A Definition of Hedge Funds

Hedge funds work very much like mutual funds. This is because hedge funds collect funds of various investors and put the money in instruments in order to make a positive return. Hedge funds generally have more flexible investment strategies than mutual funds. Many hedge funds explore the possibilities of earning a good return in all kinds of markets by using leverage. Using leverage means to increase investment exposure as well as risk. Short-selling and other speculative investment practices are also undertaken by hedge funds that are not often used by mutual funds.

Another difference between a mutual fund and a hedge fund is that hedge funds are not subject to certain of the regulations that mutual funds have to follow that pertain to protecting investor interests. Some hedge fund managers are not required to register with the country’s securities exchange authority such as the Securities and Exchange Commission (US) depending on the amount of assets in the hedge funds advised by a manager. Similar to mutual funds, the same prohibitions against fraud are applicable to hedge funds along with a fiduciary duty given to the manager for the funds that they manage.

Taking short positions are intrinsic to the strategies of hedging and this feature is unique only to hedge funds.

A hedge fund can be defined as an actively managed, pooled investment vehicle that is open to only a limited group of investors and whose performance is measured in absolute return units. There is no simple and all-encompassing definition. The European Central bank states that there is no common definition of what constitutes a hedge fund; it can be described as an unregulated fund which can freely use various active investment strategies to achieve positive absolute returns.

A hedge fund is difficult to define fairly because of a lack of clarity of agreement on its term and also due to its diverse trading scale. They are typically characterised by high leveraging, derivatives trading and short selling compared to mutual funds. They are funded by capital from investors, rather than bank loans or other sources of capital. They invest in publicly traded securities like equities and bonds. The capital is managed or invested by expert fund managers.

Like mutual funds, hedge funds pool investors’ money and invest the money in an effort to make a positive return. Hedge funds typically have more flexible investment strategies than mutual funds. Many hedge funds seek to profit in all kinds of markets by using leverage (in other words, borrowing to increase investment exposure as well as risk), short-selling and other speculative investment practices that are not often used by mutual funds.

One way of defining a hedge fund is by comparing the similarities and differences with mutual funds.

The key difference between hedge funds and mutual funds lies in the degree of regulation, the level and variety of risky investment strategies. Whereas mutual funds are required to adhere to strict financial regulations, including the types and levels of risks, hedge funds are free to pursue virtually any investment strategy with any level of risk.
Hedge fund investors are typically high net worth individuals or institutional investors like pension funds, partly because hedge funds typically require high minimum investment amounts. Mutual funds on the other hand, are typically targeted at the general public and will accept any investor who can meet the minimum investment amount. Hedge funds are banned from advertising and in some cases the investors are required to be “accredited”.
Another difference is the fund portfolio composition. Most mutual funds are composed of equities and bonds. Hedge fund portfolio compositions are far more varied, with possibly a significant weighting in non-equity/bond assets e.g. derivatives.
The historical return characteristics and distribution of hedge funds tend to differ significantly from mutual funds. For example, Capocci et al. and Getmansky demonstrate that hedge funds empirically display serial correlation in returns. Hedge funds do not perform significantly better than most investment funds.

Unlike mutual funds, hedge funds are not subject to some of the regulations that are designed to protect investors. Depending on the amount of assets in the hedge funds advised by a manager, some hedge fund managers may not be required to register or to file public reports with the SEC. Hedge funds, however, are subject to the same prohibitions against fraud as are other market participants, and their managers owe a fiduciary duty to the funds that they manage.

The nomenclature “hedge fund” provides insight into its original definition. To “hedge” is to lower overall risk by taking on an asset position that offsets an existing source of risk. For instance, if an investor is holding a large position in foreign equities, he/she can hedge the portfolio’s currency risk by going short currency futures. A trader with a large inventory position in an individual stock can hedge the market component of the stock’s risk by going short equity index futures. Hedge fund may be seen as an information motivated fund that hedges most sources of risk not related to the price-relevant information available for speculation.

Speculation is any action, with some non-zero risk, made in order to make a profit. This classic definition of speculation also includes the careful research of undervalued securities for long-term gain i.e. investing. In informal contexts, the word speculation has acquired the implicit meaning of actions based on inconclusive evidence and the desire for short-term, high-risk profit.

Theoretically, a hedge fund can be characterized as the “purely active” component of a traditional actively-managed portfolio whose performance is measured against a market benchmark. Consider the following equation.

h = w – b

Where,

w = the portfolio weights of the traditional actively-managed equity portfolio

b = the market benchmark weights for the passive index used to gauge the performance of a fund

h= the active weights. That is, the differences between the portfolio weights and the benchmark weights

A traditional fund has no short positions, hence w has all positive (not negative) weights; most market benchmarks also have all positive weights. Therefore, w and b are positive in all components except the h, has an equal percentage of short positions as long positions. Theoretically, one can take portfolio h as a hedge fund implied by the traditional active portfolio w.

The following two strategies are equivalent.

Hold the traditional actively-managed portfolio w
Hold the passive index b plus invest in the hedge fund h.

Defined in this way, hedge funds are a device to separate the “purely active” investment portfolio h from the “purely passive” portfolio b. The traditional active portfolio w combines the two components.

The above theoretical hedge fund is not implement able in reality as short positions require margin cash. The hedge fund above has zero net investment and for that reason there is no cash available for margin accounts. If the benchmark includes a positive cash weight, this can be redirected to the hedge fund. Then the hedge fund will have a positive overall weight, consisting of a net-zero investment (long and short) in equities, plus a positive position in cash to cover margin.

The operational composition of hedge funds has steadily evolved until it is now difficult to define a hedge fund based upon investment strategies alone. Hedge funds now vary widely in investing strategies, size, and other characteristics.