We’ve all heard the term “hedge fund”.

But what exactly does it mean?

We’ve asked the experts. Now we try and explain.

Let’s place ourselves at a notional Mayfair cocktail party, shall we?

And this being Mayfair, the crowd is peppered by financial types.

One of them drops into the conversation: “I’m at a hedge fund.”

What do you do? If you’re like many people, you freeze and then quickly change the conversation.

Let’s face it, many of us are too afraid to ask what a hedge fund is.

So let’s start at the beginning.

Obviously there are rules around how experts can invest your money.

There are strictures on where and how money can be invested.

The law seeks to protect investors from catastrophic financial loss.

But remember, this being the markets, you can always lose your money when you make an investment.


If you understand the markets – or just one market – then you may bristle at these rules.

Investing for yourself you can do what you want, mostly.

But, the law comes into play when handling other people’s money.

 

Enter the hedge fund…

 

Hedge funds get around some of the investing rules that apply to more established investment firms.

They declare their often aggressive, often singular investment aggressive strategies.

This is opposed to a strategy that is wide-ranging or composed of a collection of different strategies for placing money and reducing risk.

Then, they execute on that specific investment strategy by pooling funds from investors who are already financial savvy themselves and have deep pockets. (Well, typically, anyway.)

It’s a broad term, and it’s meant to distinguish those investment managers who have an investment idea that they can realise only without the rules faced by the standard financial types who operate at established firms.

Hedge fund managers can invest in anything.

This includes failing securities whereby they can reap the downside. Traditional investment houses are largely restricted to stock and bonds whose fortunes are likely to improve.


Importantly, the word “hedge” in hedge fund is often a misnomer.

When you buy a stock, you’re taking a bet that its price will go up. To hedge is to take a bet that doesn’t align with your original holding.

Say your first stock was in a construction company.

Construction companies are cyclical, which is to say they do well when the broader economy does well.

If you see a recession coming, your guess that the construction company share price will drop is reasonable.

But instead of selling it, you buy a share of a brewing and drinks company. When the economy is bad, people don’t drink less.

Indeed alcohol stocks are frequently countercyclical.

So, the drop in your construction company share will be offset somewhat by the rise in your brewing and drinks company share.

That’s a hedge.

 

But, confusingly, many hedge funds don’t “hedge” at all.

 

The managers formulate a risky strategy of buying and/or selling securities. They time those purchases and sales to reap the rewards for savvy clients.

Still confused?

Just nod politely at that hedge fund manager at the cocktail party. Then get another drink in.

 

Read the full story by Robin Black in the Mayfair Times here.