What if I want to *increase* risk?

To *reduce* risk?

The term “hedge fund” originates from the investment strategy of “hedging,” which is used to reduce risk. In traditional investing, hedging involves taking offsetting positions in different securities to mitigate the potential losses from market fluctuations.

For example, if an investor owns a stock that they believe might decrease in value, they might “hedge” this risk by also investing in a financial instrument that would increase in value if the stock decreases. This strategy can involve a variety of financial instruments like options, futures, or short selling.

Hedge funds, when they were first created, extensively used these hedging techniques to protect the capital of their investors from market downturns. Over time, however, the term “hedge fund” has evolved. Today, hedge funds may use a wide array of investment strategies and are not solely limited to hedging practices. They are known for their aggressive investment strategies seeking high returns, and their clientele often includes wealthy individuals and institutional investors.

Why evolution to aggressive

The evolution of hedge funds from primarily using hedging strategies to adopting more aggressive investment approaches can be attributed to a combination of factors:

1. Search for Higher Returns: Investors often look to hedge funds for returns that outperform traditional markets. This demand drives hedge funds to seek more aggressive strategies that can potentially offer higher profits.
2. Competitive Market: As the number of hedge funds grew, the competition among them intensified. To stand out and attract investors, funds began exploring innovative and riskier strategies.
3. Advancements in Financial Instruments: The development of complex financial instruments and derivatives provided hedge funds with new ways to speculate and leverage, allowing for more aggressive strategies.
4. Less Regulation: Hedge funds operate with fewer regulations compared to mutual funds and other investment vehicles. This freedom allows them to engage in strategies that are off-limits for more regulated entities.
5. Globalization: As markets became more interconnected, hedge funds started exploiting global opportunities, which often involve higher risks and potentially higher returns.
6. Performance Fees: Hedge fund managers typically earn a significant part of their income from performance fees. This fee structure can incentivize managers to pursue high-risk strategies that promise higher returns.

This shift doesn’t mean hedge funds have abandoned hedging entirely; many still use hedging techniques as part of their broader investment strategies. However, the emphasis has shifted more towards achieving high returns, even if it involves taking on more risk.