Demystifying hedge funds

Till recently, hedge funds and their managers were taken to be an elite, and somewhat mysterious, part of the investment fund industry. That can't last, say Narayan Naik and Mark Tapley - and that could be good news of the rest of us.

The idea of a mutual fund – a portfolio of stocks or bonds, or both, managed by an individual or a small team on behalf of a large number of investors – goes back to 1924. Today, there are more than 46,000 funds; in terms of pounds-equivalent invested in mutual funds globally, the amount easily runs into the trillions. The fund world is enormous, and hedge funds have long been considered star investment vehicles. But are they as special as they seem?

With most funds, managers do not flip their holdings as, say, a broker-dealer might do. Those who invest in standard mutual funds are expected to stay invested for some time. Investors are not encouraged to (and sometimes are even prohibited from) flipping funds, as they can stocks. Hedge funds, however, are different.

Heretofore open only to institutional investors or the ultra-wealthy, hedge funds are basically unregulated. Standard fund managers hold a set number of securities for extended periods; by contrast, hedge fund managers engage in more and faster turnover of their holdings.

Beyond that, hedge funds ensure their overall success by mixing holdings that have a long position (meaning their value to the fund will go up if a security rises in market value) or the opposite, a short position. Hedge fund managers can also freely engage in investing fund resources in futures, buying or selling at a set date-to-come; derivatives, an exchange of money based on the value of an asset that the fund itself does not actually own; or some other advanced form of investment strategy.

All of this has made hedge funds a subject of growing interest by investors as a whole; it has also given hedge fund managers the reputation of being the crème de la crème of money managers.

As the number of hedge funds and the amount of assets pouring into them has grown, the funds have taken on a level of pre-eminent interest and, quite probably, importance. According to one source, the number of hedge funds shot up from 610 in 1990 to more than 9,400 in 2006. The estimated assets held by the funds, as well as the net asset flow into the funds, have grown accordingly, as illustrated by the following chart.

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