"Hedge fund" is a general, non-legal term originally used to describe a type of private and unregistered investment pool that employed sophisticated hedging and arbitrage techniques to trade in equity markets.
Hedge funds have traditionally been limited to sophisticated, wealthy investors. Over time, the activities of hedge funds have broadened into other financial instruments and activities.
Today the term refers not so much to hedging techniques, which hedge funds might or might not employ, as it does to their status as private and often unregistered investment pools.
Hedge funds are pooled investment vehicles that accept investors' money and generally invest it on a collective basis. They pursue speculative investment strategies, usually using borrowed funds to do so. This makes their balance sheets highly leveraged.
Investors in hedge funds are usually wealthy individuals prepared to take big risks for the prospect of very high returns, or large institutional funds investing small portions of their total assets in speculative ventures.
What is shorting?
Shorting is selling something you do not own and is one of the key factors of hedge funds. Other types of funds are not allowed to short.
Carla Fiford, the head of asset management at Worldwide Capital, gives an example: Early in March Foschini's share price was R40 but the market expected the price to fall.
To short it, a hedge fund manager could have gone to a pension fund that owns Foschini stock. For a fee the hedge fund manager could borrow 100 000 shares.
The manager would then sell the shares on the JSE Securities Exchange at R40 each, making R4 million. Foschini's price did fall, to R37.
When this happened the manager could buy back 100 000 shares at R37 a share, costing R3.7 million.
The hedge fund would then have given the shares back to the retirement fund, paid the borrowing fee and pocketed the difference out of a total possible profit of R300 000.