To hedge = to protect or surround as with a fence or protective barrier. The term "hedge fund" has fallen into generic use and covers a wide range of investment strategies. The original hedge funds employed market neutral strategies such as buying Pepsi and shorting Coke, or buying a group of stocks and then shorting a correlated stock index. Over the years, strategies have proliferated in directions that have little or nothing to do with actual hedging. The defining characteristic of these funds now seems to be that they are usually exempt from the Investment Company Act of 1940 and are therefore able to engage in short selling, options, futures, derivative, and leveraged trading -- strategies typically not available to other regulated investment entities. Hedge funds are usually only available to wealthy "accredited" investors, and due to the limitations placed on their structure and membership to specifically avoid registration, they are largely unregulated. (Although recent regulation, such as Dodd-Frank and state regulation, is starting to force registration of hedge funds.)
The good news is that hedge funds can participate in investments not available to mutual funds and other investment entities. Hedge funds often attract the best talent, and have a high level of expertise in arcane areas where special profit opportunities may exist. The bad news is that they typically tend to be secretive and most investors do not really understand the positions or strategies of their hedge fund. This lack of knowledge means that investment is largely made on trust in the individuals involved (and past performance) rather than any restrictions on the investment policy.
The alluring performance of hedge funds has been tarnished in the past with the collapse of Long-Term Capital and the demise of the Quantum and Tiger funds, some of the largest and best known high-flyers in the industry. However, the basic attraction still continues. As an example, performance is cited in the February 26th cover story of BusinessWeek in 2001: "With the Standard & Poor's 500 stock index down 9.1% and the Nasdaq dropping 39%, the average hedge fund was up 8%" (for the year 2000). The article goes on to point out that short-only funds returned an average 30% return, and arbitrage funds returned 14.3%.
This performance in 2000 points out what is perhaps the greatest strength of hedge funds: they do not have to depend on the markets going up. Most individuals only buy securities. This means they only make money if their investment goes up. Many hedge funds engage in short selling, as well as option and futures trading that allows a profit to be made when a security goes down. There are also strategies such as collecting option premiums and capturing dividends that can produce a profit in flat markets.
The Nomothetic Theorem provides an ideal foundation for market neutral and multi-directional trading. The investment application of the Nomothetic Theorem analyzes the dynamic tension between the forces of stability and the forces of volatility. The strategy leads to conclusions about selling overvalued positions and purchasing undervalued positions. This is an ideal strategy to employ within the framework of a hedge fund.
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