The use of hedge funds in financial portfolios has grown dramatically since the start of the 21st century. A hedge fund is just a fancy name for an investment partnership that has freer rein to invest aggressively and in a wider variety of financial products than most mutual funds. It's the marriage of a professional fund manager, who is often known as the general partner, and the investors, sometimes known as the limited partners. Together, they pool their money into the fund. This article outlines the basics of this alternative investment vehicle.
Hedge funds are financial partnerships that use pooled funds and employ different strategies to earn active returns for their investors.
The First Hedge Fund
A former writer and sociologist Alfred Winslow Jones’s company, A.W. Jones & Co. launched the world's first hedge fund back in 1949. Jones was inspired to try his hand at managing money while writing an article about investment trends in 1948. He raised $100,000 (including $40,000 out of his own pocket) and tried to minimize the risk in holding long-term stock positions by short selling other stocks.
This investing innovation is now referred to as the classic long/short equities model. Jones also employed leverage to enhance returns. In 1952, he altered the structure of his investment vehicle, converting it from a general partnership to a limited partnership and adding a 20% incentive fee as compensation for the managing partner.
As the first money manager to combine short selling, the use of leverage shared risk through a partnership with other investors and a compensation system based on investment performance, Jones earned his place in investing history as the father of the hedge fund.
Hedge Fund Partnerships
A hedge fund's purpose is to maximize investor returns and eliminate risk. If this structure and objectives sound a lot like those of mutual funds, they are, but that's where the similarities end. Hedge funds are generally considered to be more aggressive, risky, and exclusive than mutual funds. In a hedge fund, limited partners contribute funding for the assets while the general partner manages the according to its strategy.
The very name hedge fund derives from the use of trading techniques that fund managers are permitted to perform. In keeping with the aim of these vehicles to make money, regardless of whether the stock market climbs higher or declines, managers can hedge themselves by going long (if they foresee a market rise) or shorting stocks (if they anticipate a drop). Even though hedging strategies are employed to reduce risk, most consider their practices to carry increased risks.
Aim and Characteristics of Hedge Funds
A common theme among most mutual funds is their market direction neutrality. Because they expect to make money whether the market trends up or down, hedge fund management teams resemble traders more than classic investors. Some mutual funds employ these techniques more than others, and not all mutual funds engage in actual hedging.
There are several key characteristics that set hedge funds apart from other pooled investments—notably, their limited availability to investors.