Hedge something means to spread your risk out….as an example if you are long stocks and want to hedge your bet…(you might short the market) in order to hold onto your long stocks in a market downturn.

The term Hedge fund is an oxymoron…they really don’t hedge much…they hire fast guns that lever up (use high risk leverage) and make speculative (potentially lucrative) bets. When they win …they WIN and when they loose …they LOOSE big.

A hedge fund is a partnership of investors that can invest in whatever kinds of investments the partners agreed the hedge fund could invest in. Usually the hedge fund pursues some kind of lower risk strategy (with a correspondingly low return) and then tries to goose the return higher by borrowing money to invest more in the same investment. The high risk comes from the rare instances when generally safe strategies backfire and the fund loses its money as well as the borrowed funds.

A hedge is a transaction that reduces risk. Example of a hedge: You like the prospects of Ford Motor company at $10/share. You buy Ford stock, but don’t want to lose more than 5% of your investment. You purchase a type of stock option called a put that allows you to sell your Ford shares to someone else for $10. You pay $0.50 for this option. Even if Ford fell to $2 per share, you would lose only $0.50. You have mostly “hedged” your Ford purchase.

An example of a hedge fund strategy:
The government sells 10 year treasury bonds to the public fairly often. These bonds typically get traded back and forth actively for a few months, but then settle into accounts that hold them for years on end. Once they are no longer trading as actively the price can fall a few fractions of a percent. A hedge fund will exploit this difference by buying older treasury bonds and selling short newly issued ones with a similar time left until maturity. If the hedge fund can do this and make 0.20%, but obtain lots of borrowed funds (say 50 times what they put into the trade), that comes out to a 10% return. Because the bonds on both sides of the trade are from the same issuer and have similar maturity dates, the liklihood of loss is almost zero (except for the borrowed funds).

Hedge funds are generally limited to those with large amounts of money for several reasons. 1) Lots of money is needed to fund these kinds of trades and hedge funds generally don’t have many investors 2) The strategies used by hedge funds can quickly become confusing to beginning investors and they want to make sure their investors actually know what they are getting into 3) The minimum investment rules are a way to weed out those that shouldn’t be investing in these strategies to begin with. This is based on the idea that a fool and his money are soon parted. If the fool has managed to save enough to get into the hedge fund, he probably isn’t much of a fool.