Hedge Funds 101: How do they really work?
Billionaires like James Simons, Israel Englander, and Kenneth Griffin are only a few of the extremely rich people that are hedge fund managers. To many, hedge funds are a foreign term or result in a gasp of interest. In short, a hedge fund is investing money into any kind of investment without much regulation. Hedge funds by definition (from Oxford Languages) are “a limited partnership of investors that uses high-risk methods, such as investing with borrowed money, in hopes of realizing large capital gains.” But there is more to hedge funds than what meets the eye. The entire process is unique and intense and requires a great deal of intellect, confidence, and proficiency to truly succeed.
HOW IT WORKS
A hedge in finance, in today’s world, is an investment/business position that reduces potential financial losses, as described by Investopedia. The purpose of a hedge fund is to make large transactions with the least amount of risk possible using a variety of “tools” that aren’t easily accessible to the general public. Investors will toy around with investments, plunging one stock, and rising another, in order to maximize profits in an efficient way. Investors tend to use a lot of leverage by borrowing enormous sums of money and investing them in hopes of higher returns. There are firms where proficient investors with the required knowledge and capabilities have the power to trade in ways that an average investor isn’t able to. To highlight, in terms of fees, skilled investors go by a “2 and 20” structure, which is larger than many other investments on the market. There is a 2% management fee regardless of the performance of the investment and a 20% performance fee if the shares reach above a specific level of profit.
Diving deeper into the sectors within hedge funds is the idea of options. This is a contract where two sides agree to give one the option to manage an investment and sell it at a certain price. This is an effective way to make the portfolio of a trader more private and lower the risk of exposure. Another term associated with hedge funds is derivatives, which are also contracts between two parties. In derivatives, however, one party will sell its share for a certain price at a different time in the future if the other side agrees to buy part of that investment.
Overall, there are many tools that investors consistently utilize when managing hedge funds. Yet the main idea is for firms to allow their expert investors to take large amounts of money and to change around stocks in order to make the most profit possible.
HISTORY
In order to understand the real purpose of hedge funds, it’s important to acknowledge their origin. According to a CFA Institute Journal Review, hedge funds were first created by Alfred W. Jones who bought stocks and “[hedged] their positions with short sales”.
But the term “hedge” has dated back centuries. The New Yorker goes into depth on how the idea came about and developed over the years. In the time of the Vikings, a hedge meant some sort of boundary to exhibit ownership, or the “what’s mine is mine” idea. It wasn’t until 1672 that “hedge” was used in terms of money. Such as the phrase “hedge a bet” where a bet was made without such definite backing. Instead, it was made on mere guesses on how a business would follow through. For instance, the London Stock Exchange was created in a Coffee Shop where Londoners would bet on how the British imperial joint companies would do in the future.
Throughout Europe, the idea of manipulating money garnered popularity among gamblers. They would walk in with a great deal of money and would walk out bankrupt or with double what they came with. It’s like how the New Yorker says, “for every buyer, there is a seller”. Not everyone will win this game, but whoever plays it right will be awarded a great deal of wealth. But it didn’t end there. People like Louis Bacheleir applied mathematics to this concept in the late 1800s creating a system where he established the use of an option in finance. He set the scene for many later advancements in the mathematical and financial sector of the world such as by influencing the Black-Scholes equation. A whole system of options trading had begun and many companies began giving out options with a “profit or nothing” mindset. However, due to later world economic issues, the plan had to be altered with the changing times. Similarly, in today’s world, hedge funds seem untouchable, but they are still susceptible to many ups and downs, such as during the COVID pandemic.
In essence, hedge funds were intended to protect money, but have since become a means to manipulate stocks to benefit one and destroy another. The whole idea of “protecting” has been thrown out the window and all that remains is an uneasy reputation with unsettled morals in a booming industry.
Whether it be algorithms or gut instinct, hedge funds are creating the world’s greatest billionaires, and it’s time that this is brought to the attention of the next generation. That they too, can become whoever they want, in whatever way they could imagine it to be.
