Hedge Funds 101

What do hedge funds have to do with personal finance? Not much unless your idea of personal finance involves figuring out what to do with with the idle millions of dollars sitting in your bank account.

But, with more and more capital being managed by hedge funds and with the growing influence of hedge funds on global capital markets, it's certainly worth at least knowing what a hedge fund is and is not. Just a couple years ago, if somebody asked me what a hedge fund was, I would respond by saying that a hedge fund is basically a mutual fund that is allowed to short stock, employs quantitative PhDs who create complex trading algorithms, and charges its clients outrageous fees due to its ability to create above-market returns. I suppose those types of hedge funds still exist out there, but more and more, you see hedge funds acting like private equity shops (crude definition: an investment firm that raises money, often through highly leveraged debt, to buy out operational companies, make financial and/or operational changes to those companies, and then flip the companies back out on the market to other investors - see the Wikipedia entry on "private equity" for a slightly less crude explanation) or serving as activist insurgent shareholders. Venerable companies like Goldman Sachs, which one might use to describe as an investment banking firm, now looks more like a giant hedge fund and makes far more money in its proprietary trading than it does in banking.

So, then, what exactly is a hedge fund? Whether you're curious to know or you just want to sound smart at dinner parties, I recommend checking out this New York Magazine piece which offers a good basic introduction to hedge funds. Here are a few selected passages from the article:

It’s only a vehicle for investing, albeit one that happens to be less constrained than most. Your run-of-the-mill mutual fund, for example, buys stocks and bonds, and that’s pretty much it. Most are not even allowed to employ short selling, a way of betting that the price of a security will fall. Hedge funds can employ whatever investing tools they want, including leverage, the use of derivatives like options and futures, and short sales. The New York Times decided years ago to incessantly refer to hedge funds’ use of these instruments as “exotic and risky,” thereby adding to their aura of mystery. The funny thing: Practically all financial institutions use these “exotic” instruments.

There’s a much simpler way of putting it, offered by one of the industry’s luminaries. According to Cliff Asness of AQR Capital, “Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years, they deliver a one-in-a-hundred-year flood.”