What Are Hedge Funds ?

Hedge funds are investment partnerships formed for the purpose of investing in either traditional or alternative vehicles.

If you’re like most folks, you may believe that “hedge funds” are a more recent development within the investment world. Not so. In fact, records suggest that as early as the 1920’s there were investment operations that would, by today’s standards, be considered hedge funds.

The origins of the actual term can be traced to 1949. In that year, Alfred Winslow Jones created a fund who’s investment strategy involved the buying of one stock and the selling of another. This approach provided for a “hedged” position and thus the term hedged fund came to be. Prior to gaining widespread acceptance, this type of fund was known as an investment pool, investment syndicate, investment partnership or opportunity fund.

Using the application that best fits today’s standards, a Hedge Fund is simply a specialized form of an investment organization or fund. Organized as a limited partnership or limited liability company, hedge funds accept investments from private individuals. Generally, hedge funds are organized and operated by a “general partner” or “manager” (this person or company is often the one who’s responsible for making investment decisions for the fund).

Hedge Funds Defined

hedge fund (noun):   an investment company, organized as a limited partnership or limited liability company, that employs one or more enhanced-risk investment techniques in an effort to earn profits that far exceed those of more traditional investments.

Within the investment realm, it’s generally accepted that there are two categories of hedge funds.  They are :

1.  Passive investment hedge funds – In this variation, the hedge fund itself (the company, organized as a limited partnership or limited liability company) is a “passive” investor in the investment or trading programs of others.  In this case, it’s the job of the general partner or manager of the hedge fund to locate third party investments or trading programs in which the hedge fund may invest. 

2.  Active hedge funds – As the name suggests, in this variation the hedge fund (organized as limited partnership or limited liability company) is an active participant in the investment activity.  Rather than merely placing investment capital with a third party (as in passive investment funds), the active hedge funds general partner or manager is the one who takes action (buying property, trading markets, etc) on the funds behalf.

Types of Investments Made by Hedge Funds

The investment plans followed by hedge funds are a varied as the managers that operate them. Many hedge funds are involved in more traditional types of investment such as stock and bonds. However, hedge funds often hold very diversified portfolios with investments in such things as real estate, precious metals, diamonds/precious gems and collectibles. Additionally, some funds are active participants in derivative trading (trading futures and/or option markets). To be sure, the types of investments undertaken by hedge funds are diverse and numerous.

Since hedge funds have the ability to participate in almost any type of investment, these funds have frequently posted returns that are considerably higher than more traditional types of investments. As with all investments that have the potential for substantial returns, there’s likewise a considerably higher level of risk in hedge fund investing. Most often, the degree of success realized by any hedge fund is directly linked to the performance of the fund’s manager.

Who Invests In Hedge Funds

Over the past 25 years, hedge funds have most often been thought of as an investment that’s reserved for very wealthy private investors. In general, a great many hedge funds have set very high requirements for minimum investments. These requirements (often at $1 million or more) has made hedge fund investing suitable and accessible to limited few. Although the majority of hedge funds are restrictive in this manner, there are exceptions.

In our money management business, we presently operate three hedge funds. Structured as private placement offerings (that simply means the funds are not registered as public securities), we’ve kept the minimum investment amounts in our funds at much more reasonable levels (in the $10,000 to $25,000 range). We’ve even made our hedge funds available for investment by IRA accounts. Utilizing this approach, access to hedge fund investment has been increased significantly.

Problems With Some Hedge Funds

Over the past decade, you’ve probably heard about some of the problems with a select number of hedge funds. Most often, investors in these funds have lost money due to the fraudulent or negligent activity of the fund’s manager. In large part, this problem stemmed from a lack of regulatory oversight of the hedge fund industry.

While it’s true that a great many hedge funds are subject to very little regulation, that’s not true of all funds. In our money management/hedge fund business, we’re governed by a specific set of rules and regulations. Additionally, these regulations require that our funds must perform annual certified audits and we are subject to regulatory audits on a periodic basis.

For those contemplating a hedge fund investment, the best rule of thumb is to do your homework before you invest. This is particularly true of hedge funds that have little or no regulations to which they must adhere. In a perfect world, all hedge fund managers would be honest and ethical. Since it’s not a perfect world, there’s always be a need for investors to be vigilant.