Opinions about the alternative investment category known as hedge funds have fiercely divided consultants, institutions, and even the media. Almost everyone has an opinion about them, but almost no one understands what they are or how they function.
Hedging has been traditionally defined as protection from some kind of downside risk. In the context of investments, hedging protects investors from declining markets. Hedge funds have an absolute performance objective, which means they emphasize absolute return as opposed to returns relative to a benchmark or index. Consequently, the work hedge fund managers do is usually considered more skills-based.
The reason for the level of negative publicity surrounding hedge funds is that limited understanding breeds uncertainty. For example, 1998 was a disastrous year for hedge funds. Russia had defaulted on its ruble and domestic debt. The stock market began to tumble, which sent panicked investors running to the fixed-income markets. To protect themselves from falling equity returns, investors bought up high-quality Treasury and other government bonds. As a result, credit spreads between high-quality and risky debt increased dramatically, reversing the narrowing trend. Many hedge funds that had bet on those narrowing spreads and were heavily invested in fixed-income securities suffered tremendous losses and were forced to liquidate, deleverage, or, ultimately, go out of business. Hedge fund lenders reduced their credit lines, further compounding the losses. If anything good came out of these events, it was that regulators and investors have kept a watchful eye on the hedge fund industry ever since. Hedge fund managers that quietly go about their work of creating investment strategies and opportunities aren't very newsworthy, but speculative or even fraudulent hedge funds always make headlines.
Another common misconception about hedge funds is that, unlike traditional asset classes, not every hedge fund is interested in every investor's money. Hedge funds tend to be selective. Capacity remains one of the largest internal barriers to opportunity for hedge funds because as a fund grows, its managers are often forced out of the very strategy that was crucial to performance. Ironically, large institutions have too much money to even be considered by an existing hedge fund manager because a large institution will reduce the fund's capacity very quickly.
Hedge funds are attractive to investors because they have a low correlation to traditional asset classes. The low correlation comes from the manager's ability to reduce risk by hedging, combining long and short positions, and diversifying across various financial instruments. But investors struggle with the fact that the hedge funds encompass many styles and strategies. Hedge funds don't simply mean market-neutral or long/short strategies. …