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A hedge fund is a lightly regulated private
investment fund that is often characterized by unconventional strategies
(e.g., strategies other than investing long only in stocks, bonds, or
mutual funds).
The term hedge fund dates back to the first fund
which was founded by Alfred Jones in 1949. Jones' original objective
was to buy some stocks and to sell short others against those positions.
In doing so, he mitigated much of the market risk, thus the term
“hedge”.
Most of the hedge funds today bear little resemblance to
what Jones created. Many still trade stocks from both the long and short
side, but many other do not even trade stocks at all.
In the U.S., hedge funds are simply structured as limited
partnerships or limited liability companies. The hedge fund manager is
the usually the general partner or manager and the investors make up the
limited partners or members as they are often referred to.
When the partnership is formed, the funds are pooled
together and then turned over to the fund manager for investment. The
investment style that the manager will employ is outlined in the
Offering Memorandum (aka offering documents) for the fund.
Investors typically pay two types of fees to the manager.
The first is a management fee. Normal management fees range from 100-250
basis points of the assets under management. In other words, the manager
gets 1%-2.5% for managing the pool.
The other fee is the performance fee. This is where the
rubber hits the road. The performance fee is based on the profitability
of the fund and is usually in the neighborhood of 10-25% of the annual
profits.
The most common strategy employed by hedge funds is what
is known as “long/short”. Plato Advisors and the Stock Trading Advisor
employ a form of this strategy in that we want to own the strongest
names in the strongest sectors and be “short” (short sell) the weakest
names in the weakest sectors.
Other strategies that are often employed are Selling
Short, Risk Arbitrage, Option Funds and other Fund that use other
derivative based investments such as futures, foreign currencies, and
distressed debt.
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