What Is a Hedge Fund?

The President's Working Group on Financial Markets, which looked into the causes of the failure of Long-Term Capital Management, defined a hedge fund as “a pooled investment vehicle that is privately organized, administered by professional investment managers, and not widely available.”² This is about as unhelpful a definition as one could wish for, but it does make the point that hedge funds are very hard to define. Many hedge funds don't hedge at all, for example, and some are quite widely available.

The first hedge fund, so far as we know, was established half a century ago by Alfred Winslow Jones, a former financial reporter. If Jones had $100 to invest he would invest it all in the stock market. He would then borrow another $30 and invest that as well. Then, in order to “hedge” the risk of the leveraged $30, Jones would sell $30 worth of stocks short. His idea was that if his stock picks were very good he would make far more money than a typical long-only investor: He would make money on his long positions, of course, but he would also make money from his leverage and his short positions. If his picks were only “good,” he might lose money on his short positions but make it up on his long and leveraged positions. His only real danger, aside from incompetent stock-picking, was a very bad down market, in which case his long and leveraged positions would overwhelm his short positions. (This actually happened to Jones in 1969–1970.)³

Today a hedge fund can be defined as any investment vehicle organized as a partnership in which the manager shares in the profits and in which (speaking very generally) the manager invests in marketable securities.⁴ (In other words, private equity funds don't count.) The manager may or may not sell short; he may or may not employ leverage; he might be buying equity securities or fixed-income securities or currencies; he may specialize in a specific niche or market sector, or he may migrate from niche to niche and sector to sector. The only way to know what a hedge fund is doing is to speak at length with the manager and to check everything he or she says.