1: Hedge Funds: Investing for Shorter-Term Opportunities

Much controversy surrounds hedge funds. In the aftermath of the financial crisis of 2007–2008, many politicians and commentators identified the hedge fund industrys a major cause of this financial crisis. The real reasons are much more complicated. Although hedge funds are convenient targets, they shouldn’t be the center of the controversy. Ordinary investors typically have little understanding of hedge funds and with good reason. Hedge funds are generally private, discreet, opaque, unregulated, and require large buy-ins. The purpose of this chapter is to help you determine whether hedge funds are appropriate for your investment portfolio.

A major misconception about hedge funds is that they’re relatively new. Alfred Winslow Jones launched the first hedge fund in 1949 through his company A. W. Jones & Company. Jones wrote an article for Fortune in 1948 about current investment trends. He discussed how he took $40,000 of his own money along with $60,000 from other investors and created a fund that sold certain stocks short to minimize the risk of the long-term stock positions he held. This strategy later became known as long/short investing. Short selling is borrowing someone else’s securities, selling them, and then hopefully repurchasing them at a lower price and returning the borrowed shares to the original owner. Thus, short sellers are motivated by the belief that a security’s price is likely to decline (“what goes up must come down”), enabling them to repurchase shares at a lower price to make a profit. Jones also used leverage to magnify returns. Leverage involves using borrowed funds for an investment expecting that the investment returns exceed the interest paid on the borrowed funds.