Alfred Winslow Jones coined the term and the idea of a «hedge fund» in 1940 when he wrote for “Fortune” magazine. His idea was that by combining the use of long and short positions coupled with the use of leverage, a manager of a fund might outperform the market both in good and in bad times. What Jones stresses even more is that one must be always short and always use a leverage to be considered a real hedge fund manager. Moreover aggressively picking long stocks is accompanied by being short to neutralize for market swings. To resume, three basic notions characterise a hedge fund:

• Short position is when a trader sells something that is not in his possession in order to buy it back later to earn the difference.
• Long is a simple buy of a security with intention of holding it for a certain time.
• Leverage is a mean of enhancing return or value of a portfolio without increasing investment. Classical example is buying securities on margin. That form of buying is a form of credit where the debt is covered by trader’s own securities’ portfolio.

Hedge funds came to the public spotlight when in August 26 in the late summer of 1998 Stanley Druckenmiller from the Soros organization announced a $2 billion lost in its flagship hedge Quantum Fund in the wake of the currency crisis in Russia. What the public didn’t know and didn’t care to know was that despite of that lost the fund was still one the best performing funds ever. The public confidence reached its lowest with Long-Term Capital Management (LCTM) hedge fund disaster. If the Federal Reserve (Fed) hadn’t intervened all major European and American banks would have incurred very important losses. What’s more, two Nobel price laureates Robert Merton and Myron Scholes and John Meriwether the inventor of the “rocket science” for finance with its squadrons of Quanta specialists, were the people behind the sophisticated methods used by the fund. Their know-how didn’t prevent the catastrophe. What’s less publicised is that finally the fund recovered from all losses. Nevertheless it’s not a privilege of a common fund to get a helping hand from the Fed. LTCM was simply too big to fail. The bailout of LTCM by the Fed was designed to ensure that the LTCM collapse didn’t cause the credit markets to default and make the world look grisly.

There are certain positive notes concerning hedge funds that do not reach the general public’s eye and that are worth mentioning. You must dig below the surface to reach for a lot of valuable and constructive elements. I mention only three of them. Here they are:

• A recent study by IMF indicated that in most recent financial crises hedge funds seemed to have made the situation more stable.
• The amount of money the hedge funds control is only a fraction of what is under institutional investors management thus their impact on financial environment is smaller.
• Shorting currencies by hedge funds is always followed by buying them back to cover their positions. The operation though impacting the value of a currency is intended to look for it’s real market value.

When investing in hedge funds a good understanding of their principal actors is necessary. Here they are:

• Investment advisor
• Institutional advisor
• Third-party marketer
• Individual investor
• Consulting firm
• Manager of managers

Ad. 1. Investment advisor helps client to determine what the money is for and what client’s investment objectives are. Possible portfolio’s return is confronted with client’s aversion to risk using some basic and very comprehensible simulation techniques.

Ad. 2. Institutional advisors are the largest and the most important users of hedge funds. Amongst them are pension funds, insurance companies, banks brokerages and national and multinational corporations. As they operate in strict secrecy little is known about their investments. Usually they choose the managers based on their historical performance and the hedge fund is what comes with them. It looks more as if a manager is an asset and not the hedge fund that’s under his control.

Ad. 3. Third-party marketer is a professional who does the business of raising money for hedge funds. Though most hedge funds start business using inner circles consisting of family and close friends they need to reach the outer world of wealthy individuals and institutional investors. For certain fee hedge funds use services of third-party marketers.

Ad. 4. Individual investor if not sufficiently rich usually goes through family offices that fulfil the criteria for accredited investor. The family office invests in a core group of funds that meet the needs of most of the family, while allowing the individuals to invest in other funds too.

Ad. 5. Consulting firm recommends products for hedge fund investors. Quite often it does not invest himself and does not manage any money. The firm gives their clients investment advice and helps them with asset allocation and manager selection. It looks for inefficient area of the market and advices on convergence trades that are long on illiquid trades and short on liquid ones.

Ad. 6. Manager of managers or simply known as MOM acts as an advisor to investors looking for money managers. He customizes multi manager alternative investment strategies for institutional and high-net worth investors. The customization may include tailoring contracts with managers through limits on leverage, value-at-risk (VAR) limits, selection of instruments and use of counterparty. The manager of managers monitors portfolios’ performances through daily mark to market of every trade for liquid stocks and periodically for illiquid ones. MOM uses value-at-risk or stress testing analysis for global portfolio risk management.