Bookstaber (1997) states that it is difficult to define hedge funds because they encompass all investment vehicles and strategies, minus traditional funds and investment strategies.
The US President’s Working Group on Financial Markets (1999) characterised such entities as, “Any pooled investment vehicle that is privately organised, administered by professional investment managers, and not widely available to the public”.
There are two important aspects of Hedge Funds: first, to generate positive absolute returns in any market condition and thus not to gain returns correlated to a predetermined index. Second, Hedge Funds try to control losses and avoid negative compounding of capital (Brentani, 2004).
According to Garbaravicius & Dierick (2005), “There is no common definition of what constitutes a Hedge Fund; it can be described as an unregulated or loosely regulated fund which can freely use various active investment strategies to achieve positive absolute returns”. Hedge Funds are difficult to define partly because of complicated term structures and their diverse trading spectrum.
Compared to mutual funds; hedge funds typically engage in derivatives trading, high leveraging, and short selling, giving hedge funds more flexibility in their investment strategies.
Hedge Funds are similar to any other portfolio investment in three aspects: they are funded by capital from private investors, they invest in publicly traded securities, the capital is invested by expert fund managers.
The level and variety of risky investment strategies and the degree of regulation are the key differences between Hedge Funds and Mutual Funds. Hedge Funds are free to pursue virtually any investment strategy with any level of risk. Mutual Funds are required to adhere to strict financial regulations which include the types and levels of risks that may be taken.
Hedge Fund investors are typically high net worth individuals (Garbaravicius & Dierick, 2005), partly because Hedge Funds require high minimum investment amounts. In some cases, the investors are required to be “accredited”, as we discuss later. On the other hand, Mutual funds are typically for the general public and will accept any investor who can meet the minimum investment amount.
The fund’s portfolio composition is a third key difference. Fung & Hsieh (1999) states most Mutual Funds are composed of equities and bonds while Hedge Fund portfolio compositions can be more varied, with a significant weighting in non-equity/bond assets like derivatives.
Hedge funds do not always have to “Hedge.”
The many Hedge Fund investors and the fact that they were virtually unregulated compared to other funds created a multitude of new Hedge Fund trading strategies, including the use of derivatives such as options.
Hedge Fund strategies vary from highly complex to simple, each with their own pros and cons. Some make use of high leverage or high frequency trades to only focus on delivering absolute returns to their investors without placing hedges to reduce specific risks or exposures.
Today, the word “hedge” in Hedge Funds is more of a historical hangover from Alfred Winslow rather than a strict rule for all Hedge Funds.
Bookstaber R., 1997, “Global Risk Management: Are We Missing the Point?”, Journal of Portfolio Management, Vol. 23, No. 3 (Spring), pp. 102-107
Brentani C., 2004, ”Portfolio Management in Practice (Essential Capital Markets)”; Butterworth Heinemann
Brown, S.J., 2001, “Hedge funds: Omniscient or just plain wrong”, Pacific-Basin Finance Journal
Capocci, D. and G. Hubner, 2004, “Analysis of hedge fund performance”, Journal of Empirical Finance
Faff R. Do, V. and J. Wickramanatake, 2005, “An empirical analysis of hedge fund performance: The case of australian hedge funds industry”, Journal of Multinational Financial Management
Fung, w. and Hsieh, D.A., 1999, “A primer on hedge funds”, Journal of Empirical Finance
Garbaravicius T. and Dierick F., 2005, “Hedge funds and their implications for financial stability”, European Central Bank, Occasional Paper Series
Jaffer, S., Maumus O., Meaden, N., Rizzo, S., Tomlinson, B, 1998, “Alternative Investment Strategies”, Euromoney Publication, London
Lo A.W. Getmansky, M. and I. Makarov, 2004, “An econometric model of serial correlation and illiquidity in hedge fund returns”, Journal of Financial Economics