hedge fund

DEFINITION: The phrase “hedge fund” refers to a kind of investment fund whose chief characteristic is that investors in the fund accept a higher-than-average level of risk to their principal in exchange for the possibility of obtaining a greater-than-average return.

Legally, a hedge fund takes the form of a limited partnership of private investors who pool their investments and hire skilled professionals to manage the fund on their behalf.

ETYMOLOGY: The phrase “hedge fund” was coined in 1967.

The English noun “hedge,” meaning a boundary, fence, or barrier consisting of shrubs, bushes, or low trees, derives from Middle English hegge and Old English hecg.

The English noun “fund,” which is attested from the late seventeenth century, is derived from the Latin noun fundus, meaning “bottom,” “bottom land,” or simply “piece of property.”

The phrase “hedge fund” is counterintuitive, seeing that “to hedge” means to limit one’s risk, whereas hedge funds are riskier than other types of investments. How can we account for this anomaly?

Ther answer is that when hedge funds were first introduced, in the late 1960s, they were primarily used to “short” the market, hence acting at that time as a genuine “hedge” against market declines.

Over the past 50 years, the nature of the risk associated with hedge funds has changed dramatically, but their name has remained the same.

USAGE: Hedge fund managers employ diverse strategies, such as leveraging or trading unconventional assets, constructing complex portfolios, dealing in derivatives such as options and futures, and shorting the market, to name a few, with a view to achieving returns that exceed the market average.

Since hedge funds bear a relatively high risk, certain restrictions are often imposed on prospective investors. For instance, there is often a high minimum investment requirement for participating in a hedge fund or even a minimum net worth requirement that must be met.

Affluent investors are, of course, primarily attracted to hedge funds by the prospect of increasing their capital gains. However, another allure of the best-known and most prestigious hedge funds lies in a kind of mystique cultivated by their managers. From a sociological perspective, the high-rolling world of hedge funds may be said to function much like an exclusive club.

Individual investors in hedge funds must typically be “accredited investors,” meaning that they satisfy a minimum income requirement.

In addition, many hedge funds are composed of institutional investors, notably, insurance companies and pension funds.

Hedge fund investments are considered “illiquid,” since investors are often required to commit their funds for a minimum period of one year, known as the “lock-up period.”

Even after the lock-in period has expired, withdrawals may be limited to specific intervals, such as quarterly or semi-annually.

Hedge fund managers focus on specific investments and portfolios of securities with the potential for highly profitable returns.

Different hedge fund managers may pursue different types of strategies. The following are four different kinds of hedge funds that one might commonly encounter:

  • Global macro hedge funds: Actively managing investments with the goal of taking advantage of significant market movements triggered by economic or political events around the world.
  • Equity hedge funds: Either global or country-specific investing in profitable stocks, which also seeks to counteract market downturns by shorting overvalued stocks or stock indices.
  • Relative value hedge funds: Attempts to profit from temporary price or spread inefficiencies in related securities.
  • Activist hedge funds: Investing in businesses and taking other actions that enhance the stock price. This may involve making demands for cost-cutting measures, asset restructuring, or changes in the board of directors.