Can anyone explain how "hedge funds" work please?

[Newbie 0]

I'm curious to know how they work and how hedge fund managers seem to all end up making a shit load of money.

Thanks in advance.

"Skydiving is a door"
Happythoughts

[billvon 3,120]

Hedge funds traditionally take both short and long positions in stocks, thus allowing you to make money (probably) if the market goes up _or_ down. Nowadays the term 'hedge fund' means almost any risk-mitigating investment fund. Hedge fund managers typically take a percentage for their own pay.

[lawrocket 3]

Bill's got a lot of it right. The key difference with hedge funds in the US is the lack of regulation. Hedge funds really started with short selling, which is the process of selling a stock that the fund manager believes is overvalued before they even bought it. Then they buy the stock at a lower price before they pass it, making a profit. That's what the "hedge" is - the risk of the stock going down is passed on to another while the benefit is taken by the hedge fund.

Hedge Funds are pooled resources. Because they are not available to the general public in the US (there are requirements for most investors, i.e., a 5 million dollar portfolio, 1 million net worth, etc) they are not regulated by the SEC. So, part of the reason why the hedge funds make so much money is that they are available solely to rich investors.

My wife is hotter than your wife.

[jlmiracle 7]

I worked for a guy who ran a hedge fund - he went to jail, he thought he was too good to pay his taxes.

All the information Billvon and Lawrocket said is correct.

Judy

Be kinder than necessary because everyone you meet is fighting some kind of battle.

[Newbie 0]

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Bill's got a lot of it right. The key difference with hedge funds in the US is the lack of regulation. Hedge funds really started with short selling, which is the process of selling a stock that the fund manager believes is overvalued before they even bought it. Then they buy the stock at a lower price before they pass it, making a profit. That's what the "hedge" is - the risk of the stock going down is passed on to another while the benefit is taken by the hedge fund.

Hedge Funds are pooled resources. Because they are not available to the general public in the US (there are requirements for most investors, i.e., a 5 million dollar portfolio, 1 million net worth, etc) they are not regulated by the SEC. So, part of the reason why the hedge funds make so much money is that they are available solely to rich investors.

Thanks for the explanation - can you explain how someone sells a stock before they even bought it? I don't quite follow. Also, if they then buy it when it's undervalued, how can they be sure it will rise in value, effectively making them a profit? Sorry if i appear dense, i'm not in the financial sector, so i'm coming from a purely laymans position here

"Skydiving is a door"
Happythoughts

[StreetScooby 5]

I believe there are tax advantages, also. These companies are based off shore, and are not subject to US tax laws.

Hedge fund managers typically command 2-3% of equity as their fee, plus 20% of any profits. Taking short positions is a huge part of their business. Also, they rarely make "one-sided" trades. Usually, they'll "go long" (i.e., actually own the security) in one market sector while going short against another sector. A typical portfolio will contain many such "strategies".

We are all engines of karma

[StreetScooby 5]

In order to short a stock, you must borrow the "white paper" from a securities shop. Once you have borrowed the stock, you immediately sell it on the open market and put the "green paper" in your closet.

At some point in the future, you must repay the "white paper" to your securities shop. In order to do this, you step back into the open market using your "green paper" you've kept in the closet. After paying back the white paper, you get to keep whatever green paper is left over.

Here's an example:

1) You think stock XYZ is going to lose value, for whatever reason.
2) You approach you securities shop (e.g., Morgan Stanley), and borrow 100 shares of XYZ.
3) You immediately have your broker sell those shares, let's say for $10.
4) That gives you $1000 green paper in your closet.
5) Two months later, XYZ has fallen to $5.
6) You have your broker buy back 100 shares of XYZ at $5, costing you $500. This is called covering the short.
7) That leaves you with $500 green paper in your closet. You just made money.

Pitfalls are many.
1) You have to pay an agreed "interest rate" to your securities shop while borrowing the white paper.
2) Securities shops _know_ who is shorting what. They can make a play against you that causes the price of the stock to rise. It's called a short sellers squeeze. You can lose _alot_ of money in this scenario, because you have to pay back the "white paper", not the "green paper".

