What exactly is a hedge fund?

Like mutual funds, hedge funds pool investors’ money. The aim of most hedge funds is capital preservation, positive and consistent annual returns, and limited swings in value. But unlike mutual funds, which are generally happy to beat the returns of an average benchmark, like the S&P 500 index, most hedge funds are interested in absolute returns – maximizing the increase in value each and every year.
The funds seek to maximize their goal by managing their risk, mostly by hedging. Hedging is a strategy used to protect a portfolio against sharp movements in market values, often accomplished by buying and holding assets that have good long-term prospects while simultaneously selling short assets that have doubtful prospects. In the case of investments, risk comes in a variety of forms: Market, interest rate, inflation, large weightings in a sector, region, single company, or currency.
While hedge funds initially got their name as a result of their hedging investment strategy, many hedge funds today use strategies that do not include any hedging, including funds that are either completely long-funds or completely short-funds, or even sector funds. Just because a fund is a hedge fund does not necessarily mean there is any hedging of investments.
Unlike most mutual funds, hedge funds employ a variety of aggressive tools to achieve their goals, including selling short, buying or selling options, futures, commodity and/or currency futures, investing in derivatives, leverage, arbitrage, and holding highly-concentrated positions.
Before we go any further, let me just define and demystify a few of the above terms that often confuse investors:
Selling short: Say an investor thinks the shares of the XYZ Widget Co. are overpriced at $10. He borrows 100 shares, for a total loan of $1,000 (we won’t take into account commissions for this simple example) . He then sells them, pocketing $1,000. Now, a week or so later, the shares fall to $8. The investor buys them back at a cost of $800, gives back the 100 shares he borrowed to the brokerage firm, and takes his profit of $200 ($1,000 - $800) to the bank. As you can see, short-selling is not as complicated as it sounds and is a very frequently-used tool.
Arbitrage: The attempt to profit from the fact that sometimes an asset trades at a different price in different markets at the same time. An investor may log onto his computer prior to the U.S. stock market’s opening and find that shares of XYZ stock closed in the U.S. the day before at $18.63, yet they opened on the Japanese Nikkei exchange at $18.64, creating an arbitrage opportunity. The investor would then sell the higher priced asset in the Japanese market (sells it short) and buy the lower priced asset in the U.S. market (buys it long) . When the prices converge, he will profit by selling the formerly low-priced asset in the U.S. and buying back the formerly high priced asset in Japan. You may think that a penny difference isn’t worth all that work, but when you are talking about hundreds of thousands of shares or contracts sometimes changing hands, those pennies add up!
Leverage: Borrowing in order to increase investment returns. Investors do this all the time by buying on margin – borrowing money from their brokerage firms to purchase investments that they hope will increase in value, thereby allowing them to sell the shares at the higher value, repay the loan and interest at the brokerage firm, and profiting from the difference. Hedge funds do the same thing, just with higher dollar amounts.
Similar to the returns of investments such as real estate and private equity placements, which are often deemed to be uncorrelated with those of traditional investments, hedge funds typically endeavor to achieve absolute returns not by market timing, or predicting the direction of prices. Instead they attempt to identify as many transient profit opportunities as possible that are immune to market gyrations, often resulting in greater risk-adjusted returns than the market.
Because hedge fund managers find opportunities, like the arbitrage example above, that generally involve small trading margins, they use leverage and prudent risk management to achieve their goal of good returns with less volatility. It is this potential that has attracted a growing number of individual and institutional investors who are seeking diversification and higher returns at a lower risk, to hedge fund investments.
And because the lion’s share of most hedge fund managers’ compensation is based on the percentage increase in their investors’ portfolios – not on how well they performed relative to an average benchmark – they have a strong incentive to maximize that performance. Additionally, many funds have a ‘high water mark’, whereby capital losses are required to be made up before a performance fee is paid, a further inducement toward capital preservation.
Consequently, while the media often portrays hedge funds as highly risky, due to the sophisticated tools they use to hedge their bets, the opposite is quite often the case – less risk, with higher returns.