What Do Hedge Funds Hedge?

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The answer is: very little, at least these days.  The term does have historical origins, but it otherwise it misleads. Whatever the name’s applicability, hedge funds have a perennial popularity, seeming to carry associations with wealth and sophistication.  In reality, they differ so much from one another that they hardly count as an investment style.  What they have in common is less their approach to investing than their legal structure and costs.

Where Did Hedge Funds Come From?

 Hedge funds have been around for a long time.  The first fund appeared in 1949.  Its founder, Alfred Winslow Jones, had great confidence in his ability to distinguish good stocks from bad, but he doubted anyone’s ability to forecast the direction of the overall market.  It frustrated him that he could pick the best stocks in the world and still lose money if markets fell.  His answer: buy stocks that looked good, often with borrowed money — on margin in financial jargon (more on this in a coming post) and “sell short” stocks that looked bad. Selling short involves selling a security that you do not own for delivery sometime in the future. Investors do this in the hope/expectation they can buy at a lower price before they have to deliver.  By balancing the short sales against the buys, Jones’s portfolio did not depend at all on the ups and downs of the whole market.  Instead his portfolio’s performance reflected only his stock selections.  Because the short sales were said to hedge the buys, Jones called it a “hedged fund.”

What Are They Now?

Most of these funds have long since abandoned this rather cautious approach.  Instead, they invest in a great variety of sometimes-risky assets in order to get superior returns, many of which have nothing to do with hedging.  Unlike most mutual funds available to retail investors, hedge funds can and often do invest in less common investment vehicles, including, for instance, commercial real estate, financial derivatives (to be discussed in a coming post), and currencies, among others.  They often concentrate their investments rather than diversify them.  The funds also frequently borrow money to redouble their investment bets. This “financial leverage,” as it is called, can enhance their returns when things go well, but because they owe the money regardless of how things go, it can devastate fund performance when things go wrong.  Beyond this general description, there are too many different approaches to list here.

Here is why hedge funds can take greater risk than most retail mutual funds and other investment strategies:

  1. Nearly all hedge funds require a rather large minimum investment and insist that investors leave money with them for a minimum time, called the lock-up period.  The size of the minimum varies greatly from fund to fund, but no average investor would consider it easy.  The length of the lock-up period can also vary.  Sometimes it extends to year or more.
  2. Even after the lock-up period, most hedge funds only allow withdrawals at set intervals,quarterly, perhaps, or sometimes only semi-annually.

Because of these arrangements, hedge fund managers share little of the concern common among mutual fund managers that sudden spates of withdrawal by panicky investors will force them to sell at inopportune moments. Hedge fund manages can consequently take risks that might enable them to wait out temporary market reverses.

Legal Structure

 The Securities and Exchange Commission (SEC) protects the general public from hedge fund risks by restricting the number of participants allowed into any fund, and also by limiting those participants to what the Commission calls “qualified investors.”  To qualify, you must demonstrate an annual income of at least $200,000 a year for the past two years and have a net worth of more than $1 million, excluding your primary residence.  Regulators believe that investors with these resources can more easily wait for their money and survive the potential loss implicit in the risks hedge funds frequently take.

Legally, hedge funds are set up as limited partnerships and often refer to their investors as “partners,” an arrangement that gives them tax advantages, especially because their profits are taxed at capital gains rates instead of the higher rates applied to ordinary income.  (A coming post will go into detail on taxes.)  Hedge funds also charge far higher management fees than do mutual funds or most other investment arrangements.  Hedge fund fee structures are often referred to as “two and twenty”: the fund charges 2 percent of the invested assets each year and 20 percent of any gains on them. This 2 percent is controversial because it is considerably higher than most retail mutual fund fees, and must be paid even if the portfolio suffers losses.  Because of their fee structures, tax advantages, and wide range of investment approaches, a common jibe in financial circles holds that hedge funds are compensation schemes for managers masquerading as an investment approach.


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