EFA (18): Hedge Funds

Hedge funds were one of the fastest growing areas of financial investment until the recent financial crisis. But what exactly are these funds? This is the subject of the 18th item in our Economics for Amateurs (EFA) series. You can find the series here each Monday.

A good definition of hedge funds is given in the book Hedge Funds: Quantitative Insights by François-Serge Lhabitant, (Wiley Finance): “privately organized, loosely regulated and professionally managed pools of capital not widely available to the public.”

Hedge funds get their name from the verb “hedge”, which means “take action to reduce the risk of a loss”. For example, a British company that knows it will import goods from the US could hedge against the risk of the pound falling by purchasing dollars of an equal value to its planned imports. More generally, if you “hedge your bets”, you keep all your options open.

The first hedge fund was set up in 1949 by American journalist Alfred Winslow Jones. To hedge against some of the risk of buying shares, he also sold short some shares. This means he sold some shares that he had borrowed, knowing that, if prices fell before he had to give the shares back, he could buy them at a lower price and so make a profit.

Short selling is one of the strategies open to modern hedge funds, which generally aim to provide investors with positive (“absolute”) returns on their investments, whether or not markets are rising in general.

Unlike unit trusts (US: mutual funds), hedge funds are usually private partnerships, and most are managed from the US or Britain and registered offshore in tax havens, such as the Cayman Islands or the Bahamas. As a result, hedge funds are far less strictly regulated than unit trusts. They can also use a wider range of investment strategies, including short selling, buying distressed companies (ones in trouble but expected to improve), investing borrowed (“leveraged”) money, taking positions on shares during takeover talks, and dealing in derivatives, such as options to buy shares or futures.

Traditionally, only very rich individuals invested in hedge funds, but now many institutional investors, such aslife insurance companies and pension funds, invest either in individual funds or in “funds-of-funds”, which themselves invest in a range of hedge funds.

Despite their origin, hedge funds are often seen as speculative investments, a view confirmed for many by the collapse of the heavily-leveraged US fund Long-Term Capital Management in 1998 and the recent financial crisis.

The practice of selling shares short has also been criticized and banned in some countries at least temporarily. And hedge funds have been criticized for the high management fees that they charge investors. On the other hand, successful funds can reduce the volatility of investors’ portfolios.