What is: A Hedge Fund?

A hedge fund is a private investment partnership, usually reserved for wealthy investors and entities.

It’s a pool of money managed by either one person — known as the managing director (or managing partner) — or by an organization consisting of many investment managers. The classic idea of hedge funds was, of course, to “hedge” positions, by having part of the portfolio long and part of it short. This style doesn’t apply to every hedge fund today.

The allure of hedge funds is that they’re largely unregulated, giving them leeway to use trading techniques and take risks that other investment vehicles — such as mutual funds — aren’t allowed to do. Having this freedom can result in phenomenal returns, achieved by the likes of George Soros and Warren Buffett — prior to his run at Berkshire Hathaway (ETR: BRH) — but can come with equally large risks.

Hedge fund managers are renowned for their huge personal paydays. In recent years, top-performing hedge fund managers have been paid $3 billion or more. A typical hedge fund charges investors 2% of underlying assets and 20% of the profits each year.

A Brief History of Hedge Funds

In 1949, Alfred Winslow Jones started the first hedge fund. He went long/short, and used leverage to increase returns. In 1952 he started keeping 20% of the profits for himself.

By 1968 there were about 215 funds including those run by George Soros, Warren Buffett, and Michael Steinhardt. By 1984 there were only about 68 hedge funds left (most were wiped out during the market crash of the early 1970’s). By the late 1990’s there were approximately 4,000 funds with $300 billion in capital, including Julian Robertson and George Soros. In 2007 there were about 9,000 hedge funds with approximately $1.1 trillion in assets.