Hedge Funds Definition

It is widely held in the academic literature that the first hedge fund was created by Alfred W. Jones in 1949, who aimed to achieve absolute returns regardless of market swings (Stulz, 2007). His underlying philosophy, conceived during his time researching and writing a 1948 article for Fortune Magazine on the trends in investing and forecasting, was that within the efficient market hypothesis there exists at any given time considerable pockets of inefficiency that could be profitably exploited without incurring unacceptable risks. In effect, his investment approach consisted of hedging his long stock options by shorting other stocks to protect against market volatility. At the same time, he remarkably introduced three other pioneering strategies,

An overarching definition that may be used is that a hedge fund is “any pooled investment vehicle that is privately organised, administered by professional investment managers, and not widely available to the public” (President’s Working, 1999: 1). The ambiguity of this definition gives a glimpse on how much variety there is in the “hedge fund” industry, however there are a few common characteristics that all hedge funds share. Firstly, it is usually the case that these funds are organised as limited partnerships or limited liability companies in order to give the hedge fund manager full control in his investment strategies (Tiffith, 2007) Secondly, the investors of the fund are organised as limited partners and are attained only through private offerings. Thirdly, as recent media stories have highlighted, hedge fund managers often charge a management fee (2% of fund profit) and performance fee (20% of fund profit) (Ibid). As a result, one hedge fund manager in 2005, Boone Pickens of BP Capital Commodity Fund, was compensated with $1.4 billion (Anderson, 2006). A last common characteristic that hedge funds share is a lock in period that could be up to two years; this period restricts investors from taking out their money from the fund and allows the fund manager to buy and keep illiquid assets

Managers consider ways to reduce volatility by either diversifying or hedging positions across industries and regions and hedging non-diversifiable market risk. However, the overall risk in this strategy is determined by whether a manager is attempting to prioritize returns (by having more concentration and leverage) or low risk (by creating lower volatility through diversification, lower leverage, and hedging). The core rationale of a long/short strategy is to shift principal risk from market risk to manager risk, which requires skilled stock