what i learned today

Hedge funds. You hear about them, you read about them, your friend works for one. But you don’t know what they are. Well neither did I until recently!

First off, wow, hedge funds were started in 1949. Who knew?

A hedge fund isn’t just a fund that hedges, (definition of hedge: get rid of or offset risk). It’s actually a professionally managed portfolio of investments that uses complex investment strategies to generate high returns. It’s basically just a riskier (and typically more profitable) mutual fund for rich investors. The name hedge funds comes from the first hedge funds that tried to hedge risk against the downside of a bear market (a slower or declining market) by shorting (or selling stocks or securities) in that market. I’ll explain how that works. When you short a stock you sell the stock because you think the price will fall, as opposed to going long on a stock when you buy the stock because you think the price will rise. But the difference between a short and a long, is when you short a stock you borrow shares from another investor. Here’s an example…

GOOG is at about $720 right now. I think it’s overvalued and the price of Google will go down. I currently don’t own any shares of Google but I want to profit off of Google’s stock decline, so I want to short 100 shares of GOOG. To do this I borrow 100 shares of GOOG from someone else’s portfolio and sell those 100 shares, receiving $72,000. Say the price drops to $650. I have to “close” my position and buy back those 100 shares to replenish the account from which I borrowed. I buy 100 shares at $650 each, for $65,000. I just made $7,000 ($72k - $65k). The risk here is a. if the price goes up, say to $750, then I lose $3,000, and b. if the guy whose portfolio I borrowed from wants his shares back, I have the obligation to give him back his shares no matter what the price of the stock.

*Note that the guy I’m borrowing from doesn’t know I’m borrowing from him.He likely doesn’t think that GOOG shares will decline. If he did, he’d want to sell his stocks too!

So there you have a short. But back to hedge funds. They are named so because of their original practice of shorting, betting on a decline in the market and hedging risk. Now, however, they don’t hedge much at all, but rather practice some pretty risky investment schemes in efforts to maximize their return.

Hedge funds aren’t governed by the SEC (Securities & Exchange Commission) so they can take risks that ordinary investors & mutual funds can’t. (However, in 2005, the SEC required that funds with over $30M with more than 15 clients register with the SEC, and thus be governed by their politics)They often invest aggressively in futures and options, short stocks, use borrowed money to buy securities (also called buying on margin), and bet on currency exchange rates.

So who puts money into a hedge fund? The super rich, naturally. In the US, hedge fund investors must be accredited. This means they must have a net worth of more than $1 million, must meet the minimum annual earnings, and must have a significant amount of investment knowledge. I guess I’m out of that club.

So. I want to start one. Who doesn’t? These days it takes only about $15,000 and a few rich friends or family members to invest, some legal services to set up investor contracts and a LLC, a couple of people to manage the clients, a prime brokerage through whom I will trade, and an apartment. Boom. Done.

Books to Read: The Alchemy of Finance. George Soros.