The term ‘hedge fund’ is widely discussed, and wildly misunderstood.

It refers to much more than simply an investment fund that uses hedging techniques.

Rather, it is an investment instrument that offers a risk / reward profile that differentiates it from traditional stock and bond investments.

It makes use of alternative investment strategies to generate positive returns with low volatility and low market correlation.  What on earth does this mean?

There are obvious similarities between hedge funds and mutual funds – both are investment vehicles whereby investors (institutional or private individuals) entrust their money to a manager to manage.

So maybe the clearest way to define a hedge fund is to examine the features which distinguish it from a mutual fund, or straight asset managers.  

1. Absolute (positive) returns

The fundamental nature of a hedge fund – its freedom to pursue absolute return strategies - differentiates it from its more cautious and prudent cousin, the mutual fund, who only aims to achieve a relative return (that is, it aims to beat the market).

In practice, the goal of a mutual fund is to ‘beat the bogey’, where the ‘bogey’ is the index we choose to measure the performance of a fund by.

The FTSE 100 would be a good example of an index used to measure the performance of mutual funds who invest in FTSE listed companies.  If the fund invests its assets in media companies for example, and its assets under management (AUM) go down 8%, the mutual fund is still deemed to be a success so long as the FTSE is down more than 8%.  The fund has performed badly, but not as bad as its benchmark.  This is deemed to be success!

Hedge funds, on the other hand, seek absolute returns, regardless of the performance of an index or benchmark.  As such, a hedge fund pursues more aggressive investment strategies and takes riskier positions.

2. Regulation

In order to fulfil their promise to investors to provide absolute returns, hedge funds are unregulated in terms of registration, investment positions, liquidity and fee structure. 

Unlike mutual funds, hedge funds are not registered with a financial governing body (the FSA in Britain or the SEC in the United States), and as such are not required to disclose security positions and balances to these bodies, as opposed to mutual funds, who are required to do so every quarter.
This lack of regulation gives hedge funds greater freedom of movement.

3. Investor profiles

Hedge funds are also liberated from revealing their positions and balances to their investors, who must accept this as a consequence of the raison d’être of a hedge fund. As such, all their investors must be accredited (they must meet an income or net worth standard), and there is a cap on the number of investors allowed.

One might wonder why someone would choose to invest in a manager who is exempt from disclosing its workings and risk positions to investors.

The answer is to be found in the risk profile of the investors.  The old adage ‘no risk, no reward’ is evident – some people with a lot of money are prepared to risk losing significant amounts if it means there is a chance they could gain a whole lot more.

4. Short selling

Mutual funds can only buy stocks and hope to profit if they go up.  Hedge funds, on the other hand, also seek to profit from falling stocks by ‘going short’.

To construct a short position, the hedge fund sells stock it does not own with the belief that the stock’s value will fall.  To fulfil the sale contract, it borrows the same stock from a stock lender in return for a small fee.  It then sits and waits - and hopefully the stock does indeed fall in price.  At this point, the hedge fund goes into the market and buys the stock - now at its lower price - and returns it to the stock lender.

The hedge fund has still followed the golden rule of buying low and selling high - just the other way around.

5. Use of leverage

A mutual fund only invests the money it is entrusted with by its clients.  On the other hand, a hedge fund will often supplement its funds under management by borrowing additional capital.  Thus it can use its underlying investor funds - its equity - as collateral to raise debt.  This is known as leverage.

LTCM - the infamous hedge fund that blew up in 1998 as a result of the Russian crisis, was leveraged up to 30 times.

If you raise a mortgage to buy a house, you are said to be leveraged.  Say you buy a house for $300,000 but only put down a deposit of 10%, being $30,000.  If the house goes up $30,000, its price has risen by 10%.  But this gain represents a return of 100% on the cash you invested.  Hence the magic of leverage.

6. Any asset class

Mutual funds are generally restricted to investing in either bonds or equities - so-called “investment grade” assets.

Hedge funds often invest across a variety of asset classes, such as stocks, cash, bonds and real estate.

They will sometimes invest in private companies, unlisted securities, distressed debt, junk bonds and a variety of other non-investment grade or unlisted assets in a search for greater returns.

7. Any strategy

A mutual fund is generally known as a ‘long-only’ fund.  Whereas, as we have discussed a hedge fund can also use short-selling techniques.

This is not all.  A hedge fund can follow any one or a number of strategies to achieve its investment objectives.

These strategies have complex and pretentious sounding names, like “equity long / short” or “global macro”.

Each one tries to isolate a specific risk / reward idea and profit from it, while diversifying, mitigating or restricting risks from other areas not related to the specific strategy.

The same can be said of the markets the funds invest in: whereas mutual funds will generally pick a market and stick to it (the UK equities market, for example), hedge funds often take a more opportunistic approach, giving themselves a wider remit and the option of investing in multiple international markets.