What Is So Special About Hedge Funds?

Hedge funds have been making the news and media a lot these days. The term ‘hedge fund’ refers to a broad category of funds that is easy to misunderstand. Naturally, questions like “What is special about a hedge fund?” and “How do they operate?” arise. In this article, I plan to answer these questions for the common man.

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What is a Fund?

Before we dive into hedge funds, it makes sense to clarify what a fund is. As normal people, you and I can own and trade company stocks, bonds, commodities, etc., in publicly run markets. Naturally, if we wish to invest on our own, we have to operate under our accounts, and make our own decisions.

Since the average person does not have the time and expertise to make his or her own investment decisions, funds are products offered by organisations or professionals who ‘theoretically’ know better. A fund is nothing but a bunch of investors pooling in money to buy a portfolio (a list) of stocks, bonds, commodities, etc. The costs are then split in between the investors. More specifically, this fund structure is classified as a called mutual fund. The idea here is that when a single stock or bond goes up or down, it has marginal impact on the whole portfolio added together. In business jargon, this is known as diversification.

A fund may be actively driven or passively driven. In actively driven funds, a fund manager runs the operation. He is expected to get above average results using his expertise. In a passively operated fund, the manager is replaced by an index such as the S&P500 index. Passive funds are usually cheaper than active funds (because the latter involves management fees), and statistically, perform better than active funds. So far, so good. Now let’s move on to hedge funds.

What is a Hedge Fund?

A hedge fund is by definition, also a fund, and involves a portfolio. The difference is how the fund is operated. Hedge funds are almost always actively operated and are much riskier with their strategies. Furthermore, they involve leveraged transactions and trade anything that’s tradeable. This might include derivative products, currencies, art, precious metals, etc. Most of these tradeable entities are forbidden by regulators for other categories of funds because of the risks involved.

As a result, normal investors are not allowed by regulators to invest in hedge funds, but high net-worth individuals who are classified as accredited investors. Hedge Funds also involve very high management fees because of the complex operation structures, and the best of them far outperform the average market returns.

Does all this sound too surreal? If yes, it indeed is! The number of hedge funds that outperform the market are a minority of the total proportion. Most of them fail. Their investment strategies are not as harshly regulated compared to funds that are open for the typical investors. As a result, there is lesser transparency, and a lot of shady tactics that go on in this space. This is because the hedge fund professionals need to gain an ‘edge’ compared to the rest of the market, and this often involves pushing the boundaries of what is considered legal. And whatever edge they gain, must be held a secret. If the information becomes public, everybody eventually does it, and it stops working.

What Makes Hedge Funds Special?

The word that best describes hedge funds is ‘hedge’. Theoretically, they hedge their risks by modelling counteracting positions. To put it in simple terms, this works like insurance. Assume that you are insuring your home. Every year, you incur losses in the form of insurance premiums. But if something happens to your home, you get a lot more paid to you than you paid in via premiums.

Hedge funds build similar, but complicated models, wherein they often do not take insurance on their own homes, but on someone else’s. Furthermore, the financial derivative products that they have access to, enable them to take counteracting insurance positions (they gain if the home is damaged or if it isn’t), and more complex structures like insurance on insurance. If you are starting to feel uncomfortable at this point, I totally understand you. It is a highly mathematical, computer-driven shark-eat-shark world. The level of abstractions would not make sense for the typical person.

Why Did Hedge Funds Get a Bad Reputation?

If you are not aware of it yet, the mainstream pretty much hates hedge funds. Be it the internet or the media, there is widespread negativity surrounding hedge funds. Part of the reason for this is that post the 1960s, people started to misuse the term ‘hedge fund’ to represent things it strictly did not. Consequently, any fund that was not open to normal investors was called a hedge fund. This also included funds that had no ‘hedge’ component to them. Some of the funds that brought a negative reputation to the family of hedge funds ironically did the opposite of hedging and piled on unreasonable risk and leverage.

Hedging is Not Unique to Hedge Funds

Just to clear the name for the true hedge funds, it needs to be mentioned that hedging is done by global corporations all over the world. Any multi-national corporation (MNC) needs to hedge currency risks because it operates in multiple countries at the same time. Currency risks here refer to deviations of value that arise from one country’s currency fluctuation strongly against another country’s currency.

Apart from that, companies that consume a lot of commodities also need to hedge. For instance, an international fast-food chain would need to fix chicken prices for the next 5 years to offer the same price daily on its chicken products during this period. This often involves complicated and customized hedged forward contracts between the parties involved. The only thing unique about hedge funds (at least the real ones) is that their entire business model is based on hedging.

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