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Alternative Investments: Hedge Funds

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Hedge Funds pool the capital of a small number of high net worth individuals or institutions under the direction of a single manager or small team. One of the reasons to domicile offshore is to be free to use trading strategies which traditional, domestically regulated retail fund are not allowed to do. A key technique is to use short as well as long positions. This can provide protection against a falling market, hence the description 'hedge' fund.

The original hedge funds used a mix of long and short positions to create a lower portfolio risk profile than their peers who were totally exposed to losses if the market fell. But the name 'hedge fund' became adopted by any fund which went offshore and used short positions - and many of these were far from conservative in investment style.

But all hedge funds have one thing in common. They don't buy assets for an income-stream. They look to make investment returns purely from capital gain. In fact, they're not really interested in investing long-term at all. They are all trading portfolios. And they all engage in some sort of borrowing.

Original hedge funds sold short (sold what they didn't own) by borrowing shares to sell from brokers. They would then buy the shares back later, hopefully at a lower price to return to the broker.

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Alternatively, cash can be borrowed to buy assets. This is called leverage. It increases the fund's potential returns, but also increases its risk profile. This a long way from using some short positions to 'hedge your bets.'

Short positions and leverage can also be achieved in different ways by using futures and options contracts. These derivative products and markets also give hedge funds a wide range of additional trading opportunites. Many of these funds have far more in common with an international bank's dealing operations than with traditional fund management.

So a hedge fund can mean anything from a risk reducing equity portfolio to a highly leveraged, speculative fund. This section runs you through the range of contemporary investment styles which can call themselves 'hedge funds.'

       



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