Give a dog a bad name … The near collapse of Long Term Capital Management focused the attention of the global financial community on hedge funds.
But are they really as black as they’ve been painted in some parts of the financial press?
First, a quick history lesson. Hedge funds have been around since the 1960s, causing much less trouble than many other financial institutions.
They got their name from fund managers who bought shares and sold them short at the same time – hedging their bets.
Now the term refers to funds that use one or more alternative investment strategies, such as hedging against a market downturn, investing in asset classes such as currencies or distressed securities and using return-enhancing investment tools such as gearing, derivatives and arbitrage.
“Hedge funds as a group suffer from popular misconceptions when a few funds suffer big losses,” claims Dion Friedland, founding president of the Hedge Funds Association and chairman of Magnum Funds.
Friedland says most hedge funds are not global macro funds placing large directional investments in financial instruments using lots of leverage.
Nor are they highly leveraged bond arbitrageurs like LTCM.
Other funds focus on less volatile investment strategies such as merger arbitrage, convertible bond arbitrage or market neutral investment strategies – investing equal amounts in long and short positions, usually in the same sector, in the expectation that the long will rise more than the shorts in a bull market and fall less than the shorts in bear markets.
“The vast majority of hedge funds make consistency of return, rather than magnitude, their primary goal,” adds Friedland.