As the name of this financial terminology implies, these particular financial instruments or funds are available to investors for the purposes of hedging against the risk and potential losses that can occur from other riskier investments. These use a variety of techniques including other financial derivatives and the practice of short-selling what you have invested in prior. They typically involve a broader range of investment or share-trading activities over and above what other long-term investment instruments provide you with.
Ironically, hedge funds can be utilized can be employed to increase the risk factor. In other words, they do not help to hedge the investments, especially where hedging methods such as short-selling are concerned. Instead, they increase the risk factors involved in order to increase the potential of a better ROI (return on investment). These use other hedging methods such as short-selling to increase the risk to hopefully encounter a positive gain on their investment.
Typically, hedge funds are only available to those professional and wealthy individuals that meet certain regulation criteria. However, in exchange for this, they are exempt from ordinary investment funds regulations. These regulations usually include fee structures, leverage, liquidity of fund interests, short sale restrictions and the use of derivatives.
Additionally, lighter regulations and fees based on the performance of the fund are two characteristics that distinguish hedge funds from other investment funds. Where the net asset value of a hedge fund is concerned, it can run billions of dollars whereas the gross asset value can go even higher when leverage is employed. Certain specialty markets are dominated by hedge funds. An example of one of these is the trading within derivatives that have distressed debt and high-yield ratings.
In 1949, Alfred W. Jones (author, financial journalist, and sociologist) created the first recognized hedge fund. Jones was a firm believer of the concept that price movements of a particular asset or fund was determined by two key components. One component was the overall market while the second component was the asset’s actual performance record.
In order to balance his portfolio, his basic philosophy for neutralizing the effects of the market’s overall movement included two key points. 1. Purchase only those assets that are expected to have a stronger performance than the overall market and 2. Short sale all those assets that are expected to show weaker than market performance levels
Utilizing this philosophy, Jones witnessed the fact that the effect of the overall price market’s movements were canceled out. If the market rose overall, the shorted asset losses would be canceled by virtue of the gain encountered with the assets that were purchased and vice-versa. The purpose is to hedge that part of the investment associated with the overall market’s movements.
Finally, due to the lack of statistical information, it is difficult to estimate how large the hedge fund industry is. Additionally, a single definition of what a hedge fund is and how rapidly the industry has grown make accumulating any statistics very difficult as well. It is estimated that when hedge fund values peaked during the summer of 2008, that they were worth in excess of $2.5 trillion.