% of assets under management, although lately 1.5% seems the norm and 2% is not unheard of) in addition to performance fees. In addition to the traditional limited partnership structure, there are also funds structured as offshore (Bermuda, Caymans, Luxembourg, Channel Islands, etc.) corporations, which cater to non-U.S. investors and tax-free U.S. investors, such as pension plans and university endowments.

So, to summarize, a hedge fund is a limited partnership (or an offshore corporation) that is available only to accredited investors, whose manager derives at least a part of its compensation from performance fees. The term does not imply any particular investment strategy.

Here are some of the common strategies used by hedge funds:

  • Convertible Arbitrage funds buy convertible bonds and short their underlying stocks.
  • Dedicated Short Bias funds specialize in shorting stocks.
  • Emerging Markets funds invest in government bonds of emerging-market countries (Argentina, Brazil, China, India, Russia, etc.), as well as stocks and bonds of companies from those countries.
  • Equity Market Neutral funds buy stocks they expect to outperform and short stocks they expect to underperform, in approximately equal quantities.
  • Event Driven funds come in two flavors. Distressed funds buy securities of the companies that are in bankruptcy or near it, but are expected to recover. Risk Arbitrage funds play the merger game; they buy stocks of companies that are being acquired while shorting the stocks of companies that try to acquire other companies.
  • Fixed Income Arbitrage funds attempt to profit from relative mispricing of closely related fixed-income securities (for example, a 13-week U.S. Treasury bill and a 5-year Treasury bond maturing in 13 weeks) by buying the relatively cheap one and shorting the relatively expensive one.
  • Global Macro funds attempt to profit from country- and region-wide trends in stock, bond, and currency markets.
  • Long/Short Equity funds are similar to equity market neutral funds, but they do not necessarily maintain market neutrality; at any given time, a long/short fund may be net long, net short, or neutral.
  • Managed Futures funds speculate in futures contracts on commodities, currencies, interest rates, and stock market indexes.

There are also multi-strategy funds that invest in many strategies simultaneously, and funds of funds that only invest in other hedge funds.

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March 20, 2008: A related question from Askville:

What exactly are hedge funds supposed to do? How do they differ from mutual funds?

The differences between hedge funds and mutual funds are very simple to explain.  As I said above, a hedge fund is a limited partnership (or an offshore corporation) that is available only to accredited investors, whose manager derives at least a part of its compensation from performance fees.  A mutual fund, conversely, is a special purpose entity (tax lawyers would call it a “pass-through entity”) that is available to the general public, whose manager generally receives no performance fees (the SEC frowns upon performance fees, and it has good reasons to do so).

1 thought on “What is a hedge fund?

  1. Dara

    Thanks for explaining it, I was researching for a question on FunAdvice and this really helped.

    “The term does not imply any particular investment strategy.”
    This is what I had wrong in my head 🙂

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