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In the financial world, the term “hedge” means “to neutralise risks” or “to be covered”. This means that a hedge fund is a way of providing protection against financial loss. By extension, “hedge fund” is sometimes used as an umbrella term for all alternative funds, i.e. a fund which is not dedicated to investing in equities or listed bonds, nor one which is open to the public. Hedge funds are designed for qualified investors, such as institutional investors or individuals who have significant assets, and are more loosely regulated than classic investment funds. It should be noted that hedge fund regulation has grown and has been significantly tightened in recent years, both in the United States with the passing of the “Dodd-Frank” Act in 2010 and in Europe, with the adoption of the AIFMD in 2011.
Hedge funds’ operational model differs from that of traditional funds by their relatively flexible investment strategies, with an emphasis on risk management and absolute performance, i.e. decorrelated from the movements of major asset classes. To achieve this decorrelation, hedge funds use a wide variety of strategies. The best known of these are “stock picking” (individual stock selection), “long/short equity” (buying and selling), “event-driven” (special situations) including “merger arbitrage” (arbitrage of mergers & acquisitions), “fixed-income arbitrage” (arbitrage on fixed-income products or convertible bonds), “global macro” (prediction of major macroeconomic trends), and “CTA strategies” (this stands for “commodity trading advisor”, which involves following stock-market trends, including commodity prices). These various strategies may be combined in funds of hedge funds or in multi-strategy funds in order to increase diversification.
Hedge funds use a wide range of financial techniques to achieve decorrelation and to manage risk. The main techniques are “short selling”, which involves spot selling of securities that one does not hold in the hope of buying them back for less at a later date; using derivatives, such as options, futures or forward contracts; and leverage, which means borrowing to increase the effective size of the portfolio.
The first hedge fund was devised in the 1950s by Alfred Winslow Jones, a journalist working for the US magazine, Fortune. The main principles that he defined back then are still in place today: a legal structure of a limited partnership; management fees proportionate to the total assets under management and performance; and stock selection when buying and selling in order to neutralise the effect of market movements. Alternative asset management took off in the 1970s with the emergence of seminal figures, such as George Soros.