By Julio Perez, Fall 2017 IAC Graduate Research Assistant
There are two commonly accepted yet distinct definitions of the term “hedge” in investing, neither of which have to do with topiary. The first and more commonly heard of use is in the phrase “hedge fund,” an investment group similar to a mutual fund but with more risk and intended for more sophisticated investors.
The second use for the word is as a verb, as in “hedging your securities” or “hedging your stocks.”
Hedging typically involves investing in futures to offset the risk in your main investment portfolio. I will explain futures in the future, but the simplest way to explain hedging is by comparing it to insurance, only slightly more intricate. Say I have stock in a fruit leather company, which as we know means I will profit if said fruit leather company flourishes. But it also means I will lose if the company fails. However, if I invest in a contract that says I will make a profit if that same company fails, then I have covered my bases and I will make some sort of money no matter what happens.
Of course, if I hedge my investment this way, I will by splitting up my money and missing out on a large profit margin if my company corners the market (or if it goes bankrupt, if I invest all of my funds in the futures instead). However, I also get rid of the risk that I will make no money at all and at least recoup some of my losses due to the unpredictability of the market. A hedger is, self-evidently, a person who hedges, and you can hedge either in a long market position or a short market position. I will explain exactly what those mean later, but my previous example represents a long market position, while the opposite would represent a short market position (if I would be making a profit by hoping the company succeeds when my main investment is in the company failing).
A hedge fund is something different. The “fund” part comes from a group of like-minded individuals pooling together their assets and investing as one in order to maximize their profits. I was not able to precisely find the relation between hedging and hedge funds, but I do know that hedge funds are essentially like mutual funds but with a higher bar of entry. Hedge funds tend not to be as heavily regulated as mutual funds and therefore are allowed to pursue riskier investments. This is offset by the fact that you usually need to be an accredited investor to join a hedge fund, which means you need a minimum level of income or assets to join, and generally you and your hedge fund associates will be more investment literate and less likely to make poor investments.
Translated: “My investments don’t seem safe enough, maybe I should take some steps to protect it even if the investments go down.”