Hedging Terminology- What's In A Name?

The Economist

Mar 2nd 2006

The label “hedge fund” is getting fuzzier by the day

WHAT exactly is a “hedge fund”? In essence, it is a managed pool of capital for institutional or wealthy individual investors that employs one of various trading strategies in equities, bonds or derivatives, attempting to gain from market inefficiencies and, to some extent, hedge underlying risks.

Hedge funds are often loosely regulated and usually are much less transparent than traditional investment funds. That helps them to trade more stealthily. Funds typically have minimum investment periods, and charge fees based both on funds under management and on performance.

Many experts contend it is a mistake to talk about hedge funds as an asset class; rather, the industry embraces a collection of trading strategies. The appropriate choice of hedging strategy for a particular investor depends largely on its existing portfolio; if, for example, it is heavily invested in equities, it might seek a hedging strategy to offset equity risk. Because of this, discussion of relative returns between hedge-fund strategies can be misleading.

Hedge funds use investment techniques that are usually forbidden for more traditional funds, including “short selling” stock—that is, borrowing shares to sell them in the hope of buying them back later at a lower price—and using big leverage through borrowing.

The favoured strategies tend to change. “Previously the hedge-fund industry was equity driven, but now there is less long/short,” says Oliver Schupp of Credit Suisse/Tremont Index. “Now it's a much more diverse picture with less concentrated exposure.” Some of the most common strategies include:

• Convertible arbitrage—This involves going long in convertible securities (usually shares or bonds) that are exchangeable for a certain number of another form (usually common shares) at a preset price, and simultaneously shorting the underlying equities. This strategy did very well for several years, but has been less effective recently.

• Emerging markets—Investing in securities of companies in emerging economies through the purchase of sovereign or corporate debt and/or shares.

• Fund of funds—Investing in a basket of hedge funds. Some funds of funds focus on single strategies and others pursue multiple strategies. These funds have an added layer of fees.

• Global macro—Investing in shifts between global economies, often using derivatives to speculate on interest-rate or currency moves.

• Market neutral—Typically, equal amounts of capital are invested long and short in the market, attempting to neutralise risk by purchasing undervalued securities and taking short positions in overvalued securities.


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