hedge fund, in finance, a largely unregulated investment device with a relatively small number of investors that aims to outperform the markets. Originating in the 1950s, the funds "hedge" by offsetting "short" positions (borrowing a security and then selling it at a higher price before repaying the lender) against "long" positions (borrowing money to speculate on undervalued stocks; see hedging). Not all so-called hedge funds are actively involved in hedging, and since the 1980s many hedge funds have been involved in sometimes very significant speculation. In general, hedge funds, besides being unregulated, are investment capital funds that are limited to wealthy investors and large institutions, that are structured as partnerships, and that use investment strategies involving higher risks in an attempt to produce greater financial gains. The fees associated with hedge funds are high, and can reduce the returns to levels in line with investments involving lower risks. Aggressive hedge funds work with highly leveraged securities, often purchased with less than 5% of actual investor capital, with banks covering the balance. Macro hedge funds speculate in currencies of various countries; financial analysts and government officials blamed such funds, including George Soros's Quantum fund, for disrupting the economies of Asian and Latin American countries in 1998. Other funds speculate in gold and other volatile commodities, or simultaneously buy and sell a stock or other financial instrument in two different markets to profit on the difference in value in the two markets (a technique called arbitrage). Funds are classified as U.S. or offshore; U.S. hedge funds are private investment partnerships that generally invest in traded securities. Offshore hedge funds (normally not open to U.S. investors) are mutual fund companies.
Hedge funds came to public view in 1998 when Long-Term Capital Management (a U.S. fund) nearly collapsed, requiring a $3.5 billion bailout organized by the Federal Reserve Bank of New York and paid for by private banks. The bailout led to a number of U.S. and international investigations into hedge funds and calls for greater regulation and scrutiny. An attempt by the Securities and Exchange Commission in 2004 to require hedge funds to register with it was overturned by the federal courts. In 2006 another major U.S. hedge fund collapse, that of Amaranth Advisors, cost investors more than $6 billion. By 2007 the assets of such funds were estimated at more than $1 trillion; in February of that year the Bush adminstration and U.S. financial regulators rejected increasing the regulation of the funds and instead recommended that persons, institutions, and banks engage in sound practices before investing in or lending to a hedge fund.
See study by S. Mallaby (2010).
The Columbia Electronic Encyclopedia, 6th ed. Copyright © 2012, Columbia University Press. All rights reserved.