Hedge funds invest the money of well-heeled clients in equities that include the stock market, but that range beyond into other, more exotic investments, like bundles of mortgages, the insurance on mortgage bundles and derivative bets for or against these same investments. Hedge fund traders often invest in derivatives—options, futures and credit bundles—and trade them in high-speed computer-driven transactions where equities may be held for only a fraction of a second before being sold again.
Investment Managers Who Can't Beat the Market
All investors hope to beat the market—to return profits greater than the market average. In fact, only a small minority of traditional fund managers have managed to do this. In 2006 fewer than 1 percent of fund managers performed better than the Dow Jones Industrial average.
Wealthy Investors Want Better Returns
The inability of so many conventional investment managers to do better than the market average has prompted wealthy investors to seek higher returns with investments in hedge funds, where they pay higher management fees and, in return, expect substantially better than average profits. Hedge fund traders promise to achieve those returns using innovative investment strategies, many of them unavailable to the average investor.
Taking Advantage of Market Anomalies
One hedge fund strategy consists of programming computers to watch for and then trade on short-term market anomalies. A stock on the London market may be trading a few pence higher or lower than the same stock in a U. S. market. While this anomaly may only last a few seconds, in that time a hedge fund trader may trade several million shares, buying on the lower-priced exchange and selling on the higher-priced exchange until the anomaly disappears. Market observers have estimated that high-frequency trading now accounts for a comfortable majority of all trades on world markets.
Retail stock market investors may buy on margin only modestly—$100 in cash can purchase $300 in stocks. Hedge fund traders return hefty profits by employing various strategies involving derivatives, which allow them to margin by as much as 300 to 1. One familiar kind of derivative gives the investor the right to buy or sell an equity at some future time in return for a relatively small investment in an option that carries with it the strike price—the guaranteed price at the time the trader actually buys or sells. Other more exotic derivatives, more often employed by hedge fund traders, involve credit derivatives and synthetic CDOs. A credit derivative effectively consists of a bet on the future value of a credit product, such as a bundle of mortgages. A synthetic CDO consists of a hypothetical collateralized debt obligation tied not to an actual equity, but to the market value of a named debt bundle.
Amateurs Need Not Apply
The shift from the so-called value investor, like Warren Buffet who buys under-valued stocks and holds them for years, to the contemporary hedge fund trader who buys and sells hundreds of millions of dollars of equities in a single week, has profoundly changed the stock market, tilting it further away from the individual trader and toward heavily capitalized entities, like hedge funds, that employ hundreds of math and computer experts to devise short-term and often highly leveraged strategies executed on supercomputers.
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