Hedge funds represent both the best and worst of capitalism. Originating in cutting edge math and science designed to maximize returns of elite investors in global markets, the entire industry regressed into a virtually lawless arena for market manipulation. Despite its much ballyhooed origins, the hedge fund industry has produced spectacular disasters and played a role in the housing market crash of 2007 and its aftermath.
The term "hedge fund" comes from the idea that the market risk of a given asset can be balanced, or "hedged," by either long or short exposure to another asset. For example, the risk of owning a stock that's highly correlated to the price of oil can be hedged by shorting oil futures or another stock with a similar, but less, correlation. Through the process of hedging, hedge funds were supposed to be able to deliver the holy grail of investing, high returns with low risk.
Hedge funds are organized as private investment partnerships, with membership usually restricted to accredited investors with a net worth over $1 million dollars. The high management fees associated with hedge funds are greater usually attributed to the fact that successful hedge funds far outperform the broader market. Almost every hedge fund uses leverage, that is, borrows to increase assets under management, in order to generate returns.
Because hedge funds are unregulated, specific facts about the industry as a whole is difficult to obtain. What's clear, though, is that hedge funds have infiltrated every aspect of public markets, and about the only thing they have in common collectively is the strict barrier to entry. Some hedge funds specialize in specific assets, using expertise to provide returns to their investors, while others move quickly among various assets, using access and speed to generate profits.
Between their investors and the leverage they are able to obtain, hedge funds control huge sums of money and can become dominant players in a specific market. Not only does this create the potential for manipulation of a market, it creates severe disruptions if the hedge fund is forced to liquidate. Hedge funds are also susceptible to redemptions, which occur when investors cancel their investment and withdraw their money. Several of the record-breaking declines during 2008, in stocks and other markets, were widely attributed to hedge fund liquidations.
It became obvious in 1998, when Long Term Capital Management lost $4.6 billion in less than four months, that hedging was a less than perfect way to manage risk. Nevertheless, the industry had already grown to huge proportions and continued to proliferate. Less than 10 years later, it became obvious that hedge funds no longer necessarily used the basic hedging strategy to limit risk that was their original purpose. In 2006, Amaranth Advisors LLC, a hedge fund, lost $6 billion in a single week on natural gas futures. By that time, hedge funds had already taken advantage of high leverage and tame regulation to actually pursue very risky investments, including the subprime mortgages that led to the credit crisis of 2008.