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by Derek Loosvelt | May 12, 2004

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What is a Hedge Fund?

Hedge funds are considered an "alternative investment" vehicle. The term "alternative investment" is the general term under which unregulated funds operate; this includes private equity and real estate funds. Mainstream funds are investment funds that everyday investors can purchase; mutual funds are the prime example of a mainstream fund.

Over the past decade, hedge funds have grown tremendously in terms of assets under management and also garnered a lot of media attention. Despite their growth and popularity, hedge funds still remain a mystery to many people who do not understand exactly what they are and how they work.

During the early years of the hedge fund industry (1950's-1970's), the term "hedge fund' was used to describe the "hedging" strategy used by managers at the time. Hedging refers to the hedge fund manager making additional trades in an attempt to counterbalance any risk involved with the existing positions in the portfolio. Hedging can be accomplished in many different ways but the most basic technique is to purchase a long position and a secondary short position in a similar security. This is used to offset price fluctuations and is an effective way of neutralizing the effects of market conditions.

Today, the term "hedge fund" tells an investor nothing about the underlying investment activities, similar to the term "mutual fund". So how do you figure out what the hedge fund manager does? You are able to figure out a little more about the underlying investment activities by understanding the trading/investment strategies that the hedge fund manager states he trades. The "investment strategy" is the investment approach or the techniques used by the hedge fund manager to have positive returns on the investments. If a manager says he trades long/short equity, you know he is buying undervalued equities and selling overvalued equities.

So what exactly is a hedge fund manager and what do they do? A hedge fund manager is normally the founder and the key person in charge of overseeing the whole operation of the hedge fund. This would mean that he/she would be responsible for overseeing the portfolio, often making trading decisions, hiring personnel, monitoring the risk of the portfolio and ensuring that the accounting and operations departments are in order. The hedge fund manager is often referred to as the principal or president and can also be called the portfolio manager.

Hedge funds vary in size from assets under management from as little as $1 million to over $10 billion. Unlike at a typical investment bank, the roles of the employees at hedge funds are not the same for each hedge fund. Someone entering an investment bank as a trader will likely have a similar role to someone else entering another investment bank as a trader. Traders at hedge funds are likely to have different responsibilities, which are usually determined by the size of the fund. At a smaller fund, the trader is much more likely to be involved with the operations of the trade whereas a larger hedge fund would have a separate operations person to handle this element. A smaller hedge fund may have 3- 4 employees whereas a larger hedge fund may employ over 300 people.

Hedge Fund Culture

Hedge funds vary in sizes, ranging from as little as 2 employees to as large as 500 employees. Consequently, the culture of a hedge fund is hard to generalize/standardize. Since, the nature of the business is comprised of many small hedge funds that are run like small businesses the culture of the firm is determined by the owner, or in this case the hedge fund manager.

By nature the hedge fund managers are (on the whole) a little more intense than traditional mutual fund money managers. This is because they have a lot at stake with the success of their funds so are more likely to be involved with the day-to-day running of the firm. The hedge fund manager's performance determines his or her livelihood and also his or her own net worth. This pressure on the manager means that they have a high level of involvement and interaction with most of the staff. But, as a hedge fund grows this interaction will be reduced.

Working at a hedge fund is not like working at an investment bank or a traditional mutual fund. Most of these operations exist within larger organizations, with departments that are designed to ease the workload of the investment bankers or traders at a mutual fund. For example, there are human resource and marketing departments that assist with recruitment of new employees and marketing the funds. This eases some of the pressure from the management at investment banks and mutual funds. Unlike these structured organizations, most hedge funds do not have large human resource or marketing departments and therefore this burden falls on the management of the hedge fund. All these responsibilities can make for a busy work schedule for the hedge fund manager and also mean that the employees are expected to help in various areas such as assisting with interviews of new employees and also assisting with putting together marketing documents.

The culture of hedge funds varies tremendously from the culture of another. This is because the culture is likely determined by the hedge fund manager's own personality and beliefs. A fund's strategy can also determine how the culture of the firm is affected. For example, a statistical arbitrage fund is likely to be staffed with PhD's who are less outgoing and enjoy crunching numbers in a room, while a global macro fund will have a more outgoing atmosphere with the employees watching the markets from a trading floor and openly sharing ideas. These are two stereotypes of cultures of different strategies and are likely not to be applicable to all statistical arbitrage and global macro funds, but can give you an idea for the differences to expect.

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Filed Under: Finance

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