The first hedge fund began in 1949, when Alfred Jones, a sociologist and journalist, bought his favourite stocks and short-sold stocks he felt were overvalued. This was the first market-neutral hedge fund. The subsequent 50 years have seen tremendous growth in hedge funds, culminating in the Long Term Capital Management situation three years ago.

A hedge fund is characterized by its investment flexibility; it can short, borrow, use derivatives and do many things that mutual funds, for example, cannot easily do. Hedge funds also typically feature a heavy dose of management incentives. For example, managers are typically the general partners in a limited partnership, putting much of their own capital at risk in the hedge fund. Also, the managers typically receive much of their fees in the form of performance bonuses, which are only earned if profits exceed some minimum level (often cumulated over time).

These types of features are possible because hedge funds are free from The Securities and Exchange Commission (SEC) regulation. Hedge funds escape SEC scrutiny in the U.S. by forming as a limited partnership, not advertising to the public and only attracting sophisticated investors. Offshore hedge funds form in tax-neutral jurisdictions and allow non-U.S. investors to invest without U.S. tax consequences or SEC oversight.

MANY STRATEGIES
Hedge funds follow many strategies, not all of which are market neutral. Big bets can be taken in individual stocks, as Alfred Jones did, or bets can be taken in sectors, countries or on major macroeconomic events, like interest and foreign exchange rate changes.

For example, George Soros' Quantum Fund and the Long Term Capital Management fund were both classified as global macro funds, which made bets on, among other things, global interest rate moves, with liberal use of leverage and shorting available. Sophisticated investors who are allowed to invest in hedge funds are supposedly prepared to bear the risk of such strategies.

As of 2000, about US$200 billion is invested in nearly 1,000 hedge funds. Basic management fees are from 1% to 1.5% of assets under management. Additionally, 15% to 20% of profits go to the manager as a bonus. While the hedge fund industry is small by mutual fund standards, it has grown substantially over the last 10 years.

Some hedge funds have shown dramatically good returns, while some have not. The years 1994 and 1995 were difficult for hedge funds, and so sample periods that involve these years don't show average or median hedge fund returns that are significantly better than passive indices.

Hedge funds do have higher volatility (standard deviation of return) than passive indices. However, because many hedge funds are market neutral, the typical hedge fund has very low systematic risk. Thus, comparing hedge fund returns to an equivalent-systematic-risk (low beta) passive benchmark indicates good risk-adjusted performance for hedge funds. In addition, hedge funds have low correlations with traditional asset classes.

Are hedge funds an asset class of the future? The freedom to choose more active strategies and the strong incentives to succeed built into most hedge funds would lead one to view hedge funds as a positive addition to most institutional portfolios. Low observed correlations with traditional asset classes would also seem to be a positive. However, standard mean-variance analysis often used when studying hedge funds may overlook a non-symmetry of hedge fund returns. A small probability of a large loss may avert the interest of some investors. Long Term Capital Management might be just that example.