What is a hedge fund? Definition
So what is a hedge fund?
A hedge fund is an investment vehicle that allows the proprietors to make investments counter to other investments. Simply said, the owner or manager of a hedge fund “bets with both sides”. This can be done in many ways.
One of the simplest ways to do this is to buy a stock, but in a few ways. Our hedge fund manager, Mr. Shrub decides he likes a stock named Allie’s Audacious Apples (AAA) , a new apple company from Oregon. He buys 1000 shares of stock for the long term, appropriately called “buying long”. The initial share price of this stock is $10. This means that he simply pays his $10,000 ($10 x 1000 shares) and he receives his 1000 stock certificates (mostly electronic these days unless you specifically request a paper copy). Mr. Shrub had decided to buy this stock in the first place because he thought that over the long term–say 10 years–this stock would go up in value and price and would generally be a good buy.
Next, our brilliant fund manager Mr. Shrub decides that he can take advantage of some short term fluctuations in the market. Perhaps he thinks that this company will do well over the long term, but also thinks that when the CEO of Allie’s Audacious Apples makes the next quarterly announcement, people will find out about the particularly bad apple season in Oregon and will want to sell their shares of AAA. Since there are more sellers than there are buyers, the buyers will be able to find better deals and the price will go down. So how does Mr. Shrub take advantage of this?
Mr. Shrub does what is known as “selling short” and this is slightly more intricate than buying shares long. This is when you “borrow” shares of stock from your broker (either a person who sells you shares, or much more commonly these days, an electronic service that acts in a similar manner). After “borrowing” shares, you immediately sell them to the market for whatever price is being offered. In our example we’ll say he borrows the same 1000 shares and sell them at $10 for an immediate $10,000 in his bank account. What Mr. Shrub is hoping for is that the share price will fall on the news of the poor apple season. If the share price drops to $5, he then buys his “borrowed” shares back to give back to his broker and he gets to keep the rest of the money, in this case $5000.
So why do both?
For a few reasons actually. One is that you can try and make more money on an investment than if you simply (sell) short or (buy) long. Another, and probably the most cited reason, is that you can protect your investment. Say Mr. Shrub was buying AAA long thinking that the stock price would go up in 1 year instead of 10. This is less likely to happen because there will be less time for the company to grow. In fact, the the period of a year, AAA might only go down. In our example, he is safe because whatever shares he bought long, he also sold short. However, most hedge fund managers probably won’t do this because any gain will be offset by a loss. A much more likely approach will be that Mr. Shrub will weigh the chances that a stock will go up and if he is pretty sure it will go up he’ll buy mostly long and sell a few shares short. Although it’s true that his gains will not be as big as they could be, he will protect himself from huge losses if he sells some shares short.
This is only one of many many different ways that hedge funds work, but we think that it is the simplest to comprehend at the beginning. Keep tuning back into BrokenBroker.com for tips on how to invest the right way and see long term gains that many hedge fund managers can never obtain.
