Stephen Cooper

Understanding Hedge Funds

The best ways to understand hedge funds.

In the year 1949, A.W. Jones established what is regarded as the first Hedge Fund in the United States by combining two investment tools - Short Selling and Leverage. Short selling involves borrowing a security and selling it in anticipation of being able to repurchase it at a lower price in the market at or before the time when it must be repaid to the lender. Leverage is the practice of using borrowed funds.

However, both Short Selling and Leverage are regarded as risky when practiced in isolation. Jones had the credit of showing how these instruments could be combined to limit market risk by explaining the nature of risk in stock investment. There are two distinct sources of risk(a). Risk from individual stock selection and (b). Risk of a drop in the general market. Jones sought to separate out the two and maintained a basket of stocks to hedge against a drop in the market. Thus controlling for market risk, he used Leverage to hike his returns from picking individual stocks.

The fund was thus considered "Hedged" to the extent the portfolio was split between stocks that would gain if the market went up and short positions that would benefit if the market went down. Thus the term "Hedge Funds". The fund run by Jones had two other notable characteristics that with variations continue to this day. He made the manager's incentive fee a function of the profits and agreed to keep his own investment capital in the fund, ensuring that his incentives and those of his investors were aligned.

Hedge Funds were a rage in the years 1966-68 as the stock market rose and Jones' fund gained publicity. The 1968 US survey enumerated 215 investment partnerships out of which, 140 were categorized as Hedge Funds. These funds concentrated on investments in corporate equities. With the market going up, fund managers relied more on leveraging, since hedging a portfolio with short sales was difficult, time consuming and expensive. Managers increasingly resorted to strategies with token hedging, thus rendering the funds vulnerable to the market downturn that started in 1968.

3 main classes of Hedge Funds

Macro Funds which take large unhedged positions in national market based on top-down analysis of macro-economic and financial conditions, inflation and the real exchange rate.
Global Funds which also take positions worldwide but employ bottom-up analysis, picking stocks on the basis of individual company's prospectus.
Relative Value Funds which take bets on the relative prices of closely related securities like Treasury bills and Bonds.