Hedge fund is a term used for an investment fund trading in securities
that differs from traditional mutual funds. There is no strict definition of
what a hedge fund is, more than that they are not as governed by the Securities
and Exchange Commission (SEC) as most funds are. It is the simplest form of an
investment partnership. Generally they are high-risk and use every trick
there is to make a buck. The usual minimum investment is $1,000,000, but
the more high profile players like George Soros require a lot more. The
manager of the fund usually take 20% of the net profits, so it'd better be damn
profitable to be worth while lending your one million dollars to it!
The following are techniques and instruments used by hedge funds that are
limited or forbidden for ordinary funds - in order to protect the
- Shorting stocks - Borrowing stocks for a set period of time -at a
commission -, selling them and then buying them back after the time has
passed. Used when you think a stock will lose in value. Downside is
that there is no limit in how much you can lose, if the market goes
up. That means No Limit as in A Lot More Than You Invested.
- Borrowing money / Leverage - To use credit or borrowed means to
increase one's speculative capacity. This is strictly forbidden for mutual
funds. The idea is of course that you borrow a dollar, make a 50 cent profit
and return $1.05, keeping 45 cents. Problem is when you lose borrowed money,
it's hard to pay back...
- Trading with options and futures - A way of betting on the
future development of stocks and other securities. As in shorting, the
downside in some scenarios is infinite loss, not only your initial
investment. See Nick Leeson for a what not to do with stock options.
- Arbitrage - To buy and sell securities/assets on different
markets under the assumption that the valuation of said assets are unequal
between the markets.
Example: A glitch in the exchange rates market makes it
possible to buy €1 for $0.91 in New York, and then sell it in London
Theoretically, if commissions can be held low, an arbitrage can generate
an infinite amount of money. In reality, they don't exist as simple as in my
example, but rather as a speculative difference in valuation between
different types of assets. Hedge funds can use Convertible Arbitrage,
which means that you at a fix price acquire long convertibles which will
exchange for a set number of (usually) common shares. Then you short the
underlying stocks in such a way, that regardless of the stocks future value
at time of conversion, you'll make money on either the longs or the shorts.
Problem is that large market fluctuations will destroy this scheme, with
large losses following.
Hedge funds are generally much more profitable than mutual funds, and also
usually much less unprofitable. This is because they are allowed to
protect the downside of the investment more creatively than a mutual fund.
But the risks are higher, and this is partly why they cater to people with a
lot of money, who can afford losing it all.
There's a lot of "statistical proof" of how much better hedge
funds are compared to mutual funds or other investment types, but I have no way
of validating that kind of "information" in a qualitative way, so I'll
spare you. Sources include various hedge funds homepages.