Is this a fair description of a hedge fund?

I asked one of my friends what a hedge fund was, and he said that a hedge fund “is basically a mutual fund that somehow manages to beat the market for some sort of reason.”

I asked another friend about hedge funds, and he explained “a mutual fund is based around a theme, whereas a hedge fund is based around the ideal of a few supposedly really smart guys who make idiosyncratically brilliant decisions that bring in tons of money.”

I know these aren’t literally accurate descriptions of what a hedge fund is, but are they basically fair in their sassiness?

Here’s what the SEC has to say on the matter.

Hedge funds are not mutual funds

The purpose of a hedge fund is to hedge the bet someone made in the market. For example, I have a lot of money invested in airlines. I am worried that if the price of gas goes up, my stock will go down.

Therefore, I buy a hedge fund in say gas futures. If the price of gas goes up and my airline stocks go down, my gas futures will help offset my loss in the airline stock.

Because hedge funds were special purpose funds, and they were only for the very wealthy investors, they were not regulated by the Securities and Exchange Commission. The thinking was that wealthy investors know the market better than the average investor, and didn’t need the protection of the SEC. Because these funds are very narrow in scope and very complex to setup, making these funds prepare a detailed prospectus could be impossible.

Besides, the amount of money in these funds is quite small. It’s not like the very rich will play all sorts of games with them and bring the entire national economy to a screeching halt!

Well, because they weren’t regulated, they could play all sorts of games that other funds couldn’t play. Because they were small, they could usually make more money than the more tightly regulated funds.

In the end of the 20th century, investors started getting interested in using hedge funds as a main investment vehicle instead of as a strictly insurance fund to protect against losses in other investments. More money poured into these funds, and fund managers started taking riskier and riskier bets to keep up the large returns that many investors expected.

Funny thing: It turns out that people with money are just as stupid as people without money. But as the old saying goes: If you owe a bank a hundred thousand dollars and cannot pay, you’re in trouble. If you owe a bank a hundred billion dollars and cannot pay, the bank is in trouble.

As qazwart notes, in the last several years, so-called hedge funds largely stopped working as hedges, and started going for big, big returns by engaging in extremely risky investing. Namely, by using high leverage and selling short.

There’s another thread on leverage right now, but it’s basically investing with borrowed money. It’s an economically smart thing to do because it increases your profit on the same investment – if buying WidgetCo at $100 is going to get you $5 in profit next month, why not borrow $200 more and triple your profit, minus a small interest payment? But it also means that you multiply losses too – and so if you aren’t properly hedged, a downturn in your investments is more and more devastating the more leveraged you are.

Selling short is betting a security in which you invest is going to go down instead of the regular method of betting it’s going to go up. Selling short is also a big risk, big gain strategy. If you buy a stock at $10 the absolute most you can lose is $10. But if you do a short sale on a stock at $10 and it goes up to $100, you’ve lost $90 – your losses are theoretically uncapped. Moreover, because the market is always willing to believe bad news, it can be a successful strategy to start a whispering campaign against a company you’ve sold short to ensure their stock will drop and you’ll make a bundle. There were allegations that this is what really happened to Lehman Bros., although I don’t know how credible they were. That’s financially successful, but it’s bad for GDP and the employment rate to give investors a reason to bankrupt the companies on which they trade.


Another thing with hedge funds is that if they lose money, they generally go under.

The initial idea of hedge funds was essentially to harvest gains from a market neutral portfolio, hence the hedge aspect. You would take long positions in some securities and short positions in others in order to eliminate the general movement of the market. The securities in the portfolio hedged each other, they did not hedge investments outside of the investment portfolio.

Hedge funds have grown far beyond that to the point that my definition of a hedge fund is simply an unregulated investment fund that utilizes high leverage in a variety of strategies to produce returns that would not be possible in a long only strategy. Some have a theme, such fixed income arbitrage or energy trading. Some are more broad in their approach.

Do you have to be unquestionably brilliant to run a hedge fund? Not really. You have to be able to convince your investors that you are unquestionably brilliant. Certainly many funds have invested heavily in math and tech whizzes. A lot of the guys have mathematics or engineering backgrounds. Asset selection in a lot of funds revolves around extremely complex models that utilize statistics and lots of other crap that I don’t pretend to understand. So you probably have to be smarter than the average guy on the street (or at least smarter than me) to be able to design the models and understand the output. That stuff tends to really impress the rest of us saps who have trouble using a pocket calculator.

Over and above being smart, the funds have to be able to exploit the smartness. If there is some sort of a market inefficiency out there, they have to jump on the opportunity and jump on it with boatloads of borrowed money.

Where these managers tend to go wrong is when they have a model that tells them that “statistically speaking” some outcome is so unlikely to occur that its safe to bet the farm against that outcome. What we learn is that highly improbable outcomes are far more probable than the models told us they were. Imagine betting on a horse race where there are two horses. One has won every race in its career. Horse two is 15 years old and only has three legs. The odds on horse one are 1/100, you win $1 for every $100 you bet. So the brilliant thing to do is to go borrow $1 million and bet on horse one. Its a virtually risk free proposition where you are walking away with $10,000 profit, right? So when the race starts, horse one immediately suffers a massive stroke and dies. Horse two crawls across the finish line. That’s kind of what happens when these hedge funds blow up.

So all that having been said, your second friend is closer in the description. In a perfect world, these outrageously brilliant people are identifying opportunities that 99.99% of the market cannot. I would just add that they generally use lots of borrowed money to do it. In the real world, some of these people are pretty smart, some are just plain old bullshit artists.

Long Term Capital Management was founded in 1994 and was bailed out in 1998, so depending on your definition of ‘several’, it’s not fair to say it’s been a phenomenon over several years. It’s not like LTCM was the only heavily leveraged shop at the time, either.

Also as **Neptunian Slug **said, hedge funds have moved so far from the hedging suggested by their name that it’s no longer meaningful in discussing them. The fact that they’re not required to register with the SEC and are exempt from many regulations is their distinctive trait.