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Both short selling and leverage are regarded as risky when practiced in isolation. Jones is credited with showing how these instruments could be combined to limit market risk. Jones's insight was that there were two distinct sources of risk in stock investments: risk from individual stock selection and risk of a drop in the general market. He sought to separate out the two. Jones maintained a basket of shorted stocks to hedge against a drop in the market. Thus, controlling for market risk, he used leverage to amplify his returns from picking individual stocks.
He went long on stocks that he considered "undervalued" and short on those that were "overvalued". The fund was considered "hedged" to the extent the portfolio was split between stocks that would gain if the market went up, and short positions that would benefit if the market went down. Thus, the term "hedge funds". Jones's fund had two other notable characteristics that, with variations continue to this day, he made the manager's incentive fee a function of profits (in his case, 20 percent of realized profits) and agreed to keep his own investment capital in the fund (ensuring that his incentives and those of his investors were aligned).

The Two Axis: Leverage & Derivatives

Hedge funds leverage the capital they invest by buying securities on margin and engaging in collateralized borrowing. Better known funds can buy structured derivative products without putting up capital initially but must make a succession of premium payments when the market in those securities trades up or down. In addition, some hedge funds negotiate secured credit lines with their banks, and some relative value funds may even obtain unsecured credit lines. Credit lines are expensive, however, and most managers use them mainly to finance calls for additional margin when the market moves against them.

Market Dynamics

Hedge fund managers are often regarded as astute and quick off the mark. Mere rumor that they are taking a position may encourage other investors to follow. Commonly, this phenomenon is known as "Herding". Although pension funds, insurance companies, and mutual funds are subject to prudential restrictions on their foreign exchange market positions, they still have some freedom to follow. And their financial assets are far larger than those of hedge funds.

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* Contributed by -
Swetha Narayanaswamy,
M.B.A. II year (Finance),
ICFAI Business School, Mumbai.