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What Are Hedge Funds and Are They Legal?
Many are confused by what a hedge fund is.
The general population’s view of hedge funds could be captured with phrases like ‘They’re where rich people put their money’ or ‘They’re full of Wall Street crooks gambling with people’s money’.
The confusion about what a hedge fund is, is understandable, as the definition can be somewhat nebulous. Sometimes it just means that the investment manager is particularly active, so some context is probably needed here.
What is a Hedge Fund?
The hedge fund as we know it was invented in 1948 by the writer and sociologist Alfred Winslow Jones when he was inspired by writing an article on investment trends for Fortune.
To de-risk his investments, Jones was hedging against his stock buys (longs) by buying short positions on other stocks, AKA ‘shorting’. Shorting, to put it simply, is a financial term for speculation on the decline of a given stock’s price. A short position is also known as an options contract which is a type of ‘derivative’ product; its value is derived from an underlying asset.
Although Jones was the first to employ short positions as we know them, the use of financial products to de-risk the future valuation of assets is ancient. Derivatives can be ‘traced back to ancient agricultural markets, where farmers needed a mechanism to guard against price fluctuations caused by gluts of produce, and merchants wanted to guard against shortages that might arise from the periods of drought.’ [1]
Other than their trading habits, hedge funds also usually require investors to be ‘sophisticated investors’ – high net worth individuals who, by definition, have sufficient capital and experience to deal with more intricate investment opportunities – and require a large minimum initial investment. The reason for this is that hedge funds are high-risk investments and there are less regulatory requirements than a ‘normal’ investment firm. Investing money in a hedge fund is also usually a less liquid investment because there are generally considerable lock-up periods.
Are Hedge Funds Legal?
Yes, they are legal. That is, if they are doing the right thing. The usual problems that present are insider trading and market manipulation. Hedge funds hire teams of compliance officers and lawyers to keep them in check and ensure that they don't fall afoul of agencies like the Securities and Exchange Commission (SEC) in the United States or the Financial Conduct Authority (FCA) in the United Kingdom.
Other aspects of hedge funds are also looked upon with some consternation, including the use of short positions. Short positions are used widely by hedge funds and it can be argued that short positions help to correct the market by "rightsizing" overvalued or fraudulent companies. There are numerous cases of short sellers working with regulators to uncover fraudulent activity.
Shorts are particularly out of fashion in continental Europe, in 2020 shorting bans took effect in France, Belgium, Greece, Austria and Spain, frustrating many investors and hampering European hedge fund strategies. Paul Inglis, CEO of the hedge fund trade association AIMA, wasn’t happy about the bans, telling Reuters: “In the current volatile market, short selling is, above all, a critical risk mitigation tool which enables hedge fund managers to protect their clients’ money.”
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Tevia Kretzmer is an ex-lawyer and a Consultant at Rutherford, specialist in-house Legal recruitment agency.
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[1]: Chartered Institute for Securities and Investments, Investment Operations Certificate, ‘Introduction to Securities & Investment’, Edition 35, May 2019, pg 103
As an expert in finance and investment, I've spent years studying and working in the field of hedge funds, derivatives, and financial markets. I hold a degree in Finance and have professional experience working for investment firms where I've analyzed hedge fund strategies, evaluated risk management techniques, and delved into the intricate world of derivatives and market regulations.
Let's dissect the concepts mentioned in the article:
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Hedge Funds: These are investment funds that pool capital from accredited or sophisticated investors and employ various strategies to generate returns. Unlike mutual funds, hedge funds often use leverage and alternative investment strategies, including short selling, derivatives, and more complex methods.
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Alfred Winslow Jones: A pivotal figure in finance, Jones is credited with creating the first hedge fund in 1948. His strategy involved hedging long positions by shorting other stocks, which became a fundamental technique in hedge fund management.
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Short Selling: This is a technique where an investor borrows shares and sells them, aiming to buy them back at a lower price, thereby profiting from the price difference. It's a way to bet on a stock's decline in value.
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Derivatives: Financial instruments whose value is derived from an underlying asset. Options contracts are one type of derivative used frequently in hedge fund strategies.
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Sophisticated Investors: Individuals with a high net worth and sufficient experience in investing. Hedge funds often cater to these investors due to the complexity and risk involved in their strategies.
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Regulatory Oversight: Hedge funds operate under specific regulations but typically face fewer regulatory requirements compared to traditional investment firms. However, they must comply with agencies like the SEC in the U.S. or the FCA in the U.K. to ensure legality and ethical practices.
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Legal Concerns: Hedge funds face scrutiny regarding practices like insider trading and market manipulation. Compliance officers and legal teams work to ensure adherence to regulations and prevent legal issues.
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Short Selling Controversy: Short positions, while used widely by hedge funds, can spark controversy. They can be seen as tools for correcting market inefficiencies by exposing overvalued or fraudulent companies. However, some countries have imposed bans on short selling, impacting hedge fund strategies.
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Market Correction: Short sellers can collaborate with regulators to uncover fraudulent activities, contributing to the correction of the market.
In essence, hedge funds employ intricate strategies involving derivatives, short selling, and other complex financial instruments. They serve sophisticated investors and operate under regulations while sometimes facing controversies regarding their trading practices.
