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Hedge Funds 101: What They Are and What They Do

By Motley Fool Staff – Sep 27, 2016 at 2:44PM

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These exclusive investment partnerships are laden with mystique and no wonder, since only the very wealthy can put their money into them.

In this segment of Motley Fool Answers, Alison Southwick, Robert Brokamp, and former hedge fund manager Ron Gross discuss what hedge fund managers do, what makes a fund a hedge fund, how they make money, and the varied strategies that make their name a misnomer. 
 
A full transcript follows the video.

This podcast was recorded on Aug. 30, 2016.

Alison Southwick: When I think of the '80s, a few things come to mind. Keds. Koosh balls. Tom Cruise being totally normal.

Ron Gross: Wow!

Southwick: I also think of hedge fund managers in French cuff shirts drinking three-martini lunches and talking about leveraged buyouts and spreads on orange juice futures.

Gross: Hmm!

Southwick: Is that accurate? Was that what it was like?

Gross: I did have French cuff shirts. I did not drink during the day, but I am a former hedge fund guy. Don't hold it against me.

Southwick: I know. That's what I have in my little description here. Hedge funds -- so elite, so secretive, but not today. Ron, a recovering hedge fund manager, joins us to explain what hedge funds do and how they aren't as bad as all those movies in the '80s made them out to be.

Gross: Or are they?

Southwick: Or are they? Dun-dun-dunnn! Did you really have... the shirt that is so hedge fund manager to me is where it's blue. Like a light blue.

Gross: Yes. Blue with white cuffs.

Robert Brokamp: With the white cuffs, yes.

Southwick: It was blue with the white cuffs...

Gross: And the white collar. I swear I had it.

Southwick: Oh, I don't doubt it.

Gross: And loved it. I loved it. I felt like I was so cool. Being a Fool is way better -- I've got news for you.

Southwick: So tell me a little about your background. You ran a hedge fund?

Gross: I ran two. I was co-portfolio manager of one, and then I started my own for my second one back from the year 2000 until about 2008, 2009, when I joined the Fool. So yeah, a lot of fun. A lot of good experience. A lot of hard work. But it was a good time.

Southwick: Yeah. Well, we're going to get into that good time a little bit here and start off with the question of what makes a hedge fund a hedge fund.

Gross: Hoo! Are you ready? Buckle up.

Southwick: Here we go.

Gross: Here we go. So, first of all, I wish they weren't called hedge funds, because it gets everybody confused. They should be called private investment partnerships, because that's really what they are. They're not publicly traded. They are actual partnerships in form. The investors are limited partners. The fund manager is the general partner. The investors put money -- the general manager pools it all together and makes investments on behalf of the limited partners.

Some of these investment partnerships utilize sophisticated strategies that help to hedge the market -- hedge against a downturn in the market; hedge against a specific stock going down -- but many, many of these investment partnerships do not hedge, and that's why I wish they weren't called that. And there's as many strategies as you can think of. There's so many ETFs out there now -- exchange-traded funds -- and there's a million of those strategies. Hedge funds, the same way, have a million different strategies.

The long-short strategy is kind of what made hedge funds famous, where you own some stocks long, you sell some stocks or indexes short. That hedges it out. So that's kind of how the industry grew up, but it's diversified so far from that one particular strategy that "hedge funds" is really a misnomer at this point.

Brokamp: So just to be clear, "long" means you own the investment and you'll benefit if it goes up...

Gross: Yep.

Brokamp: When you sell it short, you're basically looking to profit if the price of that goes down. So that's where the hedge comes in, right? So if it goes down, you're limiting the risk on what you own long.

Gross: Right. If I own $1 million worth of stock and I'm concerned about the stock market, as a whole, going down, I could short an S&P 500 index fund, or ETF, really, so if the market does go down, that short would make money and offset the loss of the stocks that I own.

Brokamp: Right. And if it doesn't, then that short will have been an unprofitable investment. Sort of like insurance.

Gross: It's insurance. Exactly.

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