Typically, investing professionals _never_ make one sided trades. They always go long in one security, and short another. This is the operating definition for a hedge.

We are all engines of karma

[bmcd308 0]

>>can you explain how someone sells a stock before they even bought it? <<

If a stock is selling for $10 per share, you give me $10 cash and I give you an IOU for the share. I just shorted the stock. I am betting that it will go down in price such that when you come to collect on the IOU, I can buy a share for $5 and give that to you. In the meantime, I will have had to pay interest on the $10 I got from you. Essentially, I am going into debt, but instead of borrowing cash, I am borrowing the share of stock.

Brent

----------------------------------
www.jumpelvis.com

[kelpdiver 2]

you guys left out the part where if it goes badly, they'll aim for a bailout! Talk about low risk...

[mdrejhon 8]

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Thanks for the explanation - can you explain how someone sells a stock before they even bought it? I don't quite follow. Also, if they then buy it when it's undervalued, how can they be sure it will rise in value, effectively making them a profit? Sorry if i appear dense, i'm not in the financial sector, so i'm coming from a purely laymans position here

Good explanation:

http://www.fool.com/FoolFAQ/FoolFAQ0033.htm

You just borrow somebody's shares and sell them (i.e. for $100 per share). The company bombs and the stock is only $50 now. You buy the shares back and give it back to the person you borrowed from. (It doesn't even have to be the exact same shares by serial number, just shares of the same ticker symbol). Because you sold at $100 and bought back at $50, you make a $50 profit per share.

That's how short selling works, in layman's terms. All legal. It's actually all automated so all you have to do is sell before you buy. The stock exchange computer systems automatically does the borrowing and returning the shares.

However, it can be somewhat dangerous, if you sell at $100 and the company skyrockets to $250, you can lose more money than the principal.

[Newbie 0]

Quote

In order to short a stock, you must borrow the "white paper" from a securities shop. Once you have borrowed the stock, you immediately sell it on the open market and put the "green paper" in your closet.

At some point in the future, you must repay the "white paper" to your securities shop. In order to do this, you step back into the open market using your "green paper" you've kept in the closet. After paying back the white paper, you get to keep whatever green paper is left over.

Here's an example:

1) You think stock XYZ is going to lose value, for whatever reason.
2) You approach you securities shop (e.g., Morgan Stanley), and borrow 100 shares of XYZ.
3) You immediately have your broker sell those shares, let's say for $10.
4) That gives you $1000 green paper in your closet.
5) Two months later, XYZ has fallen to $5.
6) You have your broker buy back 100 shares of XYZ at $5, costing you $500. This is called covering the short.
7) That leaves you with $500 green paper in your closet. You just made money.

Pitfalls are many.
1) You have to pay an agreed "interest rate" to your securities shop while borrowing the white paper.
2) Securities shops _know_ who is shorting what. They can make a play against you that causes the price of the stock to rise. It's called a short sellers squeeze. You can lose _alot_ of money in this scenario, because you have to pay back the "white paper", not the "green paper".

Typically, investing professionals _never_ make one sided trades. They always go long in one security, and short another. This is the operating definition for a hedge.

ahhh i see, good explanation, thanks. Am i right in thinking "going short" is holding onto a share just for a short amount of time? What would this equate to roughly speaking? 1-12months?

Also, when you invest in a hedge fund, do you leave the decisions purely to your hedge fund manager? Is it down to the manager to decide which shares he will go short/long in? Will these long/short shares typically be across a diverse industry range? What happens if a securities shop initiates a short sellers squeeze, and the shares in the long stock fall? How is that hedging your bets? Or rather, is that the worst case scenario, and you then up and find another manager?

I'm trying to get my head around how it's supposedly meant to make money, even if your short/long shares do not depreciate/appreciate in value accordingly?

"Skydiving is a door"
Happythoughts

[Newbie 0]

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you guys left out the part where if it goes badly, they'll aim for a bailout! Talk about low risk...

Hi, can you explain what a bailout means please? Thanks

"Skydiving is a door"
Happythoughts

[mdrejhon 8]

There's no time limit for a "short position", although this is indeed typically a short-term position.

