Friday, April 04, 2008

Hedge Funds

Someone asked me to explain a hedge fund. Here is an explanation from Wikipedia, accessed through Google.

A hedge fund is a private investment fund that charges a performance fee and is typically open to only a limited range of qualified investors.

Hedge fund activity in the public securities markets has grown substantially as it constitutes approximately 30% of all U.S. fixed-income security transactions, 55% of U.S. activity in derivatives with investment-grade ratings, 55% of the trading volume for emerging-market bonds, as well as 30% of equity trades.

Hedge Funds dominate certain specialty markets such as trading in derivatives with high-yield ratings, and distressed debt.

Alfred Winslow Jones is credited with inventing hedge funds in 1949.

In the United States, in order for an investment fund to be exempt from direct regulation, it must be open to accredited investors only and only a limited number of investors can belong to it.

While there is no legal definition of "hedge fund" under U.S. securities laws and regulations, typically they include any investment fund that, because of an exemption from the types of regulation that otherwise apply to mutual funds, brokerage firms or investment advisors, can invest in more complex and riskier investments than a public fund might.

Hedge funds managed from other countries have similar relationships with their national regulators. As a hedge fund's investment activities are therefore limited only by the contracts governing the particular fund, it can make greater use of complex investment strategies such as short selling, entering into futures, swaps and other derivative contracts and leverage.

As their name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging their investments using a variety of methods, most notably short selling.

However, the term "hedge fund" has come in modern parlance to be applied to many funds that do not actually hedge their investments, and in particular to funds using short selling and other "hedging" methods to increase risk, and therefore return, rather than reduce it.

Hedge funds have acquired a reputation for secrecy. Being outside the regulatory regime that applies to retail funds greatly reduces the information a hedge fund is legally required to make public. Additionally, divulging trading methods and positions would compromise the business interests of many types of hedge fund, tending to limit the information they want to release.

The assets under management of a hedge fund can run into many billions of dollars, and this will usually be multiplied by leverage. Their sway over markets, whether they succeed or fail, is therefore potentially substantial and there is a continuing debate over whether they should be more thoroughly regulated.

A big risk in hedge fund is that its investment is "multipled by leverage". They borrowed additional funds at the market rate of interest to increase their investments. During the market downturn, the borrowers refused to refinance the short term loans. This caused the liquidity crisis.

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