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What is a hedge fund?


These days the term hedge fund refers to an investment portfolio generally open only to wealthy individuals and institutions and therefore unregulated by authorities like the Securities and Exchange Commission. These pools of capital either operate in markets that are not in the mainstream, such as commodity futures or foreign currency, or they do operate in mainstream markets but with methods that are out of the mainstream. A fund might trade stocks, for instance, but rather than buying and holding them, it trades in and out, keeping positions for as little as a few minutes to try to make a small but fast profit. Hedge funds can make big one-way bets, but they often go short as well as long – borrowing a stock or other asset that it doesn’t own in the hope that it can sell it and then buy it back cheaper later to turn a profit.
Holding long positions in some securities and short ones in others is a common strategy in hedge funds, and it’s how they got their name in the first place. Although a portfolio that bets for and against the same type of asset might seem unlikely to make or lose much money, managers of funds like these believe that they are skillful enough to do it. They think that they can discern which assets are superior or inferior to the broad market and make money by buying the first kind and selling the second kind. To magnify their profits, they often borrow heavily, controlling many dollars’ worth of assets with each dollar of real money. When it works, it can be fabulously successful. When it doesn’t, it can go spectacularly wrong, leaving shareholders with huge losses.
-Conrad de Aenlle