So what's a hedge fund?
Hedge funds seem to make headlines when things go bad on a trading day. But what are these funds and how do they really affect the stock market? Mitchell Hartman explains the term in our latest Marketplace Decoder.
The floor of the New York Stock Exchange (Chris Hondros/Getty Images)
More on America's Financial Crisis, The Marketplace Decoder
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Kai Ryssdal: Hedge funds were supposed to be the smart money. Special investments for rich people who know how to pick 'em. But a lot of those funds have lost billions for their investors -- everybody from individuals to pension funds to college endowments. Some of them have shut down. Some of them even invested in Bernie Madoff's Ponzi scheme.
Others, though, are still the smart money even though there's still a lot of mystery about what hedge funds are. So we asked Mitchell Hartman to find out for us earlier this year in the Marketplace Decoder.
Mitchell Hartman: First, the textbook answer. A hedge fund is a private partnership that pools money from wealthy individuals, pension funds, corporations, and the like, and invests it to make a profit. Because the fund is private, it doesn't have to report how much it earns, or what it's holding, to financial regulators.
Will Swarts of SmartMoney.com has been reporting on hedge funds for over a decade. He says it used to be pretty simple to define a hedge fund.
Will Swarts: It was a fund that held some stocks long -- where you'd make money if they'd go up -- and some stocks short, where you would make money if they went down.
By betting both sides of the market, the fund balanced out, or hedged its risk.
These days, hedge funds invest in all sorts of markets -- currency, oil, precious metals, stocks, bonds, or all of the above. And, Swarts says, most of them use borrowed money, or leverage, to juice their returns.
Swarts: Now a hedge fund is basically a catch-all term for any number of investment strategies that can invest in anything from bonds, stocks, the third race at Aqueduct.
The third race at Aqueduct? Well, if a hedge fund manager did walk up to the betting window with a few million bucks, he'd be looking to place a bunch of bets, all at different odds.
Washington University finance professor Charles Cuny explains the goal would be to spread the risk around the whole field of horses.
Charles Cuny: So they might bet on Candy Dandy to come in fourth, Lucky Tiger to come in sixth, and some other horse is going to break its leg.
By betting on a lot of different outcomes, the hedge fund can make money off the third race no matter how it finishes. And in theory, the same goes for any market -- stocks, bonds, commodities -- that a hedge fund might invest in.
But hedging is no guarantee of success. In really crazy markets, like we're living through right now, so many bets go wrong, that the fund can be exposed to huge risks. The problem's amplified by all that leverage -- just a small movement in markets can induce big losses, and force managers to sell off assets at any price. And we've seen a lot of that lately at the racetrack called Wall Street.
I'm Mitchell Hartman for Marketplace.
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From Silver Spring, MD, 02/25/2009
Eliminating the Orwellian tendency to bend the English language for the pecuniary benefit of a small number of people in the financial sector would go a long way towards "regulating" the business. Two such horrible abuses come immediately to mind, and they both are offensively dangerous practices. The first is the so-called "hedge fund." HEDGING is an investment strategy (as pointed out in one of the comments above) whereby you ELIMINATE risk by purchasing a combination of short (things you promise to buy in the future) and long (things you actually purchase and hold) positions in a commodity or security. In this way you essentially lock in a range of profit and eliminate both the upside and downside fluctuations. How did this low-risk, (usually) low-return practice EVER come to mean extremely HIGH risk, potentially high return (or loss) unregulated investments. Using the word "hedge" to describe this form of investment activity borders on criminal deceit. Curiously, the other example of this form of blatant fraud is almost identical in its morphology--"risk arbitrage." As all people in the investment sector know, arbitrage is a RISK-FREE strategy that employs simultaneous purchases and sales of the same commodity or security to lock in a small but guaranteed profit that arises from differences in prices in different markets. There cannot POSSIBLY be anything like "risk" arbitrage. That is like calling some black white or safe deadly.
From San Francisco, CA, 12/31/2008
While hedge funds have been lightly regulated in the past, it is likely that Congress will require hedge fund managers to register as investment advisors which will likely have a chilling effect on hedge fund start ups.
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