What is a hedge fund? The finance perspective focuses on what it does. It is a single or set of strategies that can be represented by risk factors. The hedge fund is a delivery mechanism for the packaging of risk factors with alpha. The hedge fund is an investment vehicle for receiving alpha. It serves the purpose of providing risk premia and alpha to a set of customers, yet this story focuses on the delivery of products and services and not what is the entity called a hedge fund.
We can go a little deeper using modern corporate finance which states that a corporation is the nexus of contracts that reduce transaction costs for investing. We can us the theory of the firm from Jensen and Meckling and whole school of researchers on transaction costs.
This description provides us with a rich framework for thinking about the hedge fund. It is a set of contracting arrangements for the delivery of alpha to clients. The generation of alpha is expensive. It requires gathering and processing information. It involves the trading which leads to a set of costs that must be controlled to deliver the alpha. It must control traders and managers, so they follow a set of rules within an investment policy agreement. Obviously, there are issues of asymmetric information and principal-agent problems for how is monitoring and oversight provided when money is released to the hedge fund from the investor client.
The simple story is that an investor gives money to a manager to generate return, yet the success of this objective may only be achieved through a set of contracting relationships that control behavior and costs. This issue has not been fully explored by the marketplace. How does the hedge fund structure along with skill create alpha?
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