An Introduction to Hedge Funds

The term “hedge funds” have become ubiquitous in the financial markets nowadays. This is a term which incites a strong emotional reaction from all market participants and observers. Some are of the opinion that these funds are evil and endanger the entire market with their reckless risk taking. Others are of the opinion that hedge funds balance the markets balance the markets and play an important role.

One might be surprised to know that “hedge funds” are a very recent phenomenon. These funds, as we know them today, were invented in the 80’s and the 90’s. Since then, they have become considerably popular. In this article, we will understand what hedge funds are and we will also trace the reason for their extreme popularity today.

Background and Definition of Hedge Funds

The first hedge fund in the world dates back to 1949. It was started by a man named Alfred Jones. This fund, like the hedge funds of today was structured like a limited liability partnership. It was free to invest in any asset class and undertake any amount of leverage. This fund was a private fund and was therefore beyond the scope of any regulation.

This fund and many others that were created back then, were not known to the average population. These were high risk high reward alternatives that were only available to a few investors that were willing to indulge in such trades. The idea of an unregulated fund that was available only to an exclusive class of investors was born. These funds are what we today know as colossal market moving hedge funds.

The definition of hedge funds is as follows:

“A hedge fund is a vehicle where people pool their money to make investments. This fund must be privately organized i.e. to ensure that minimum regulation is applicable to this fund. The fund also needs to be managed by a professional firm. Also the fund must be free to chose or change its asset classes and investment decisions when required without an lengthy processes. Lastly, there must be very little or no regulations regarding the amount of leverage that can be undertaken by the fund”

Usually, hedge fund companies function as conglomerates which have several funds. The responsibility for marketing each fund lies on the individual hedge fund manager. Companies like Credit Suisse and JP Morgan Chase merely provide an established brand name and charge a fee. The funds are structured as limited liability partnerships and are run exclusively by the fund managers.

Claim to Fame

Hedge funds rose to prominence in the mainstream media thanks to George Soros. This fund manager made billions for himself as his hedge fund called the “Quantum Fund” led a pack of hedge funds to nearly bankrupt the British Central bank. These hedge funds unleashed their collective might on a central bank of a developed nation and won! The Bank of England was forced to devalue the British pound to stop the massive short selling by these funds.

Prior to this, central banks were thought of as being invincible. A new breed of funds called hedge funds had taken them on and defeated them in the marketplace. Thus, hedge funds became known, respected as well as feared on Wall Street. Post the Bank of England incident, investors queued up to invest in hedge funds and the assets under management for these funds suddenly underwent a drastic increase.

Hedge Funds as Entrepreneurial Ventures

Many traders who were working for banks and mutual funds realized that they could realize their entrepreneurial dream via the hedge fund route. This led to the proliferation of hedge funds in the market. After making a name for themselves as a trader, most managers would quit their job and launch their own fund.

The amount they received as salaries at these corporations was replaced by an annual management fee. Also, the bonuses that they received at these corporations were replaced by an incentive fee. Traders who were confident in their ability to manage investments and profit from them had no reason to stick to a job. This is when the idea of hedge funds really caught on.

The Decline of Hedge Funds

The hedge fund mania hit its peak when a fund named Long Term Capital Management went bust causing a domino effect in markets worldwide. This fund was started by Nobel laureates who thought that they had figured out a formula to consistently beat the markets.

Investors at first lined up to invest with this fund. The clout of the fund steadily grew as the assets under management swelled up. At its peak, the fund had open positions of over a trillion dollars in the market and this is when the hedge fund went bankrupt.

Till then, people had seen only the high returns that hedge funds could provide. This is when they were first introduced to what could go wrong in the process of earning those returns. This was when hedge funds came under negative publicity and people started criticizing them.

This same feat was to repeat itself in 2008 when hedge funds caused mayhem in the markets. George Soros, the poster child of hedge funds is said to have netted over a billion dollars for himself while the rest of the world was teetering on the verge of bankruptcy.