Investments, tenth edition

26 

26 

2

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 P

AR

T VII 

  WHILE MUTUAL FUNDS 

are still the domi-

nant form of investing in securities markets 

for most individuals, hedge funds enjoyed far 

greater growth rates in the last decade, with 

assets under management increasing from 

$200 billion in 1997 to about $2 trillion in 

2012. Like mutual funds, hedge funds allow 

private investors to pool assets to be invested 

by a fund manager. Unlike mutual funds, 

however, they are commonly organized as 

private partnerships and thus not subject to 

many SEC regulations. They typically are open 

only to wealthy or institutional investors. 

 Hedge funds touch on virtually every 

issue discussed in the earlier chapters of the 

text, including liquidity, security analysis, 

market efficiency, portfolio analysis, hedg-

ing, and option pricing. For example, these 

funds often bet on relative mispricing of 

specific securities, but hedge broad market 

exposure. This sort of pure “alpha seeking” 

behavior requires a procedure for optimally 

mixing a hedge fund position with a more 

traditional portfolio. Other funds engage in 

aggressive market timing; their risk profiles 

can shift rapidly and substantially, raising dif-

ficult questions for performance evaluation. 

Many hedge funds take extensive deriva-

tives positions. Even those funds that do 

not trade derivatives charge incentive fees 

that resemble the payoff to a call option; an 

option-pricing background therefore is neces-

sary to interpret both hedge fund strategies 

and costs. In short, hedge funds raise the full 

range of issues that one might confront in 

active portfolio management. 

 We begin with a survey of various hedge 

fund orientations. We devote considerable 

attention to the classic “market-neutral” or 

hedged strategies that historically gave hedge 

funds their name. We move on to evidence on 

hedge fund performance, and the difficul-

ties in evaluating that performance. Finally, 

we consider the implications of their unusual 

fee structure for investors in and managers of 

such funds.  

 CHAPTER TWENTY-SIX 

 Hedge  Funds 

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 Hedge 

Funds 

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 Like mutual funds, the basic idea behind    hedge  funds    is investment pooling. Investors 

buy shares in these funds, which then invest the pooled assets on their behalf. The net 

asset value of each share represents the value of the investor’s stake in the portfolio. In this 

regard, hedge funds operate much like mutual funds. However, there are important differ-

ences between the two.