How Does A Hedge Fund Work

Hedge funds are often mentioned in media. Huge bets by hedge funds are often blamed for big movements in various markets. Hedge fund managers are buying some of the most expensive properties in London, outbidding Russian billionaires and oil sheiks. Hedge funds are often being criticized, especially outside the English speaking world. But how does a hedge fund work? What makes them so special?

Most people think that hedge funds are a relatively recent invention. After all, first time the term hedge fund appeared in mainstream media was when George Soros hedge fund made a fortune by speculating against the British pound in 1992. After that hedge funds have been mentioned much more often in media. But the first hedge fund was created already in 1949 by Alfred Winslow Jones. It is possible to go even further back but Jones is regarded as the inventor of the modern hedge fund.

Jones had a very simple idea, he bought shares which he expected to go up and went short on other shares which he thought would drop in value to the same amount. This, to some extent, protected him against loses. As long as he picked more winners than losers, he would end up with a profit. But this by itself would most likely not give much better results than the average return on the stock market. To increase the profit, Jones use leverage. He borrowed money, which increased the potential for both wins and losses.

Jones turned out to be very good at picking winning shares. But it was first after an article about him and his hedge fund in 1966 that hedge funds become popular. According to the article, Jones had outperformed the best mutual fund by 87% over the last ten years, despite charging a 20% fee on profits. A lot of hedge funds were created after the article, many hedge fund managers were probably attracted by the generous fees they could charge on profits.

Jones had set up his fund as a partnership in order to avoid the strict regulations imposed by SEC. This structure is still popular, the fund managers are general partners while the investors are limited partners.

Nowadays, hedge funds are much more complex creations but the basic principles are the same. They use a lot of leverage and cover the downside by a hedge. Despite that the number of hedge funds has exploded, the generous remuneration for the managers is still around. This has made many successful hedge fund managers super rich.

Jones invested in shares but nowadays hedge funds invest in anything that they believe will make them a profit. While it is possible to put hedge funds into categories, many of them operate in more than one category making such classifications more or less meaningless. It is also possible to divide hedge funds into two broad groups, funds that are trying to generate a steady return regardless of how the markets are going and funds that are trying to get a higher return but also accepting a higher risk of losses. The first group is trying to generate a return that is higher than the return on bonds. The second groups is trying to generate a return that is higher than the return on shares but this can also produce losses.

Hedge funds are often registered in places like the Cayman Islands, giving them not only tax privileges but also allowing them to operate with very little regulations. While many hedge funds are registered in places which impose few restrictions, they are generally operated from the US or the UK. In London, Mayfair rather than the City, has become a centre for hedge funds. In the US, most of them are based in south-west Connecticut, rather than Wall Street.

Many hedge funds have done very well in good times but a lot of hedge funds disappeared during the bear market in the 1970s and after the global financial crisis in 2008. The collapse of the Long-Term Capital Management (LTCM) hedge fund in 1998 proved that hedge funds are not foolproof, despite that they are supposed to be run be some of the most intelligent people in the business.

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