(Also, see my post above)

[Newbie 0]

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Thanks for the explanation - can you explain how someone sells a stock before they even bought it? I don't quite follow. Also, if they then buy it when it's undervalued, how can they be sure it will rise in value, effectively making them a profit? Sorry if i appear dense, i'm not in the financial sector, so i'm coming from a purely laymans position here

Good explanation:

http://www.fool.com/FoolFAQ/FoolFAQ0033.htm

You just borrow somebody's shares and sell them (i.e. for $100 per share). The company bombs and the stock is only $50 now. You buy the shares back and give it back to the person you borrowed from. (It doesn't even have to be the exact same shares by serial number, just shares of the same ticker symbol). Because you sold at $100 and bought back at $50, you make a $50 profit per share.

That's how short selling works, in layman's terms. All legal. It's actually all automated so all you have to do is sell before you buy. The stock exchange computer systems automatically does the borrowing and returning the shares.

However, it can be somewhat dangerous, if you sell at $100 and the company skyrockets to $250, you can lose more money than the principal.

Right, right, thanks. Can you please explain how someone goes about "borrowing" a share? I mean, who is going to just

a)lend you their shares and then
b)pay you full value for them after the share has gone down?

What is the turnaround time frame from securing the share, to having to sell it? Surely this has to be a very quick turn around? I can't imagine someone can just "borrow" a share until they want to sell it can they, especially if it has already been sold on to a 3rd party? Why would someone "borrow" you their share? Surely if the market value of that share is falling they may want to pull the shares back and sell them? What happens then?

"Skydiving is a door"
Happythoughts

[mdrejhon 8]

In my trademarked PlainEnglish(tm), which may be somewhat watered down, it's actually more complex than this, but, here goes:

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Right, right, thanks. Can you please explain how someone goes about "borrowing" a share? I mean, who is going to just
a)lend you their shares and then

It's all done automatically. Whenever you buy stock, you also automatically give short sellers permission to sell your shares. It's implied automatic permission, as long as the shares are in 'electronic' format. But you can ask for the real shares in paper format to be mailed to your address, you can prevent short sellers from "borrowing" your shares.

You can sell your owned traditionally shares ("long" positions) even if they are lent out. When you place a sell order of your existing shares (that were already lent out) -- it just automatically forces the short seller to sell back to you *instantly* (the brokerage/exchange computers will automatically buy them back for you and put it back into your account instantly, so that you can sell instantly).

Computer systems keep track of what shares are available for shorting, and automatically forces an instantaneous buy-back of lent shares.

In fact, that Microsoft shares or General Electric shares or Coca-Cola shares in your retirement account, may currently be lent out to somebody else right now without you really knowing. The shares are 'virtually' there though anyway, because you can sell anytime -- if they're lent out, you get the shares back instantly if you feel like selling right now -- the computer systems pretty much guarantee that. So it's as if you've never lent out the shares!

In fact, if you own ANY mutual fund containing stocks, I can pretty much guarantee you are indirectly affected by a short position -- A mutual fund containing stocks, often let them be lent out. (And it doesn't have to be hedge fund)

[mdrejhon 8]

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b)pay you full value for them after the share has gone down?

Nobody pays original value ever (original value may be matched only if it's also the current market value too).

People (buyers and sellers) deal in the current market value, which fluctuates.

This is another whole ballpark that needs explanation, but think of an auction of a seasonal item. At one time, an item may be valuable and another time it may not be. A stock market is often like an auction for shares in a company.

It's been modernized and automated to the point where all you have to do is click a button to buy or sell. Often easier than eBay.

[mdrejhon 8]

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Surely if the market value of that share is falling they may want to pull the shares back and sell them? What happens then?

You cannot predict the market.

Sometimes the stock bounces up, so that's why many keep holding on. And other times, other buyers think the discount is like a bargain -- a sale on stock. So people that sell, there are always buyers.

I've owned stock that was, say, $5, that fell agonizingly $2 before going to $10. I had many temptations to sell while the stock went from $5 to $2. But I did not. (1000 shares, that's $5000 down to $2000). At least, that was $10,000 when it recovered.

