To "hedge", according to Webster's dictionary, is "a means of protection or defense (as against financial loss), or to minimize the risk of a bet." The term "hedge fund" includes a multitude of skill-based investment strategies with a broad range of risk and return objectives. A common element is the use of investment and risk management skills to seek positive returns regardless of market direction.

A hedge fund is a private "pool" of capital for accredited investors only and organized using the limited partnership legal structure. The general partner is usually the money manager and is likely to have a very high percentage of his/her own net worth invested in the fund.

Characteristics of Hedge Funds

The fund has an offering memorandum, which is intended to provide much of the necessary information to support an investor's due diligence. Among several topics, the offering memorandum will specify the trading style, hedging strategies, and instruments to be employed by the fund at the discretion of the general partner (e.g., being long and /or short stock; use of puts, calls, and futures; use of OTC derivatives).

Although some hedge funds don't use leverage at all, most of them do. Leverage in hedge funds often runs from 2:1 to 10:1, depending on the type of assets held and strategies used. High leverage is often part of the trading strategy and is an essential part of some strategies in which the arbitrage return is so small that leverage is needed to amplify the profit. As in any other investments, however, leverage also amplifies losses when the market direction turns out to be unfavorable.

Investor redemptions can also magnify losses for hedge funds.

Hedge Fund Strategies

Hedge funds utilize alternative investment strategies for the purpose of achieving superior returns relative to risk (i.e., return vs. standard deviation). Performance objectives range from conservative to aggressive. The degree of hedging varies. In fact, some do not hedge at all while others simply use S&P put options and futures in lieu of shorting equities. Consequently, there is a broad spectrum of expected risk and return within the hedge fund universe.

Hedge funds can be classified in a variety of ways. They typically have more flexible investment strategies than other options, such as mutual funds and EFTS. Here is one way of classification (by investment strategy):

• Equity hedge strategies take long and short positions in equity and equity derivative securities. For example, the key feature of market neutral funds is the low correlation between their returns and the general market's movements. Other examples include fundamental growth, fundamental value, quantitative directional, short bias and sector specific strategies.

• Event-driven investing is an investing strategy that seeks to exploit pricing inefficiencies that may occur before or after a corporate event, such as a bankruptcy, merger, acquisition or spinoff.

  • Merger arbitrage. Before the effective date of a merger, the stock of the acquired firm typically sells at a discount to its announced acquisition value. A risk arbitrage involves buying stocks of the acquired firm and simultaneously selling the stocks of the acquirer. However, there is the risk that the merger may fall though.

  • Distressed debt investing. The securities of companies having financial problems usually sell at deeply discounted prices. Distressed securities funds take bets on the debt and/or equity securities of such companies. For example, if a fund manager believes such a company will successfully return to profitability, he or she will buy its securities. If the manager believes the company's situation will deteriorate, he or she will take a short position in its securities.

  • Activist. A fund takes large positions in companies and uses the ownership to participate in the management.

  • Special situations, such as corporate spin-offs.

• A relative-value arbitrage strategy seeks to take advantage of price differentials between related financial instruments, such as stocks and bonds, by simultaneously buying and selling the different securities - thereby allowing investors to potentially profit from the "relative value" of the two securities. Examples include fixed income convertible arbitrage, fixed income asset backed, fixed income general, volatility, and multi-strategy.

• Macro funds (Opportunistic Strategies) take bets on the direction of a market, a currency, an interest rate, a commodity, or any macroeconomic variable. For example, George Soros of the Quantum fund took a billion dollar profit from his historical bet against Sterling and the Bank of England in September 1992.

Hedge Fund Investment Forms

Most hedge funds are set up as limited partnerships, with the portfolio manager acting as a general partner (GP) and the institutional investors acting as limited partners (LPs). This is the direct form of hedge fund setup. For smaller and retail investors, indirect forms, such as funds of funds, help obtain a hedge fund exposure.

The legal and contractual relationship between the GPs and LPs is governed by the fund offering documents. In addition, a manager could draft a "side letter" applicable to some investors only, with different legal, regulatory, tax, operational, or reporting requirements.