What makes a hedge fund?

By Pratima Desai

LONDON (Reuters) - Confusion about what hedge funds are is widespread and often adds to their notorious reputations for being risky, but the concept is really simple, speakers at the Reuters Hedge Fund and Private Equity Summit said.

As with most things, there are exceptions, but the majority are trying to make money using tools such as derivatives and short selling -- betting on a lower price for a security in the future -- to cover downside exposure, they said.

"They use hedging strategies in order to protect performance and ultimately are looking to generate alpha (excess returns regardless of market movements)," said Nicholas Roe, managing director and European head of equity finance at Citigroup.

"Hedge fund is such a generic term, you can get lost trying to analyze what it is."

Some describe hedge funds as lightly regulated investment pools because most are registered in low-tax offshore centers such as the Cayman Islands.

However, the reason hedge funds are registered in offshore centers is so they can use derivatives and short sell. Most onshore jurisdictions do not allow investment funds to make effective use of these tools.

"The practice is something that people in financial markets have been doing for decades in some shape or form," said Ted Platt, head of global equity finance and services for EMEA at Merrill Lynch.

So can investment banks that allow traders to gamble with their capital also be called hedge funds?

"You could define a lot of institutions' proprietary businesses as hedge funds," Roe said. "(Hedge funds) have a lower correlation to market."

MEASURING SUCCESS

However, the claim that hedge fund returns have little or no relationship to stock market performance is normally only true when prices are falling and only if the funds offer absolute or real returns -- above zero.

That brings us round again to tools. The offer of real returns is really only possible if hedge funds can protect their investments with derivatives.

"The most important thing is the absolute return ... There are a few exceptions, but for the most part, hedge funds will not be happy if they are down," said Michael Brian, head of equity prime services Europe at Barclays Capital.

"Traditional funds are happy if they outperform the benchmark ... The way in which hedge funds charge fees aligns their interests with investors."

The motive to make money for clients comes from charging fees -- sometimes up to 20 percent -- of any outperformance of preset targets -- often the interest investors would have received if they had left their money in dollar deposits.  Continued...