What is a hedge fund?
The term hedge fund is a misnomer. There is very little if any hedging going on. By restricting who can invest hedge funds to wealthy sophisticated investors they are able to utilize an exemptions in the Securities exchange act of 1933 and the Investment company act of 1940.
The exemptions allow funds to trade strategies and markets that are not appropriate for average investors. The first hedge funds traded stocks by going long strong companies in a sector and selling short weak companies. This was in contrast to mutual funds that are only allowed trade long stocks.
This is where the name hedge fund came from. The hedge fund has evolved into an investment fund with few restrictions on what and how it can trade. A hedge fund can trade stocks, bonds, futures, options, currencies, OTC forwards, swaps, leaps, art, and really anything else they want.
They can do this by buying and going long or selling to go short and use leverage in search of higher returns. The reason so many hedge funds trade derivatives is the leverage. Being able to control a large amount of product with very little cash.
For example a hedge fund can go long a $100,000 of 10 year treasury notes using a futures contract by only putting up $2k in margin. To buy the physical t-note they would have to put up the full face value. Hedge funds work with a number of other parties depending on the strategy and the products they are trading.
Funds that trade stocks work with a prime broker who are large investment banks (companies like Goldman Sachs) to trade. Funds that trade currencies trade with the big banks. Funds that trade futures work with Futures Commission Merchants (FCM).
They can sell short as well as take long positions.
A hedge fund is a private, actively managed investment fund.1 Hedge funds seek to provide returns to their investors by investing in a diverse range of markets, investment instruments, and strategies.213 Hedge funds are subject to various regulatory restrictions, which generally limit participation to certain classes of accredited investors.
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