I’ve been trying to follow the Wall Street bets situations, but I can’t find a simple definition of hedge funds. Help?
In: Economics
**There is no such thing as a “hedge fund”**
These firms should be called by their proper name: **Speculative Funds**. They make high risk (and often highly leveraged) gambles in the securities markets, using hedging tools and techniques that were originally meant to mitigate risks (such as shorts, options, futures, and other derivative securities).
They are much less regulated than traditional investment banks (JP Morgan, etc) and as such operate under the radar. They also appeal to high net worth individuals.
A famous Speculative Fund, Long Term Capital Management, nearly caused a systemic collapse years ago. It was run by some of the most brilliant Financiers and Economists to ever live, which stands to this day as a testament that even the geniuses cannot predict everything.
And that is what we are seeing with GME these days. A large number of Speculators gambled with very wealthy people’s money and underestimated the number of people who also knew how to play their games. And more importantly play those games against THEM.
And they are pissed, because peasants are not supposed to beat them at their own games.
Actual ELI5:
A normal fund invests in stocks and bonds. Basically you invest in cash-generating machines, which makes a lot of sense long-term. But nothing else is allowed.
A hedge fund may invest in anything, usually derivatives but can really be anything. This is **more like taking bets**. So they take a bet with someone else on the market. “We think this cash-generating machine will generate _less_ money next year” and someone is on the other side of the bet. This is much more risky, includes different regulation, may go in the opposite direction of the market (hedge) and is not long-term in itself since it needs new bets continuously.
Everyone here’s taking way too long to explain it.
Wall Street bigwigs like to short stocks. This means borrowing a bunch of them and selling them off, but you agree to buy them back at a certain point in time.
When you do this, you want the stock to tank in value, so that when you buy them back, you pay much less, leaving you with a large profit. Wall Street hedge funds, which are the bigwig’s mutual exchange fund, tried to short GameStop stocks. r/wallstreetbets retorted; they’re a group of small time investors and circlejerkers who artificially inflated the moribund company’s value by purchasing shares en masse. They essentially turned GameStop into a Fortune 500 company overnight, and the Wall Street bigwigs actually took a loss for once.
Imagine you ask your mom to borrow her watch for a week. Now you tell your little sister that the watch is worth a lot of money, and she pays you a lot of money for it. A week later, you come back to your sister and tell her the price for a watch isn’t so high anymore, and ask if you could buy the watch back for a low price. Now you give the watch back to your mom, after making money off of it without really doing anything.
That’s what hedge funds do, except on a bigger scale and with stocks instead of watches. They borrow the stocks, sell them when they’re expensive, buy them back when they’re cheap, and make millions.
What hasn’t been mentioned is that the general public is not allowed to invest in hedge funds unless you have something like a million liquid lying around. Hedge funds exist solely to richen the rich without any public benefit.
No one has really covered the whole point of a hedge fund here.
Sure, the idea is that you pick instruments (stocks, futures, options, commodities, etc.) that you expect to go up, and go long on those, and you pick things you think will go down, and go short on those. And then you do the part that actually makes you a hedge fund: Try to work out the correlations across the rest of the market to those stocks you have picked, and go long/short in the opposite direction, so that you are market neutral.
Simple example: You think BP will do better than Shell, and you think BP & Shell are generally pretty closely correlated in the market. So you go long BP and short Shell.
If you’re right, then if the whole market goes up you make money, because although you will lose money on your short position, you more than cover that with your long given BP will go up more than Shell will.
But the point of the hedge is that if the whole market goes *down*, you *still* make money, provided you were right in your analysis of BP outperforming Shell, because BP goes down less than Shell does.
You have thus hedged out your “market risk” (otherwise known as “beta”) and locked in your market-neutral independent profits due to your stock picks (otherwise known as “alpha”).
The simplest explanation:
Imagine you have a candy market in town. You can buy a piece of candy from each stall, and as their supply decreases, your piece of candy increases in value as there are fewer of them.
Normally you can only buy the “normal” candy, and only a little bit as you don’t have a ton of money by yourself. But what if you and your friends went together to gather all your money and buy candy from each stall? Suddenly much more candy, and if one stall does poorly, it wont be a big problem as you have candy from other stalls.
Now say you wanted to buy the special candy. The stuff not found in stalls. You would have to go together with your friends, get a bunch of money and call yourself something, so other people recognize you. One day, however, you realize: “there are other things than candy. What if we bought things like race cars, dinosaur fossils and shoes, held onto them and sold them when they became worth more?” So you do. You borrow money or get it from wherever you can, and risk it all on something you believe is a good idea. You’ve now become a Hedge Fund. Here comes the tricky part: People now recognize you. They know what you do, and that you do it well, so they want in, so you make a demand: “you have to make this much money available so we can buy dinosaur bones, candy and anything else, and we’ll share the profit with you if we make any”.
Suddenly, you’re an exclusive group, which means you can be tricky. People trust you when you say Twirly candy will soon be sold out. They trust you when you say Candy canes are not worth the price they cost. So you do the tricky: You bet with the other people that buy candy that Candy canes are going to drop massively in price, then immediately afterwards you go out and say “Candy canes are not worth as much as they are being sold for.”
Suddenly Candy canes are being sold en masse. Their value drops a ton, which is normally a bad thing, but since you’ve bet that they would drop in value, you are now making money.
This was possible because you:
A: Pooled your funds with other people.
B: Don’t have the same regulations and oversight as other collective investors, as you trade practically anything, so you are free to bet a ton of candy is going to go down (commonly called “shorting”).
C: Are considered an authority.
Just to go further: This is what happened with Gamestop. A Hedgefund (collection of people) shorted Gamestop believing it would do terrible. Since they are kind of dicks with much too much money – oversimplification – another subreddit – Wallstreetbets – decided to buy a ton of Gamestop candy, so their value went up. This made the Hedgefund lose all their money, as they bet a ton on Gamestop doing poorly, and lost that bet.
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It is a private pool of funds from accredited investors that can be invested however the managers see fit, as long as they can raise the money. They are loosely regulated because of accredited investor rules. Basically, the wealthy investors must (should) know what they are getting into.
Hedge fund managers can be aggressive, conservative. Basically whatever they want to do that is ‘legal’.
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