For most individuals, hedge funds are perceived as risky and complex investments that provide above average returns to investors with very deep pockets.

Whenever we experience market volatility or hear about a hedge fund in distress, we may want to ask ourselves whether hedge fund managers make decisions that could also affect the rest of us. Indeed they do.

Most of us can recall the near collapse in the late 1990s of the US hedge fund, Long Term Capital Management, which made a huge bet on interest rates and lost. The fund was leveraged at 100 to 1 and faced potential losses running into the billions. In 1998, US Government officials, fearing the worst for big banks, stepped in to coordinate a successful private sector bailout.

Hedge funds have also been implicated in financial market upheavals worldwide, including the Asian currency crisis of 1997. This is because hedge funds are capable of moving billions of dollars in and out of markets in a flash and they can significantly impact daily trading in currency, stock and bond markets.

The important lessons here are that the stakes are higher when investments are heavily leveraged and there is no holy grail of investing. Stay diversified as markets are unpredictable. And, although we can do little about the gyrations they create in financial markets, we should take stock of the activities of hedge funds and try to learn from their mistakes.

What are Hedge Funds?
Hedge funds are diverse pools of money that are typically structured as private placements and are often set up offshore for tax and regulatory reasons. The fund's managers usually have their own money invested in the instrument and are paid a performance-based fee, consequently attracting some of the best brains in the investment business.

The first hedge fund was established in 1949 by AW Jones, who combined two investment techniques - short selling and leverage - as a means of reducing market risk. Jones maintained a long position on stocks that he felt were undervalued and went short on those that were overvalued. Short selling involved borrowing a security and selling it in anticipation those prices would be lower when the security was repurchased at a future date.

Leverage or borrowed funds were used to secure individual stocks and boost returns. The fund was considered "hedged" to the extent that the portfolio was split between stocks that would appreciate if the market went up and short positions that would benefit the fund if the market went down.

Hedge fund managers today have refined their hedging techniques in an effort to limit market risk and to exploit inefficiencies in the marketplace. However, individual and institutional investors will often engage in the very same investment practices as hedge funds, such as purchasing securities on margin, or borrowing cheaper funds in one currency and investing in higher yielding securities in another - thereby blurring the lines between hedge funds investing and other forms of investing.

How hedge funds work
The industry is currently estimated at US$1 trillion and is said to be growing at a rate of 20 per cent per annum. Yet for all this attention, there is a dearth of information on the extent of hedge fund activities, which makes defining their role in financial market dynamics a daunting proposition.

On the one hand, hedge funds act as lead steers, and their managers have developed a reputation for being the best and the brightest. Hence, a tip-off that hedge funds are taking a position may trigger the "herd" and encourage a large group of investors to follow. Conversely, hedge funds by their very nature tend to avoid the "herd" and instead make bold investment plays that produce superior returns. Hedge funds can serve to stabilise markets as well.

Understand the risk
A common misconception is that all hedge funds are high risk. This is not the case, as investment returns, volatility and risk differ significantly among hedge funds. There are over 8,000 active hedge funds with distinctive investment and funding profiles that range from low to high risk.

The most aggressive structures are funds that engage in short selling and that use derivates - funds that are highly leveraged - and macro funds, which take large bets on the direction of currencies, equities, bonds and commodities in mature and emerging markets.

Investor shift
Hedge funds require substantial minimum investments of between US$500,000 and US $1M, with individuals comprising more than 50 per cent of all hedge fund investors. Recently, however, both institutional and corporate investors have increased their exposure to hedge funds as a means of diversification.

As hedge funds are not publicly regulated, fund managers are not inclined to disclose their trading strategies, which can make it difficult for the potential investor to fully understand the nature of the investment. As competition intensifies, though, investors are increasingly demanding greater transparency - an expectation that may very well revolutionise the way in which hedge funds operate in the future.

Mildred Moss is the Chief Operating Officer at Sterling Asset Management Ltd.

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