What is a hedge fund? A hedge fund is a pool of money invested by private individuals. Their money has more power together than they each would have individually.
The expression “hedge” fund came about in 1949 and the word “hedge” was used to imply that the fund was hedged against risk. That means that the investments are spread in such a way that if one goes down, another will go up, ensuring an overall success. The word “hedge” to imply an offsetting of risk comes from the 1670s. The idea probably comes from the fact that you can surround something with a hedge as a fence to make it safer. If you are hedging a bet, you are surrounding it with something else to reduce its risks.
The idea of investing as a group rather than as an individual is not new. Ever since the invention of trade, people have invested. You have to buy merchandise to trade, or spend money to grow the crops to trade, and there is no way of knowing if you will get that money back. You have to invest up front in the hope that you will receive a payoff. Investing as a group can increase profits because there is a larger pool of money to invest, but it can also decrease the risk because any losses will be spread across more people, potentially reducing individual losses. Investing flourished along with society, but it really took off with the age of sail and the dawn of truly international trade. People who owned ships couldn’t usually afford to fill them, so they would seek investors and those investors would be guaranteed a percentage of the profits, assuming that the ship wasn’t captured or sank in bad weather. This idea grew to become the Dutch East India Company and the British East India Company.
The first hedge fund is said to have been formed in 1949, but they probably existed before then. The idea was that the invested funds would be spread across different areas and types of stocks so that the risk was hedged. The fund was managed by a fund manager and that manager was paid a management fee, usually 2%, and a performance fee, usually 20% of the profits. That meant that any manager was invested in trying to get as big a gain as possible because they would earn a large chunk of those profits. This is a great incentive for the fund manager to work harder, but it is also an incentive for them to take more risks because that will increase profits. These days, hedge funds are not completely risk free.
Hedge funds generally have several different strategies for investing money. They can invest on a global level, using the differences in values of certain commodities between countries to make a profit. They can invest in regular companies, using long or short strategies. That means they bet money that a company will do better than expectations or worse than expectations. They choose competing companies so that their risk is minimized. They can invest money based on certain events, such as a merger, or a natural disaster. Or they can just invest in regular stocks. There are many other investment strategies as well and each fund manager will have different ideas and different areas of expertise. By spreading their investment over a large number of categories, hedge funds are freeing themselves from being tied to the stock market, which is a way of hedging risk. The idea is that the fund goes up an equal amount (let’s say 10%) when the stock market is doing really well and when the stock market is doing really badly. This is the hedge.
Hedge funds don’t take money from just anyone. You need to have a certain amount of wealth to be allowed to join the fund and this is because you need to be able to cope with any losses. A lot of large institutions, like pension funds and insurance companies invest large amounts of money in hedge funds. There are many hedge funds around the world and collectively they hold about $3.2 trillion. The two largest funds are a US fund called Bridgewater Associates and a UK fund called Man. Together, they have about $260 billion.
Hedge funds are supposed to hedge risk, but you obviously cannot have zero risk in investing and hedge funds do fail. This can be due to bad decisions, bad organization, or have turned out to be scams, like Bernie Madoff’s empire. And this is what I learned today.
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Sources
https://www.investopedia.com/terms/h/hedgefund.asp
https://en.wikipedia.org/wiki/Hedge_fund
https://www.etymonline.com/word/hedge
https://www.truewm.com/guides/The-history-of-investing-and-what-you-can-learn-from-the-past.pdf
https://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.htm
https://en.wikipedia.org/wiki/Bridgewater_Associates
https://www.insidermonkey.com/blog/5-biggest-hedge-fund-failures-925034/?singlepage=1
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