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Kai Ryssdal: Hedge funds were supposed to be the smart money. Special investments for rich people who know how to pick 'em. But a lot of those funds have lost billions for their investors -- everybody from individuals to pension funds to college endowments. Some of them have shut down. Some of them even invested in Bernie Madoff's Ponzi scheme.
Others, though, are still the smart money even though there's still a lot of mystery about what hedge funds are. So we asked Mitchell Hartman to find out for us earlier this year in the Marketplace Decoder.
Mitchell Hartman: First, the textbook answer. A hedge fund is a private partnership that pools money from wealthy individuals, pension funds, corporations, and the like, and invests it to make a profit. Because the fund is private, it doesn't have to report how much it earns, or what it's holding, to financial regulators.
Will Swarts of SmartMoney.com has been reporting on hedge funds for over a decade. He says it used to be pretty simple to define a hedge fund.
Will Swarts: It was a fund that held some stocks long -- where you'd make money if they'd go up -- and some stocks short, where you would make money if they went down.
By betting both sides of the market, the fund balanced out, or hedged its risk.
These days, hedge funds invest in all sorts of markets -- currency, oil, precious metals, stocks, bonds, or all of the above. And, Swarts says, most of them use borrowed money, or leverage, to juice their returns.
Swarts: Now a hedge fund is basically a catch-all term for any number of investment strategies that can invest in anything from bonds, stocks, the third race at Aqueduct.
The third race at Aqueduct? Well, if a hedge fund manager did walk up to the betting window with a few million bucks, he'd be looking to place a bunch of bets, all at different odds.
Washington University finance professor Charles Cuny explains the goal would be to spread the risk around the whole field of horses.
Charles Cuny: So they might bet on Candy Dandy to come in fourth, Lucky Tiger to come in sixth, and some other horse is going to break its leg.
By betting on a lot of different outcomes, the hedge fund can make money off the third race no matter how it finishes. And in theory, the same goes for any market -- stocks, bonds, commodities -- that a hedge fund might invest in.
But hedging is no guarantee of success. In really crazy markets, like we're living through right now, so many bets go wrong, that the fund can be exposed to huge risks. The problem's amplified by all that leverage -- just a small movement in markets can induce big losses, and force managers to sell off assets at any price. And we've seen a lot of that lately at the racetrack called Wall Street.
I'm Mitchell Hartman for Marketplace.