In addition to selling short, Jones used leverage (borrowed money to trade in addition to the capital provided by his investors), changed an incentive fee (a fee based on a portion of the clients profits as opposed to a fixed percentage of assets) and had a substantial portion of his net worth in his investment funds -- all characteristics common in today's hedge funds.
One common hedge strategy is to buy shares of a company that is in the process of a merger and acquisition. The stock of the company has an announced price that it will be worth on the date of the merger, so if the stock is currently under that value, its a safe investment to purchase it and wait. The risk is that the merger will not go through and the stock will be left at its current value. Frequently, the trader will also sell the stock of the acquiring company in addition to buying the stock of the target.
Most of the early hedge funds did just this. They became very popular as a way of seeing gains better than the investment grade bond market, while still having low risk.
However the side effect of this popularity was to dramatically increase the interest in all of the non-standard investment strategies, and soon other funds were being set up with new strategies aimed primarily at high growth. Although there is no hedging in these cases, the term is still used for these funds as well.
A special type of hedge fund is a fund-of-funds, a fund which invests in other hedge funds rather than trading assets itself.
Hedge funds use alternative strategies such as selling short, arbitrage, trading options or derivatives, using leverage, investing in seemingly undervalued securities, and attempting to take advantage of the spread between current market price and the ultimate purchase price in situations such as mergers. They can be extremely risky investments as illustrated by the example of Long-Term Capital Management.
In the United States, regulations by the Securities and Exchange Commission do not allow hedge funds to be offered to the general public and the funds are limited to purchases by qualified investors, who have total incomes of over US$200,000 per year or a net worth of over US$1,000,000. For the funds, the trade off is that they have fewer investors to sell to, but they have few government imposed restrictions on their investment strategies. The presumption is, that hedge funds are pursuing more risky strategies, which may or may not be true depending on the fund, and that the ability to invest in these funds should be restricted to wealthier investors who are presumed to be more sophisticated. No evidence is cited for this assertion.
A further typical characteristic of a hedge fund is secrecy. Being private, unregulated partnerships, hedge funds can negotiate directly with their clients as to the content and frequency of disclosure. This is in contrast to a fully regulated mutual fund (or unit trust) which will typically have to meet regulatory requirements for disclosure. In addition, in general hedge funds do not have to report their assets, clients or positions to any central regulatory authority.
A byproduct of this secrecy and the lack of regulation is that there are no official hedge fund statistics. An industry consulting group, HFR (hfr.com), reported with suspicious precision that at the end of the second quarter 2003 there are 5660 hedge funds world wide managing $665 billion. To put that in perspective, at the same time the US mutual fund sector held assets $6,818 billion (according to the Investment Company Institute).
The combination of secrecy and rich investors means that hedge funds are a target for criticism whenever markets move against some group's interests.
See also: Derivatives marketFund Strategies
Hedge Fund Secrecy