There is perhaps no term as misunderstood in the financial world as hedge fund, which is usually accompanied by some boiler plate definition referring to loose regulation, high risk and secrecy. In reality many hedge fund strategies are less risky than standard long-only mutual funds. Hedge funds utilize multiple strategies, most of which provide diversification from typical stock and bond portfolios.

Perhaps the confusion stems from the need to pigeon hole what these strategies are and what the do. Despite the massive growth estimated to be more than $1 trillion (see No stopping them, below) hedge funds are still a small fraction of what is invested in standard mutual funds strategies. While the standard mutual fund investments tend to be a somewhat homogeneous stock and bond portfolio, though that is changing, hedge funds are heterogeneous. Basically hedge funds use regulatory exemptions to avail themselves of a vast array of assets and investment strategies. While the trading methodologies and logic behind them may be complex, it does not, despite popular wisdom, translate into greater risk.

The term hedge is defined as a transaction that reduces the risk in an existing investment position. How it became synonymous with high risk is debatable. The industry a long time ago seemed to have struck a bargain with regulators that allowed them freedom as long as they kept these strategies to high net worth individuals and institutions. The secrecy of hedge funds is not the result of opaque strategies and shady investments as much as the regulatory structure that requires managers to refrain from not only offering these products to retail investors but from even holding themselves out as investment advisors.

This structure is similar in other jurisdictions though there appears to be a greater ability to create retail structures to offer hedge fund strategies. Guillaume Dehan, a spokesperson for French-based John Locke Investments, says most managed futures programs in Europe are offered as listed funds and though they cannot market to retail, retail investors can invest in those funds through banks. It is a good investment for retail, Dehan says.

French business school Edhec produced a study showing an allocation of 20% to hedge funds can reduce a funds probability of extreme loss by 50%. Hedge funds have a [large] amount of investment freedom. They are not tightly regulated but their distribution is somewhat restricted. That is the same in continental Europe. The only way retail investors can invest in hedge funds is through fund of funds, says Edhec research engineer Felix Goltz.

IN THE BEGINNING

The first hedge fund strategies are believed to have been started by Alfred Winslow Jones in 1949. Jones sought to eliminate market bias by simultaneously buying undervalued stock while selling short overvalued stock. The idea behind balancing long and short positions was that overall market risk would be reduced and performance would be based on skill instead of overall market performance. He also employed leverage, which was possible because of the reduced risk in his portfolio. While Jones was an innovator by creating long/short portfolios, his funds would not be classified as market neutral, notes Carol Kaufman, founder and CEO of TLC Alternatives. In the 1970s a number of hedge funds collapsed because they tried to employ long position leveraging techniques that Jones used successfully in the 1960s, but in the 1970s bear markets, they failed. But in the 1980s, hedge funds outperformed the S&Ps..

Today the definition of a hedge fund has expanded significantly but the underlying defining characteristic is still the ultimate goal: To hedge against a declining market and still perform well in a rising market, Kaufman says.

But the defining characteristic of hedge funds for many is the use of leverage. The use of leverage always scares people. Leverage is associated with risk. It is associated with pyramid schemes, Kaufman says. However, leverage is best understood through futures style margining. The level of leverage allowed in a futures account (margin required) is directly correlated with the risk associated with the position.

Most people dont understand futures. If you go into a traditional investment firm, they really still are not as accepting of the futures industry; they may actually be more accepting of the hedge fund industry because hedge funds incorporate traditional instruments into a hedge fund portfolio. But if you go to a traditional firm and try to talk to them about futures, what scares them is the leverage and not understanding that leverage and risk are controllable, Kaufman adds.

At a forum at the Managed Funds Association Network conference in Key Biscayne, Fla. in February that point was made by Bruce Cleland, president of Campbell and Co. Cleland noted institutional investors are much more comfortable with investing in what they would term a hedge fund than when confronted with investing in a futures trading strategy.

This disconnect is somewhat troubling because as an instrument of diversification, managed futures suits the needs of institutional investors arguably better than most hedge fund strategies. Managed futures score better on a noncorrelation test; and on the critical issue of transparency, managed futures offer daily liquidity. But in a report analyzing the fundamental return characteristics of hedge fund strategies, Lyra Capital found the strategies utilizing the highest amount of leverage also produce the highest Sharpe ratios, a measure of risk adjusted returns.

HEDGE FUND ANYONE?

The term hedge fund refers more to a structure than a strategy. But while the traditional investment industry likes to caution investors on the risk of hedge funds, many are mimicking hedge strategies to juice up returns. The Wall Street Journal reports the likes of Oppenheimer, Allianz, Janus Capital Group and American Century as utilizing hedging techniques. There also are indexes of hedged mutual funds.

While the traditional world is learning to hedge, other alternative investment strategies are adopting the hedge fund structure adding to the number of disparate strategies. Private equity is going to be another strategy, so is insurance, so is real-estate I have even been reading lately about wine funds, Kaufman says.

Private equity or venture capital groups are not synonymous with hedge funds but many are adopting its structure. The Childrens Investment Fund (TCI) has caused a stir in Europe by working to break up Deutsche Brses (DB) bid for the London Stock Exchange. TCI played a role in the resignation of several DB board members and are acquiring significant stakes in Euronext and are thought to be pushing a merger of the two European titans.

TCI is referred to in articles not as a private equity firm but as a hedge fund. Its strategy may or may not prove profitable but it is odd that they can be lumped together with trend following commodity trading advisors, forex traders and even convertible arbitrage players. John W. Henry wouldnt tell a farmer how many soybean acres to plant, he would just buy or sell soybeans based on his model.

You cant talk about hedge funds and group them together as one category because these are different strategies. You should talk about the strategies that they employ, Goltz says. A retail investor in a pension fund thinking about allocating to hedge funds [is] really not asking the right question.

Goltz says an allocator needs to determine what exposure he needs to a group of alternatives. Which strategies should [be added] and how much of which strategy? There should be more of a focus on the actual strategy rather than just the structure of hedge funds. You cant say anything about hedge funds; you can only say something about the actual strategy.

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