A hedge fund is a type of investment portfolio that incorporates a variety of investment products and strategies. The fund can be managed by the investor who created it or it can be created in the form of a company, such as a Limited Liability Company (LLC). This last option creates a safeguard should a company go bankrupt; creditors cannot go after investors for any more money than they put into the fund. Investors will put money into the fund and the manager receives a portion of the profits that the fund earns; profit gains in a hedge fund rely on the choosing of appropriate stocks and acting on them at the most opportune moment.
The term hedge fund comes from the phrase "to hedge one's bets", and refers to the practice of balancing out transactions to ensure that no matter which way the market turns, a profit can still be made. It is this balancing transactions which distinguishes hedge funds from a spate of other fund strategies that sprang up at the beginning of the 21st century.
Evolution of Hedge Funds
The first hedge fund was created in 1949 by stock pioneer Alfred Winslow Jones. Originally, the hedge fund was essentially meant to be a fund that sold some stocks short, and bought other stocks long. Buying stocks short involves selling borrowed stocks with the hopes of buying them back at a lower price, while buying stocks long means to buy stocks that are expected to increase in value and selling them once they do. With this technique, the overall value of buying and selling balances out, thereby eliminating heavy losses due to large market swings. For the most part, the term hedge fund now refers to any fund that is mostly unregulated and employs unconventional methods of investing, and most hedge funds have the status of partnerships, rather than the corporate model of other funds.
Hedge funds have evolved to include a number of strategies, in addition to the balanced short-long strategy of Alfred Jones. Some common hedge fund strategies include: trading stock options and bonds, the purchase or sale of highly undervalued securities, and arbitrage. Another common strategy is called risk arbitrage and includes buying shares in a company that is in the midst of a merger and acquisition — in this case there is a guaranteed profit if the merger does complete, with the only risk being that the acquisition will fail.
In order to keep regulation very low, hedge funds have the status of unregistered investment companies. This means that only accredited investors and qualified purchasers may invest in them — those who have incomes of over $200,000 USD per year, a net worth of over $1 million USD, or those who already have at least $5 million USD in investments.
Unlike mutual funds, hedge funds are very lightly regulated; as a result, they can keep their actions relatively secret. Most contemporary hedge funds are handled by offshore companies in places like the Virgin Islands or Cayman Islands, where regulation is minimal. This secrecy makes it difficult to predict actual numbers for hedge funds, but as of January 2011, about $1.9 trillion US Dollars (USD) worth of assets were under hedge fund management.