A hedge fund is a small pool of capital that a money manager uses to buy stocks, sell stocks, or perform other activities that a more traditional firm with a larger amount of assets—say, a mutual fund—would not be able to. Hedge funds have been around since 1949, when Alfred Winslow Jones, a financial journalist, started a fund whose investment approach involved “hedging” long stock positions by selling short other stocks to protect against market risk. (Selling short means selling a stock which the seller does not own and believes the price will continue to decline; he or she may borrow the stock from a broker and sell it, then buy it back at a lower price. One buys long with the expectation that the stock will rise in value.) Unlike mutual funds and other investment firms, hedge funds are essentially unregulated by the government, and because of their relatively small amounts of capital, managers can move funds more quickly in and out of certain areas, with (usually) less effect on the market. They can also pursue a market-neutral strategy—identifying cheap stocks that may be on their way upward or stocks whose growth is stalling and declining, and investing equally in both.

Using such a strategy, a hedge-fund manager could start 10 funds, half of which would go long, the other half going short. The market would determine which position would make money in a given year, and at the end of that year, the five funds that lost money would likely be closed. In the meantime, a “lot of money [would get] transferred from investor to manager,” points out Dr. Marshall Blume, the Howard Butcher III Professor of Financial Management and professor of finance, in Knowledge@Wharton, the bi-weekly electronic newsletter. “There’s a lot of incentive to do that.” Furthermore, by closing funds that perform poorly, those managers help create hedge-fund indexes that suggest overly robust returns, notes Knowledge@Wharton, “like figuring a class’s performance by ignoring the fact that half the students dropped out.”

Hedge funds also have extremely high barriers to entry, welcoming only the most sophisticated—and well-heeled—investor. A net worth of $1 million or an annual income of $200,000 for an individual (or $300,000 with a spouse) is generally the minimum, and most investors are worth far more than that. Additionally, hedge funds consist of a small pool of investors, usually less than a hundred, and their advertising is done through word of mouth or reputation.

The only things that hedge funds have in common are their legal structure for investing, and the lucrative fees they charge their clients. Unlike mutual funds, which can only collect management fees based on the size of the assets regardless of how well the fund performs, hedge funds charge asset fees and performance fees. While hedge funds generally keep asset fees low, at about two percent, they set performance fees as high as 20 percent (a fee structure known as “two and 20”).

Transparency is not part of the hedge-fund picture. Whereas mutual funds must publish holdings reports that show full disclosure of their funds every six months, hedge funds have no such requirements. Only their investors who are accredited and meet minimum standards know how well a hedge fund is performing.

This past June, a year and a half after the Securities and Exchange Commission (SEC) ruled that hedge-fund advisors must report a few basic details (the name of their funds, their location, and the assets they manage) and open their books to routine inspection, a federal appeals court overturned the rule. The court’s decision “abruptly halts, for now, the SEC’s attempt to regulate the murky world of hedge funds,” The Wall Street Journal noted. But, it added: “Observers say it’s unlikely the SEC would close the door completely on some form of hedge-fund regulation, given the growing size of the industry and the use of such funds by less sophisticated investors, such as pension funds.”

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©2006 The Pennsylvania Gazette
Last modified 08/31/06

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FEATURE: Betting Their Hedges
By Aaron Short

Sept|Oct 06 Contents
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