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Standard Definitions of a Hedge Fund:
A hedge fund can be defined as an actively managed, pooled investment vehicle that is open to only a limited group of investors and whose performance is measured in absolute return units.
Explanation:
To “hedge” is to lower overall risk by taking on an asset position that offsets an existing source of risk.
For example, an investor holding a large position in foreign equities can hedge the portfolio’s currency risk by going short currency futures.
A trader with a large inventory position in an individual stock can hedge the market component of the stock’s risk by going short equity index futures.
Alternatively, a hedge fund can be defined theoretically as the “purely active”
component of a traditional actively-managed portfolio whose performance is
measured against a market benchmark.
Illustration:
Let w denote the portfolio weights of the traditional actively-managed equity portfolio. Let b denote the market benchmark weights for the passive index used to gauge the performance of this fund. Consider the active weights, h, defined as the differences between the portfolio weights and the benchmark weights:
A traditional fund has no short positions, so w has all non negative weights; most market benchmarks also have all nonnegative weights. So w and b are nonnegative in all components but the “active weights portfolio”, h, has an equal percentage of short positions as long positions.
Theoretically, one can think of the portfolio h as the hedge fund implied by the traditional active
portfolio w.
The following two strategies are equivalent:
1. Hold the traditional actively-managed portfolio w
2. Hold the passive index b plus invest in the hedge fund h.
Standard Definitions of a Hedge Fund:
A hedge fund can be defined as an actively managed, pooled investment vehicle that is open to only a limited group of investors and whose performance is measured in absolute return units.
Explanation:
To “hedge” is to lower overall risk by taking on an asset position that offsets an existing source of risk.
For example, an investor holding a large position in foreign equities can hedge the portfolio’s currency risk by going short currency futures.
A trader with a large inventory position in an individual stock can hedge the market component of the stock’s risk by going short equity index futures.
Alternatively, a hedge fund can be defined theoretically as the “purely active”
component of a traditional actively-managed portfolio whose performance is
measured against a market benchmark.
Illustration:
h = w – b
A traditional fund has no short positions, so w has all non negative weights; most market benchmarks also have all nonnegative weights. So w and b are nonnegative in all components but the “active weights portfolio”, h, has an equal percentage of short positions as long positions.
Theoretically, one can think of the portfolio h as the hedge fund implied by the traditional active
portfolio w.
The following two strategies are equivalent:
1. Hold the traditional actively-managed portfolio w
2. Hold the passive index b plus invest in the hedge fund h.
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