What are 'Hedge Funds'

Hedge Funds have matured from an almost mystical investment vehicle that takes care of the very wealthy's portfolios taking huge risks and returning huge profits. These days we all know about the managers making billions and every other fund seems to be called a 'hedge fund'. What is the reality and what really is a hedge fund?

Alfred Winslow Jones was cooking something up. After graduating from Harvard in 1923, Jones toured the world working as a purser on tramp steamers, served as a U.S. diplomat in Germany during the rise of Nazism in the 1930's and as a journalist covering the Spanish Civil War. In 1941, he received his Doctorate in Sociology from Columbia University and became a reporter for Fortune Magazine.

He was interested in the markets and started researching an article on current fashions and market forecasts for investing. It was 1948 and, after his reserach, Jones came to the conclusion that he had a better system for managing money. In 1949, he raised $100,000 ($40,000 of which was his own money) and began putting his theories to practice in a general investment partnership. In modern terms this was about $800,000 (according to this neat calculator).

His basic theory was that he looked at those companies whose share price rose faster than the average when the markets were up, invested in them and 'hedged' these with short sales on shares the fell faster than the average when markets were falling. In theory whther the market was up or down the fund would make money. He also borrowed to invest creating a leveraged fund. Thus the term 'Hedge Fund' was born. In actual fact Jones called his a 'hedged fund'.

His strategy turned out to be a success out performing the best five year mutual fund by 85%. The hedge fund was born and so, was the fee structure, Jones charged investors 20% of the gains.

Of course hedge funds started to crop up, but the strategy of Jones's was 'adjusted' by many who ran such funds. It takes discipline to run a truly hedged portfolio when markets are good, because, obviously, you are losing on your shorts while your longs are making money, many didn't bother with the 'hedged' part. This changes the risk profile of the fund dramatically.

Modern complex hedge funds, although inspired by Jones's original theory, bare little resemblance to the simplicity of Jones' original. Derivative products such as futures and options etc changed the face of investing forever and with the advent of wide spread computer systems the hedge fund industry introduced ever more complex trading patterns that could only be handled by computer. These 'quant' or 'algorithmic' systems use complex mathematical computations to trade programmed transactions across a wide variety of instruments and sectors.

For example is there a correlation between the gold price and the dollar rate? Could there be a trade computed for both? Long one short the other for example. By crunching numbers you could see the statistical correlation between the price of gold and silver over a period of time and create an 'algorithm' to spot trading opportunities in this market place. The trades for a system like this are endless and you can be sure that there are maths geeks sat with traders everywhere in the City and on Wall Street working out the latest wheeze.

Of the 9500 funds supposedly out there however, many are traditional 'long' funds that really are not a true hedged situation. The idea of hedging is that whether the markets are up or down the fund has an opposite trade to offset losses. If the funds were truly hedged how would it be possible for one to 'blow up' and lose lots of money?