Hedge Funds Semantics
Hedge funds are very risky investments. They invest in derivatives, employ unconventional trading strategies, and are usually greatly leveraged... All for the pursuit of extraordinary profits. A lot of hedge funds have come and gone and the survival rate is not encouraging. So why are they called "hedge" funds in the first place?
When we hear the word "hedge" we usually think of protection and safety. In finance, a hedge, usually in the form of derivatives, is used to protect an investment from loss. But it also limits the gains of the position as well. This makes potential earnings predictable and constant. Risk is eliminated since risk is defined as "uncertainty".
But looking at the hedging instrument individually, it is just as exposed to losses as other instruments. Moreover, derivatives are leveraged and losses are potentially greater than conventional assets. The hedge only takes shape if the hedging instrument is taken together with another position, and their reaction to changes in market factors should cancel each other out.
Hedge funds act in the same way. Taken alone, hedge funds are risky investments. But when combined with conventional funds, they can provide diversification benefits and even enhanced returns due unconventional strategies and assets employed. These unconventional strategies and assets result into low correlations with conventional funds.
I guess a lot of people assume that hedge funds are supposed to be safe investments because of the word "hedge". But if these funds are meant to safe in the first place, they should be called "hedged" funds instead.
Tags: finance derivatives hedge funds investments
4 comments:
Point taken. Sometimes it's better to classify funds by investment strategies. At least investors know what they're getting in to. But of course invenstment strategies may change during the life of some fund if allowed.
The term hedge fund is very misleading as most are quite risky. I always have to explain to people what hedge funds are, where the name comes from, and why the name isn't correct.
Correct me if I'm wrong. When hedge funds first started to appear on the radar, the traditional approach was a long-short strategy, where the risk exposure to a particular industry was hedged.
But I agree, that the term can be misleading.
...Especially now when all types of alternative investment vehicles and investment strategies fall under the Hedge fund umbrella.
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