Grown from short roots: What is a hedge fund?

The original hedge funds were formed in the United States in the 1950s. At that time, they differed from normal funds in that they not only bought shares that they thought would increase in value, but also took short positions in shares they thought would do badly.

This meant they sold shares they did not own and, if the market prices fell, bought them back at a lower value - to make a profit.

The term 'hedge' was used because the short positions would protect the funds from any fall in the market.

Things have changed, however, and today the label 'hedge fund' is a bit of a misnomer. Michael Steinhardt, one of the pre- eminent US hedge fund managers, says in the book Market Wizards:

'The term now refers to a limited partnership (or an offshore fund) in which the general partner is typically paid on a performance basis, as opposed to more traditional money managers who are paid on assets managed.

'Typically, the manager of a hedge fund has a great deal more flexibility than a traditional money manager, and that is really the key element.'

Investors must typically put at least pounds 100,000 into a hedge fund and can withdraw money only in limited circumstances, to give the managers maximum discretion. Fees are usually 1 per cent of assets and 15 to 25 per cent of profits.