Suppose you uncovered a fabulous model for successfully picking gold stocks. What would you do next? Chances are you would not broadcast your brilliant model to the world and invite others to participate in your success by copying you. What you might do instead is start a hedge fund. This is the alternative that we want to discuss in this overview.

We have chosen to classify hedge funds into two distinct groups: isolation funds and correlation funds. We do not define funds that employ derivatives and high leverage with no discernible strategy, or speculation funds, as hedge funds.

Isolation funds are hedge funds for which the investment strategy is to isolate unique or unsystematic effects using long purchases, combined with short sales to create a position with the desired market exposure. The manager can choose to isolate a particular stock, currency, commodity or other financial instrument from general market movements. For example, the manager might wish to isolate a particular sector from market effects, or a particular market from global effects. The traditional ratio between the choice of asset class and the skill of the manager is reversed for such funds, with the emphasis landing squarely on the manager's skill. Indeed, the rewards in place for hedge fund managers are designed to be lucrative for talented managers and so to attract the best.

Isolation funds come in many guises. Consider the following example.1 McDonald's develops a new low-fat, health-conscious hamburger and makes it part of the children's meal combination. Burger King quickly follows with its version of the same thing. The Burger King healthy hamburger tastes fabulous and the McDonald's one is unpalatable and hated by your children. Believing your children are representative of the average juvenile food connoisseur, you quickly buy Burger King stock and short McDonald's. You have just taken a market neutral position. Market neutral hedge funds typically invest equally in long and short equity portfolios, usually in the same sectors of the market. The portfolio is constructed in such a way that it is beta neutral, or uncorrelated to market movements.

Event-driven isolation hedge funds focus their investments on special situations, perhaps distressed firms or takeovers. For example, the strategy might be to buy the target firm and sell the takeover firm. The risk of the position is reduced by making the portfolio uncorrelated to the market. Other types of isolation hedge funds include convertible hedge funds, sector hedge funds and growth funds.

There are a host of investment strategies employed under the name of hedge funds. Most such funds are highly specialized and rely on the specific expertise of the manager; fund performance is not usually dependent on the performance of bond and equity markets. The success of many strategies is linked to how much capital can be successfully employed before the target returns diminish. As a result, the investor should expect that hedge fund managers might limit the amount of capital they will accept.

The hedge fund industry is large and growing fast. The estimated size of the industry was between $200 and $300 billion in 1999 and growing at 20 percent each year. There were then between 4,000 and 5,000 active hedge funds.2

There is significant merit to hedge fund investing. The expert manager is permitted to concentrate on the securities or sectors of his or her knowledge base. Residual risk is eliminated as cheaply as possible. In this way, much of the dead weight of other fund strategies is mitigated. This investment vehicle is not without drawbacks or cautionary warnings. Though the expected returns from, for example, an isolation fund are high, there is significant risk of loss. The expert hedge fund manager is not bailed out by market forces. Another potential difficulty is the degree of ambiguity for the term "hedge fund." The investor considering hedge funds should investigate carefully and thoroughly before taking the plunge.

Endnotes
1. This example comes from an article available on the Hedge Fund Association web site at http://www.thehfa.org.
2. This information comes from the Hedge Fund Association web site at http://www.thehfa.org.

Eric Kirzner is a professor of finance and Alex MacKay is an assistant professor of finance at the Rotman School of Management, University of Toronto.