There has been a lot media attention on hedge funds as of late. A couple spectacular blow-ups have thrust the funds into the limelight. These explosions typically consist of a lot of people finding out all at once that returns reported by their investment fund were completely fabricated. Shortly after this they find out all of their money is gone (not just the false returns) and the managers have fled the country. I imagine this usually ruins their day. After reading a bunch of these soap operas I realized I had seen the term hedge fund all over the place but didn’t actually know what it was.

I first heard about a hedge fund in an investment group at Brown [1]. The name hedge fund came from a style of investing which hedged one investment with another to minimize risk. This heading allows the money manager to take aggressive positions in high risk investments because he or she hedge the risk with an opposing investment. These tactics provide a conservative investment option that is designed to preserve wealth. For example a hedge fund of this type might take a long position in a company’s convertible bonds but a short position against their common stock. If the company takes a dive and their bonds are devalued, typically their stock will fall, hedging the loss from the bonds.

I was surprised to learn that a hedge fund doesn’t have to hedge at all, despite what the name implies. A hedge fund is simply a private pool of unregulated money that can be invested in just about anything. Joseph Nocera in his article The Quantitative, Data-Based, Risk-Massaging Road to Riches [New York Times Magazine, June] estimates “there are now 8,000 hedge funds, about 40 percent of which have been opened in the last four years.” That is a lot of funds. With this rapid growth it appears as if hedge funds have morphed from specifically what their name suggests to generally mean “a pool of money that is invested in stuff without those pesky SEC folks always getting in the way.” The type of investment hedging I mentioned in the above paragraph is only one type of investing style employed by hedge funds called arbitrage.

Mutual funds, in contrast to hedge funds, operate under a set of rules dictated by the SEC. The regulation hedge funds avoid seems to mostly be around disclosure of information (what you are buying and selling), using specific rules for determining the market value of the fund, and how much of one position the fund can hold. There are a ton of other regulations hedge funds avoid but they were boring and didn’t seem all that important. Without regulation comes a great deal of flexibility but it also means you end up giving your money to somebody who doesn’t have to tell you anything about how they are investing your money, and can use whatever methods they want to calculate the market value of the fund. Additionally your money isn’t insured but that shouldn’t come as a surprise.

While hedge fund doesn’t seem to have any agreed upon definition, there were some common themes:

• Large personal investment in the fund by the fund manager
• Small number of investors, high investment minimum
• Focus on absolute returns — while mutual funds seem to focus on relative returns (”4% better than the S&P 500″), hedge funds seem to focus on absolute returns (”14% returns in a bear or bull market”)

My favorite investment style is a kind of arbitrage which is described as “taking advantage of market inefficiencies.” [2] I think it is a great way to think about what hedge funds do. You might wonder why more people don’t take advantage of these market inefficiencies. As far as I can tell it seems to be a function of knowledge, access, attention, risk, and capital — most of us are short in all five of these areas. The best example of this at a small scale is something I have seen Faktor do on eBay. At some point he noticed that he could buy a waterproof camera kit (that includes a digital camera) and make a profit by selling the case and camera separately. He had to take the time to understand this (knowledge, attention), have an open market like eBay (access), and invest the money up front (risk, capital).

Just waiting for the Faktor hedge fund. Oh, and some money to put in it.

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[1] My investment career in college consisted of buying a stock on recommendation, making a lot of money, believing I was an investing genius, joining an investment group, buying a stock I actually researched myself, losing nearly everything I made from the first stock on the one I picked, moving what little was left into Cisco and forgetting about it. Six years later that Cisco stock turned into an engagement ring.

[2] There is something that just seems overly nice about this statement. Kind of like when you say “putting the dog to sleep” instead of “killing Spot.”