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What is a Hedge Fund?

Alfred Winslow Jones developed what is generally considered the world’s first “hedged fund” in the 1950s. His innovation was to use a combination of short selling and leverage (selling borrowed stocks and buying stocks with borrowed money) to magnify gains and minimize losses. By taking long positions on some stocks and short positions on others, he insulated his fund from wide market swings. He also employed smart stock pickers. Consequently he profited spectacularly from his investments: Between 1949 and 1968, starting with $100,000 (about $60,000 of which he raised from friends), he earned a cumulative return of almost 5,000 percent. (A lot of investors made a lot of money during that long bull market, to be sure.)

A concise definition of hedge fund is elusive. It is more useful to study various successful hedge funds and their strategies than try to roll them up into a singular definition. Start by studying A.W. Jones & Co. from the 1960s; then Steinhardt, Fine, Berkowitz in the sluggish 1970s; then George Soros’s bank-breaking Quantum Fund and Julian Robertson’s swashbuckling Tiger Fund in the 1980s.

Risk Management

Another reason why a concise definition is elusive is that the purpose of hedge funds has broadened since the 50s and 60s. The most conservative view is that the purpose is to manage risk. In this view, a hedge fund employs an investment strategy that is not correlated with the market, in order to keep its capital fully invested, make money, and minimize volatility of returns whether the market booms, crashes, or flattens.

Opportunistic Strategies

Especially since the 1990s, more aggressively growth-oriented hedge funds have emerged whose purpose is generally to take advantage of diverse and in some cases event-driven, contrarian, or ultra-short-term investment opportunities — including long and short positions, alternative asset classes, the use of arbitrage, market-timing, bolder use of leverage, etc. — to produce superior returns.

There are still many funds that adhere strictly to the conservative purpose of risk management. But fund strategies, returns, volatility, and risk vary enormously today.

If you absolutely must have a short definition of today’s hedge fund, I think the most realistic one comes from Joshua Kennon, an investment writer for “A hedge fund is simply a term used to describe an investment partnership set up by a money manager.” Kennon’s definition is just weaselly enough to be unassailable.

Here is a more cynical, but not unfair, definition from Cliff Asness of AQR Capital: “Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has been making money.” (Reported by Bob Frick in Kiplinger’s Personal Finance, October 2011)

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About David M. Freedman

David M. Freedman has worked as a financial and legal journalist since 1978. He has served on the editorial staffs of business, trade and professional journals, most recently as senior editor of The Value Examiner (National Association of Certified Valuators and Analysts). He is coauthor of Equity Crowdfunding for Investors, published in June 2015 by…

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