What is a Hedge Fund and How do Hedge Funds Work

In 1949 the first hedge fund was established by Alfred W. Jones. He used a combination of short sales and leverage techniques, which was later transferred to a limited partnership. This led to the creation of the first multi-manager hedge fund in cooperation with a number of independent portfolio managers. Even though the hedging of market risk was not in the focus of attention of most funds, they later realized the benefits of this investing mechanism and incorporated the short-selling of shares into their services.

The first success of hedge funds was announced in 1966 when several of them managed to outperform all of the mutual funds. Success was achieved despite the high incentive fee, which during these years was around 20%. Hedge funds managed to outperform all of the mutual funds thanks to their significantly higher rate of return.

Initially, the term hedge fund was used to describe a type of private investment pool, unregistered in its character, which included the use of hedging and different arbitrage techniques for the purposes of trading on the corporate equity market. When hedge funds were first introduced, only wealthy investors with large amounts of assets were able to benefit from them. However, as time passed, hedge funds managed to enrich their portfolio of services to lure other investors. Nowadays most investors refer to hedge funds as unregistered and private investment pools, in which hedging techniques may be applied, but it is not obligatory.

Hedge funds carry many of the characteristics of mutual funds. The basic similarity refers to the pooling together of the money of several investors for the purposes of investing in different securities. Hedge funds defer from mutual funds by the rules that regulate their activities. The US legislation facilitated the avoidance of registration with the SEC by hedge funds, whereas the activities of mutual funds are closely regulated by the institution.

On the other hand, Europe has imposed several limits on hedge funds. For example a tool used is the regulation on who can invest in a hedge fund. Additionally, European legislation imposes limits on the minimum subscription level that is obligatory for investing in a particular hedge fund.

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