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
You and I as individual investors can trade a company’s stock, bonds, commodities etc. on a public market.
Then there are investment companies which offer pooled funds, where we can put in money and they will bundle it together and trade common securities (stocks, bonds etc.) for us, hopefully getting positive returns while saving us from having to do the work ourselves. There are different types of such funds, mutual funds being the most common – either actively managed by an investment manager or tracking some index like the S&P 500. The basic idea is to buy hundreds or thousands or more securities together to not be affected by fluctuations in a single one.
Hedge funds take things up a notch. They are specialized and exclusive versions of mutual funds open only to institutional investors or very high net worth individuals. They are also far less regulated than publicly accessible funds. Hedge fund managers use very aggressive investment techniques and invest in a wider array of products than just stocks or bonds – like options and other derivatives, real estate, currencies, art, precious metals or really anything else that can be bought and sold. They often use large amounts of borrowed money (aka leverage) and so are generally exposed to a lot more risk than normal funds. They also frequently take short positions (bet that a stock will go down instead of up) in order to “hedge” against market downturns or take advantage of failing companies.
Worth noting though that while the name “hedge fund” originated in the 50s and 60s because such funds would optimize their investments to reduce risk, today’s hedge funds are mostly the opposite. It’s more and more just a generic label used by private funds with varying (and sometimes opposite) goals and investment strategies.
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You should think of hedge funds in investing terms similar to the difference between a basic car like a Honda Accord versus say a Ferrari. Most regular individuals will invest in stocks or index funds, or mutual funds, just like most people will have a regular car. These will only go ‘long’ positions (which just means they tend to only buy stock in companies they like and hope they go up for a profit). Hedge Funds are the Ferraris of the investment world, they are private and generally only accessible to the wealthy. They can use a host of different complicated financial instruments to invest money. The most basic example is shorting, basically betting against a company. How does shorting work?
Example: John shorting company A
Let’s say you own 1 share of company A and John believes its stock price will go down. John will borrow that share from you and promise to return it at a specified date (let’s call it a month from now.) So he borrows your share, sells it on the open market for its fair price, call it $100, believing it will go down. Let’s say in two weeks the price goes down to $50. John can repurchase the share for $50 dollars, give you back the share worth $50 and profit $50 off of the decline of the stock price. Bear in mind this is an extremely risky strategy, because the maximum profit to be made off shorting company A would be $100 a share (because the stock can only go down to 0), but theoretically, the price can go up to anything, $1,000, $10,000, etc. In the event company A’s share price went to $1,000 by the end of the month, John would have to purchase the stock for $1,000, losing $900. Extremely risky.
These sorts of more complicated financial instruments are why hedge funds are only accessible to the wealthy. The US has drafted laws that are supposedly meant to ‘protect’ lower income and less knowledgeable investors (apparently concluded from how rich you are) by only allowing those with a certain net worth to invest in these types of complicated strategies. This is also why they charge substantially higher fees than regular investment managers (think 2% of assets managed and 20% of profits, compared to roughly 0.5-1% for a regular actively managed investment fund).
Now, being that hedge funds are the Ferraris of the investment world, they should have all of the bells and whistles that a Honda does not. Sure, both are trying to make your money go up, just like cars get you from point A to point B, but hedge funds should ensure a smoother ride and only be staffed with the best talent. In reality, this isn’t necessarily the case, but that is a whole other discussion.
In short: Hedge Funds are Ferraris, while regular investment funds are Hondas. Ferrari is shiny, loud, fast, and seems amazing compared to a boring Honda, that is, until you realize new tires will cost you 5 grand, you can’t fit your groceries in the trunk, and it costs an arm and leg to maintain. Honda actually seems like a cheaper, better way to get around that will more easily fit your needs.
Not sure how well I explained it but I’ve worked in industry so feel free to ask any questions, happy to help answer them more thoroughly or explain it differently so it makes sense!
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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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.
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”).
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.
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.
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