What is... | March 15, 2010

What is a hedge fund?

Are hedge funds virtuous or villainous? Find out the basics and read both sides of the debate. Despite the quirky name, hedge funds are neither connected to horticulture nor are they investments held by ordinary households.


A hedge fund is one that takes larger risks, often using unconventional investments, in order to generate high profits on behalf of institutions or wealthy individuals.
Hedge funds are often in the headlines. Once they were accused of destabilising financial markets in Greece.

From obscurity to ubiquity – the rise of hedge funds
The term was first used in the middle of the last century, according to the Alternative Investment Management Association (AIMA). An American investor called Alfred Jones coined the term “hedged fund” to describe a strategy of including investments that hedged against losses in other parts of his portfolio. The rise in its use is attributed to a 1986 article in Institutional Investor magazine, which revealed the Tiger Fund generated compound annual returns of 43% over a six-year period. AIMA estimates the hedge fund industry had as much as $2.85 trillion (€2.10 trillion) of assets under management in 2008.

The long and the short of it: investment styles explained
Traditional funds use investors’ money to buy assets, such as shares and bonds, with a view to the value rising over time. This is known as going “long”. Investors can also buy contracts that produce a profit if the price of an asset falls. This is known as going “short”. Hedge funds often use short investments as part of strategy to make money when they believe an asset price will fall.

Do hedge funds really hedge?
According to The Economist hedge funds aim to maximise their absolute returns rather than relative ones. In other words, they concentrate on making as much money as possible, not simply on outperforming the share market as many conventional funds do. As well as using short contracts, hedge funds take positions in more risky markets such as credit derivatives that traditional investment funds avoid. In that sense the term hedge fund is a misnomer as they often seek to take on risk rather than hedge against it.

Are hedge funds virtuous or villainous?
Hedge fund promoters say the funds make financial markets more efficient by spotting where prices are too high or too low. They argue it benefits all investors by ensuring assets are priced correctly.
Moreover, the OECD says hedge funds can play a positive role in improving corporate governance of publicly held companies. But the funds were blamed for contributing to financial crises such as the 1992 European exchange rate mechanism debacle and the upheaval in Asian markets in 1997. More recently politicians accused them of contributing to the 2008 crisis by taking short positions on falling bank stocks and pushing prices down further. High fees associated with some of the funds have also come under criticism.

Time for a trimming
Governments of the United States, United Kingdom and Australia introduced temporary bans on short selling in 2008. This year, the US Government put forward legislation to prevent banks from running or investing in hedge funds. Leaders of the G20 countries have said hedge funds must register and reveal key information to regulators.

Risk

Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics

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