Yes, sometimes a stock never recovers. You can never know.

There are times you make money and times you lose money. In the long term, you hope to earn a lot more money. Often, good and smart research make it profitable instead of a gamble. Other times, people treat the stock market like a casino. It depends on what kind of mindset you have.

Over the last 100 years, the stock market has gone up "on average", so the odds are stacked in your favour if you make the right decisions and stick to it for more than 10 years to average out the good and bad times. If you don't feel like dealing with stocks, leave it to the professionals and buy mutual funds or an index fund (which matches the stock market index)

[Guest]

One thing not mentioned yet is a difference in risk between short and long positions.

If you buy a stock for $10 (per share) the worst you'll do is lose all your money (goes to $0). If you short a stock at $10 and it goes up to $20, you've lost your $10. But whose to say it won't go to $30, $40, or $50 per share, where you'd then be losing $40 per share on the old $10 stock.

I know a guy who has had some short positions in the money for years, so it does happen. But I believe that most short positions are for a relatively short duration of time.

So why short at all? Often the movement downwards in price happens much faster than movement upward, hence the opportunity to make money faster than waiting around for a stock to go up. Another reason is that that market as a whole may be going down, so long positions may be battered no matter how good a stock-picker you are.

As far as the actual trading goes, for an online brokerage, if your account is approved for short selling, (basically) all you do is click on the sell-short button instead of the buy-long button to open a short position. You never have to gain physical control of paper in short or long positions nowadays (unless you really want to, and that costs more $).

The fool.com is as good a place as any to read about this stuff. Also you can call the brokerage houses and they'll probably send you all kinds of information or steer you to their web sites.

You can have it good, fast, or cheap: pick two.

[haymangonzo 0]

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I'm curious to know how they work and how hedge fund managers seem to all end up making a shit load of money.

Thanks in advance.

The reason that hedge fund managers make "a shit load of money", is because they get paid for the service they offer their clients(the real investors). As stated before, most hf managers get a percentage of the capital invested and a percentage of the profit made. So if the hf manages a 100.000.000 hedgefund and gets 1.5% of the capital invested, he has already a cool 1.5 million in the pocket even without making a profit for the client and if he makes a profit he also gets a percentage from the profit. There is at the moment at least one HF manager that only demands a percentage fee of the profit made. The fee they demand is a bit higher than average(25%), but clients don't pay fees if they don't make a profit.

***
Nice to meet you toot!

[StreetScooby 5]

Where do you go borrow shares? From a "clearing house". A clearing house is responsible for keeping electronic entries, and reporting for SEC requirements, and these days Sarbanes-Oxley. In banking terms, the clearing house turns white paper into green paper, and vice versa, in the eyes of the Federal Reserve.

In order to borrow the shares, typically you must have a relationship with the clearing house, i.e., you've used them to clear trades from your broker for a long time.

You can hold a short position as long as you want, or until the clearing house buys you back in. What is that? Whenever a clearing house keeps track of your long positions, there is a clause in your contract with them that allows the clearing house to loan those shares out at their discretion. If lots of people start selling their long positions, they have to get those shares back from anyone they've lent them to. Thus, the short seller's squeeze.

Also, there are two basic types of agreements with a broker (...who, guess what, tends to work for a clearing house either directly or indirectly).

1) Discretionary - The clearing house/broker makes trades without your permission
2) Non-discretionary - The clearing house/broker makes trades only with your permission.

You need to read the contract in order to determine what type of agreement you've entered. If you've entered into a discretionary agreement with a broker who shorts at will, you can lose your shirt and everything around you. Caveat emptor.

We are all engines of karma

[mdrejhon 8]

Yeah, that's what happens behind the scenes.

At the front end, bottom line, it's just a "BUY" and "SELL" button on my computer. I can click "SELL" before clicking "BUY" for a short position. Everything else happens automatically behind the scenes. The brokerages, clearing houses, stock exchanges, computer systems, floor traders, and all that, do the hard work, paid-for by the commission charge I pay per trade. In the front end, it's a lot simpler - sometimes deadly simple.

I'm a longer-term guy though, not a day trader.