The name hedge funds can be confusing because it is not the case that these funds hedge with its strategies only against losses. Moreover they absorb risks and focus on misvalues of shares or markets they have identified. In this way hedge funds try to achieve high yields by using appropriate strategies in the right time. Therefore hedging can only be a part of the strategy as it secures the portfolio against risks which the hedge fund has not included. The final success of the investment of hedge funds ultimately depends on the correction of assumed misvalues. Alfred Winslow Jones was the founder of the first hedge fund in 1949 and obtained the idea to eliminate the unpredictable market trend.
Therefore he launched an investment company named “Jones Hedge Fund” which was the first hedge fund worldwide. But his invention was not in demand until 1962 when the stock market collapsed. While all shares and funds lost their value, the “Jones Hedge Fund” reached an absolute return due to the falling prices of shares. The reason for this phenomenon will be explained in the fourth chapter. Since then hedge funds became
quite popular even though the real break trough started during the
technolgy boom in the 1980’s. The total capital asset under management of hedge funds was in the beginning less than 200 million US Dollar which has been extensively growing up to 25% in average in the last 16 years. Although they have been growing a little weaker with approximately 19 % for the last six years, their asset under management is risen of approximately 1.5 billion US Dollar. So far there is no predicted end in sight. But surprisingly they represent a relative small size compared to the asset management industry. Furthermore due to the remarkable growth of hedge funds, the significance on the financial market is increasing and ensures a continued attention of public authorities and the financial community. The following chapters will show the position of hedge funds in the present time and discuss the role of hedge funds on the financial market as well as possible chances and risks.
Table of Contents
1. THE BEGINNING OF HEDGE FUNDS
2. WHAT ARE HEDGE FUNDS?
3. HOW DO HEDGE FUNDS WORK?
4. THE FIRST HEDGE FUND
5. CLASSIFICATION OF HEDGE FUNDS
5.1. Relative Value (Arbitrage Strategy)
5.2. Event Driven
5.3. Directional Strategy
5.3.1. Quantum Fund
5.3.2 Long Term Capital Management (LTCM)
6. HEDGE FUNDS IN GERMANY
7. POSSIBLE DANGERS FOR FINANCIAL MARKETS THROUGH HEDGE FUNDS
7.1. The Risk through Leverage
7.2. Risk for the banking section
8. POSITIVE EFFECT OF HEDGE FUNDS
9. CONCLUSIVE STATEMENT TO HEDGE FUNDS
Objectives and Topics
This paper examines the evolution, classification, and economic impact of hedge funds within the national and international financial landscape. The primary goal is to analyze how these alternative investment vehicles function, the risks they pose to global financial stability, and the positive contributions they offer to market efficiency.
- Mechanisms and strategies utilized by hedge fund managers.
- The historical origin and developmental path of hedge funds.
- Risk assessment, focusing on leverage and systemic banking risks.
- The regulatory environment and growth of hedge funds in Germany.
- The dual role of hedge funds as both market disruptors and providers of liquidity.
Excerpt from the Book
3. How do Hedge Funds work?
Truly independent from the risk hedge funds absorb, they all attempt the goal to achieve an absolute positive return under all market conditions. This means other than traditional investment funds like mutual stock- and real estate funds, hedge funds, as a species of alternative funds, do not depend on a rising market performance to obtain a good rate of return. Furthermore they expect exclusively absolute positive returns on a quite volatile market. The conditions are positively ruled for the hedge fund managers, to provide a quick reaction to any possible chances that arise on the market. Mostly they trade extensively with derivatives and short-sellings, which happens with little amounts of equity and a multifold of borrowed money to achieve a good leverage. The aim is a notable return on investment and a maximum gain on profit. However the combination of short- selling and leverage increases the risk of high eventually even total losses because of unexpected negative market events. Therefore the salary for hedge fund managers depends on their success because they usually get 15 to 25% of the profit they make and another 1- 2% of management fee. The moral hazard shall lower the risk when hedge fund managers trade with large amounts of money which their investors have put in. For this reason they also need to invest a very high contribution of their own assett in this investment to prevent immoderate high risks. Otherwise if this fails, hedge fund managers will lose automatically their invested capital as well.
Summary of Chapters
1. THE BEGINNING OF HEDGE FUNDS: Discusses the origins of hedge funds, tracing their inception to Alfred Winslow Jones in 1949 and their growth during the 1980s.
2. WHAT ARE HEDGE FUNDS?: Defines hedge funds as largely unregulated, flexible investment vehicles that operate outside traditional market constraints.
3. HOW DO HEDGE FUNDS WORK?: Explains the reliance on absolute return strategies, leverage, and short-selling to generate profit regardless of market direction.
4. THE FIRST HEDGE FUND: Details the foundational investment tools, such as long/short equity and leverage, introduced by the first hedge fund.
5. CLASSIFICATION OF HEDGE FUNDS: Categorizes funds into three primary strategies: Relative Value, Event Driven, and Directional Strategy.
6. HEDGE FUNDS IN GERMANY: Examines the regulatory hurdles and the gradual legalization process for hedge funds in the German market.
7. POSSIBLE DANGERS FOR FINANCIAL MARKETS THROUGH HEDGE FUNDS: Addresses the systemic risks posed by high leverage and the potential for spillover effects into the banking sector.
8. POSITIVE EFFECT OF HEDGE FUNDS: Highlights the role of hedge funds in providing market liquidity and enhancing overall financial market efficiency.
9. CONCLUSIVE STATEMENT TO HEDGE FUNDS: Summarizes the growth prospects, regulatory needs, and the complex balance of risk and reward associated with hedge funds.
Keywords
Hedge Funds, Absolute Return, Leverage, Short-selling, Financial Markets, Risk Management, Arbitrage, Quantum Fund, LTCM, Market Efficiency, Liquidity, Investment Strategy, Financial Regulation, Derivatives, Capital Management.
Frequently Asked Questions
What is the fundamental focus of this paper?
The paper provides a comprehensive analysis of hedge funds, exploring their definition, strategic mechanisms, historical context, and the economic impact they have on modern financial systems.
Which thematic fields are central to the work?
The central themes include the classification of trading strategies, the role of leverage, systemic risk assessment, and the regulatory challenges faced by hedge funds globally.
What is the primary goal of this research?
The aim is to demystify hedge fund operations and provide an objective evaluation of whether these funds function as beneficial market participants or sources of systemic instability.
Which scientific methodology is applied?
The study utilizes a descriptive and analytical approach, synthesizing existing literature, market reports, and historical case studies of prominent hedge funds.
What specific topics are covered in the main section?
The main section covers the evolution of hedge funds, specific strategy classifications (Relative Value, Event Driven, Directional), German regulatory status, and a detailed analysis of risks and positive market contributions.
What are the characterizing keywords of this work?
The work is characterized by terms such as Absolute Return, Leverage, Financial Stability, Market Efficiency, and Alternative Investments.
How did the Quantum Fund historically influence the market?
The Quantum Fund demonstrated the power of global macro strategies, famously using borrowed capital to profit from the devaluation of the British Pound in the 1990s.
What were the primary lessons learned from the LTCM crisis?
The LTCM crisis highlighted the dangers of excessive leverage and the failure of mathematical models to account for unforeseen human and market behaviors, necessitating intervention to prevent global financial instability.
- Quote paper
- Dennis Sauert (Author), 2007, Hedge Funds. Principles, Chances and Risks, Munich, GRIN Verlag, https://www.grin.com/document/138912
