Once upon a Time

Hedge Fund

It used to be common for students applying for business schools to express that after graduating, they would prefer employment with companies such as Goldman Sachs, Morgan Stanley, or General Motors.Ð' Today however, students who have completed degrees in Business, answer that they would pursue employment with companies like Omega Advisors or Soros Fund Management. Those corporations were viewed as small and insecure on Wall Street, but today they represent one of the fastest growing areas in the world financial markets. Hedge funds, as well as those that manage and invest in them have become the most talked about investment outside of Internet initial public offerings (IPO's). According to the Wall Street Journal because of their nature, hedge funds are supposed to do well regardless of the market condition. First, we will introduce the subject with a background that will provide an objective point of view of the industry to better understand the complex world of hedge funds that has dramatically changed since 1940's. Second, we will try to understand where the concept of hedge fund comes from, what a hedge fund is and how it works. Third, we will try to understand the phenomenon that permitted hedge funds trend to bubble and what are the consequences of this rapid rise and popularity. Lastly we will discuss the collapse of Long-Term Capital Management in the 1990's and how the impact of a failure of one or more hedge funds might affect the economy.

Hedge funds began gaining popularity after the astronomical returns that many corporations reported during the bubble of the investment world in recent years. The term hedge fund was defined by Alfred Winslow Jones, in 1949. He exemplified the term by his approach of investing, management, and organizational structure. Its main goal was to eradicate a part of the market risk involved in holding long stock positions by short-selling other stocks. Additionally, Jones was the first to utilize short sales; leverage and incentive fees in combination. Leverage being the money that was borrowed and will be invested at a later date. According to the popular press hedge funds are lightly regulated private investment pools of money that wealthy individuals, families, and institutions invest in to protect assets and to achieve rates of return above and beyond those offered by mutual funds or other investment opportunities. As described by Carole Loomis in her January 1970 article in Fortune titled "Hard Times Come to the Hedge Funds", a hedge fund is a limited partnership structured so as to give the general partners and the managers a share of the profits earned on the limited partners' money. In a hedge fund two types of partner exists. First the general partner who is the individual, who creates the hedge fund, takes care of the trading activity and the daily operation of running the business. Then, the limited partners who only provides the capital, and as no other power. Furthermore, a hedge fund is any investment vehicles that chase absolute returns on their investment. The definition includes any absolute returns corporation investing in the financial market (commodities, currencies, derivatives, stocks, etc) as well as non-common management techniques like shorting, arbitrage, and leveraging (which will certainly enhance the risks/rewards of their bets). Hedge funds are not required to register under the federal securities law since they usually accept only financially sophisticated investors and do not offer their securities in public. They limit the number of investors at 100. Even though hedge funds are not under the control of constant regulations that apply to mutual fund, they still are under the supervision of the antifraud provisions of the federal securities laws. Unlike, mutual funds, hedge funds are forbidden to advertise. Therefore, they use the means of consultant, internet websites, and the words of mouth to raise money. Here are some data and explanations on how the general partner get paid and how those funds whether a loss or a gain are allocated. The general partner will generally receive an incentive fee which usually corresponds to 20% of the net profit of the partnership. However, this fee could vary from hedge to hedge and it will be approved on the partnership agreement. Also, an administrative fee is added to the incentive which could vary from 1 to 2% and is taken from the net asset value of the year. Hedge fund managers are remunerated on performance of the company meaning if they do well they will collect money but if they do badly they will do a little money or no money at all.

Today, in addition to trading equities, hedge funds have diversified their investments strategies; they can trade fixed income securities, convertible securities, currencies, exchange-traded futures, over-the-counter derivatives, futures contract, and other non-securities investments. Nowadays, hedge funds use all kinds of trading strategies and are free to use any investment tools. A broad range of strategies can be used to enhance returns, however only three of them are mostly known. The first strategy is Arbitrage, which consists of exploiting price discrepancies