Hedge Fund Analysis: An In-Depth Guide to Evaluating Return Potential and Assessing Risks

Chapter 2

Hedge Fund Asset Class

“I playfully suggest that they drop the ‘h’ and become ‘edge funds.’ After all, their claim is they seek an edge on the rest of the market.”

Sebastian Mallaby, author of More Money Than God

Chapter 1 provided historical context for the hedge fund industry, from its obscure beginnings to its current status as a major influence in global financial markets. This chapter will define the modern hedge fund, highlight the major strategies, and discuss how and why hedge funds fit in the asset allocation picture.

Definition

When I think of a hedge fund, I think of a private investment vehicle in which the underlying investment manager offers some unique “edge” that is embedded within the process, systems, or the investment team. It can be something tangible, such as a quantitative model that interprets data in some unique way, or it can refer to a more qualitative edge, such as the stock-picking ability of the fund's managers.

The term hedge fund is a bit of a misnomer, as there are many hedge funds that do not actually hedge at all while others hedge only some of the time.

To be more formal, hedge funds can be defined as an investment structure for managing a private investment pool that can invest in physical securities and derivatives markets. They can employ leverage and have an absolute return mandate. Legally, they can take the form of a limited partnership, corporation, trust, or mutual fund based on where the fund is domiciled.

In any case, there ...