Let us start with "Hedge Fund"

"Hedge fund" is a general, non-legal term that was originally used to describe a type of private and unregistered investment pool that employed sophisticated hedging and arbitrage techniques to trade in the corporate equity markets. Hedge funds have traditionally been limited to sophisticated, wealthy investors. Over time, the activities of hedge funds broadened into other financial instruments and activities. Today, the term "hedge fund" refers not so much to hedging techniques, which hedge funds may or may not employ, as it does to their status as private and unregistered investment pools.

A Short History and the Definition of a Hedge Fund

The first hedge fund was set up by Alfred W. Jones in 1949. Jones was the first to use short sales and leverage techniques in combination. In 1952, he converted his general partnership fund into a limited partnership investing with several independent portfolio managers and created the first multi-manager hedge fund. In the mid 1950's other funds started using the short-selling of shares, although for the majority of these funds the hedging of market risk was not central to their investment strategy.

In 1966, an article in Fortune magazine about a "hedge fund" run by a certain A. W. Jones shocked the investment community. Apparently, the fund had outperformed all the mutual funds of its time, even after accounting for a hefty 20% incentive fee. This is because the rate of return was higher on the hedge fund versus all other mutual funds.

Facts about Hedge Funds
-Estimated to be a $1 trillion worldwide industry and growing at about 20% per year, with approximately 8350 active hedge funds in the world.
-Includes a variety of investment strategies, some of which use leverage while others are more conservative and employ little or no leverage. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or derivatives.
-Their returns over a sustained period of time have outperformed standard equity and bond indexes with less volatility and less risk of loss than equities.
-The popular misconception is that all hedge funds are volatile -- that they all use risky techniques and strategies and place large bets on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge funds are of this sort.

Useful Terms

Arbitrage: the simultaneous buying and selling of securities in different markets with the purpose of profiting from the price difference in the markets.

Derivative: a volatile financial instrument whose value depends on or is derived from the performance of a secondary source such as an underlying bond or currency.

Hedge: making arrangements to safeguard against loss on an investment (can involve various techniques)

Leverage: the use of credit (such as margin) to improve one's speculative ability and to increase the rate of return on an investment

Short Sale: a sale of a security that the seller doesn't own (if the seller does own the security she is said to be in a long position), and that the seller must borrow. Usually, the technique is employed when prices drop. If the price of the security does drop, the seller can make a profit on the price of the shares sold versus the price of the shares bought to pay back the borrowed shares.