Characteristics, Strategies and Aspects of Hedge Funds

Seminar Paper, 2007

15 Pages, Grade: 1,1



1. Introduction

2. Hedge Funds
2.1 Definition
2.2 History
2.3 Characteristics of hedge funds
2.3.1 Absolute return target
2.3.2 Flexibility in investment
2.3.3 Use of Leverage
2.3.4 Illiquidity of the invested capital
2.3.5 Little transparency
2.3.6 High minimum investment
2.3.7 Performance linked compensation
2.3.8 Less regulated environment
2.4 Strategies of hedge funds
2.4.1 Relative Value
2.4.2 Event Driven
2.4.3 Directional or opportunistic Strategies
2.4.4 Multi-Strategy
2.5 Positive Aspects
2.5.1 Option for portfolio diversification
2.5.2 Increase market efficiency
2.5.3 Negative feedback trading
2.5.4 Supply markets with liquidity
2.5.5 Overtake risk for other market participants
2.6 Negative Aspects
2.6.1 Increase of market volatility
2.6.2 Transmission of instability
2.6.3 Market risk
2.6.4 Complicate political desired corrections

3. Conclusion

1. Introduction

With the recent announcement of the investment bank Bear Stearns that two of their hedge funds High-Grade Structured Credit Enhanced Leverage Fund and High-Grade Structured Credit Fund had become nearly worthless, the discussion about hedge funds was newly rekindled. The funds were mainly invested in the market for mortgages loans to debtors with a medium or low degree of credit worthiness, the so called sub prime lending. They traded with collateralized debt obligations (CDO), which bunch the risk of those loans. Due to the decline in prices of properties and the increase in interest rate debtors got into trouble. Therefore the CDOs lost worth and the funds became bankrupt. Even if that is very problematic for the investors and the investment bank some economists think, that there could occur bigger problems. Meanwhile there are rumours that other funds got into trouble and economists worry that they could destabilize the whole financial system, due to their close relations to other financial institutions. Banks, in particular, which financed the funds, are in danger of being affected.[1]

Whether this small crisis will spread or not can actually not be answered. In the next days and months that remains to be seen.

But for sure the discussion about hedge funds will be renewed. Therefore this essay will deal with that complicated topic. It is tried to explain what hedge funds are and how they work. For this purpose, first of all a proper definition for hedge funds is given. Secondly, the origin of hedge funds will be described and then the typical characteristics will be elaborated. Next, there is a short overview of the common strategies and about the development of hedge funds given. In the last part, the positive and the negative aspects will be described. Finally a short summary and a future outlook will end this paper.

2. Hedge Funds

2.1 Definition

Actually there are a lot of different definitions, but the international financial services London gives the following, that provides more common sense of the most ones.

“Hedge funds are private pooled investment limited partnerships which fall outside many of the rules and regulations governing mutual funds. Hedge funds therefore can invest in a variety of securities on a leveraged basis. Today, the term hedge fund refers not so much to the hedging techniques hedge funds may employ as it does to their status as private investment partnerships.”[2]

2.2 History

Hedge funds have their seeds in the ideas of Karl Karsten, who was the first one to develop and to use trading strategies based on scientific methods[3]. But historically, the beginning of the hedge fund industry is dated 1949, when Alfred Winslow Jones founded the first long-short equity fund. He added two new elements to the previously traditional portfolios of his investment company. He used short sales and borrowed capital to improve the performance of his fund. Thus, due to the combination of short and long positions he was able to neutralize a part of the market risk and due to the use of leverage, he boosted the performance of the chosen securities. Though his funds performed very well, it took years (until 1966), until an article about him was published, that his idea spread in the fund industry.[4]

In that article, the performance of different funds was compared and the published result was that Jones fund developed better than the best traditional funds. In the following years, more than 100 hedge funds had been founded, but a lot of them were closed again during the crisis in 1973/74. After that setback, the hedge fund industry made a comeback in 1986 when there was another article about the fund of Julian Robertson, who used the global macro strategy and managed to increase value of his fund up to 750%. Despite of the LTCM-crisis in 1998, the number and assets under management grew faster and faster since 1990.[5] One can see in chart 1 the number of hedge funds has increase from 610 funds with about 39 billion US$ under management to about 3870 funds with assets under management of 490 US$ in 2000. Since then there was another enormous growth and the number enhanced to 9228 funds with a estimated value of about 1.4 trillion US$ in 2006. More than one trillion are in the US, about 325 billion are managed in Europe and 115 billion US$ are in Asia.[6]

illustration not visible in this excerpt

Chart 1: Growth of the hedge fund industry (Source: Ferguson (2007), S. 46)

2.3 Characteristics of hedge funds

Even if hedge funds are very heterogeneous most of them have certain characteristics in common.

2.3.1 Absolute return target

One of the most important targets in differ to traditional funds, which normally try to perform better than a certain benchmark, is the absolute return target. It means simply that hedge funds want to achieve a positive return, independent from the market development.[7]

2.3.2 Flexibility in investment

To realize this target, they are very flexible in the choice of their investments. They use short sales and also derivatives for speculations to improve their performance.[8]


[1] Vgl. Semmler Willi (2007)

[2] vgl. IFSL (2007), S. 2

[3] vgl. Peetz Dietmar (2007), S. 43

[4] vgl. Bankenverband (2005), S. 3

[5] vgl. Bundesverband alternative Investments (2003), S. 15f

[6] vgl. Ferguson (2007), S. 46

[7] vgl. FMA (2005), S. 9

[8] vgl. FMA (2005), S. 9

Excerpt out of 15 pages


Characteristics, Strategies and Aspects of Hedge Funds
Berlin School of Economics
National and International Financial Relations
Catalog Number
ISBN (eBook)
ISBN (Book)
File size
445 KB
Hedge, Funds, National, International, Financial, Relations
Quote paper
Daniel Detzer (Author), 2007, Characteristics, Strategies and Aspects of Hedge Funds, Munich, GRIN Verlag,


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