Hedge Funds 101

There is no precise definition of a hedge fund because they are so heterogeneous. Most definitions focus on hedge fund structure and fee arrangement rather than the composition of the investments. Perhaps the best way to get a basic understanding of hedge funds is to compare their primary characteristics with the plain-vanilla investment structure of long-only mutual funds. This chapter addresses the essential differences between hedge funds and mutual funds and discusses various types of hedge funds. There is a wide range of hedge fund strategies, but absolutely no consensus on how they should be categorized. Even the number of hedge fund strategy categories differs widely among different hedge fund data providers. The fact that hedge funds can trade virtually any type of financial security and in any combination complicates their classification into strategy styles. Also, many managers use strategies that overlap several classifications, while other hedge funds do not fit neatly into any classification. The most basic, as well as most prevalent, hedge fund strategy is the equity hedge fund, which takes both long and short equity positions. The degree of correlation between different hedge fund strategies and equities varies widely. At one extreme, long-only hedge funds would be highly correlated with equities, and at the other extreme, short-selling strategies would be negatively correlated.