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The use of the term "hedge" was originally coined by the agriculture industry
in the United States. Farmers hedged by selling crops or cattle yet to be harvested
at a specific price for future delivery. They hedged their market exposure for the
period of time it took them to harvest and deliver their product.
The early hedge funds pursued similar strategies by short-selling stocks to eliminate
market exposure created by being long (buy) stock positions. Hedge funds have traditionally
been shrouded in mystery. Their funds and their managers remain largely an enigma
to many. They are largely thought of as a monstrous group of megalomaniac speculators
intent on causing ripples in the global financial markets.
The growth of hedge funds has been stunning. The industry is estimated to be a US$200-US$300
billion industry and growing at about 20% on an annual basis. Currently there are
an estimated 4,000 to 5,000 active hedge funds around the world. Their returns over
a sustained period of time have largely outperformed standard equity and bond indexes
and mutual funds.
What are actually hedge funds? Simply, a hedge fund is a fund that can take both
long and short positions, invests in almost anything where it foresees attractive
returns at minimized risk - employ various strategies such as arbitrage, trade options
or bonds, buying/selling distressed securities, etc. It is also commonly used to
refer to any private investment limited partnership that invests in a variety of
securities.
Hedge funds often hedge against market downturns, which is particularly important
in today's volatile investment climate, where market swings can exceed 10% in a single
day. Hedge funds, unlike most conventional funds, are extremely flexible in their
investment strategies, from the basic buy and hold to currency arbitrage.
Due to this flexibility, the performance of hedge funds is not dependent of the direction
of the bond and equity markets unlike conventional investment funds, which are generally
100% exposed to risk in that particular market.
The flexibility in the portfolio management gives hedge funds the room to best manage
investment risks - not only to be defensive but to be responsive and opportunistic
in its investments. Hedge fund managers are interested in absolute rates of return
and unlike traditional money managers, they are not bound to the game of beating
relative benchmarks.
Hedge fund managers are generally highly professional. They have to be disciplined
and diligent as they depend heavily on remuneration from performance incentives -
an incentive fee remunerates the manager only when returns are positive. This incentive
fee structure tends to attract the "best brains" to the hedge fund industry.
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