Hedge Funds Explained

In the past, hedge funds were so named because they involved a form of investing that focused on placing specific bets, in the hope that these investments would be able to “hedge” other ones. Unlike other types of funds, like mutual funds for example, which purchase stocks and hold them in the hopes that they will go up, hedge funds sell stocks short, purchase futures contracts to offset risks, and employ a complex set of derivatives that allow investors to “hedge” the basic risks of owning a stock or fund.

As these funds evolved, a number of different strategies were developed, and today’s hedge funds can be one of thousands of unregulated funds that for the most part, restrict their list of investors to individuals with considerable wealth or large corporations or pension funds that can afford to absorb losses.

In terms of the derivatives mentioned in the first paragraph, these can include many things. A good example are sub prime mortgage backed securities, since by combining risky mortgages into different classes of bonds, governed by rules concerning which bond investors will be paid first, the theory behind them is that even if some of the borrowers are unable to remain “in,” at least some of them would be able to keep paying, and the investors who secured a place initially usually come out much better, and are much safer than those at the end.

This practice worked very well, but after a few high profile losses from some of these funds that were invested in sub prime bonds, hedge fund managers and other primary holders began to rethink just how much their mortgage bonds were worth. Since many of these bonds had been purchased with borrowed money, some of the lenders began to request cash to cover any potential losses, and nervous hedge fund investors, in turn, began to ask for a refund.

Since hedge funds are not required to report holdings, it is hard to determine whether these types of funds are good investments, and equally hard to determine how much of an impact a failed hedge fund investment may have had on a large bank or insurance company. This is not to say that hedge funds are not a viable option, but much research and self evaluation of risk absorption is required before investing. Your personal financial planner can, and should, be your main source of advice, since they will be able to help you create a personalized investment strategy.