Hedge funds are frequently mentioned but seldom understood. Often, we hear about hedge funds in the news connected with the economic crisis. But what do they do and why are they called hedge funds? According to Investopedia, a Web site that specializes in defining financial terminology, a hedge fund is an "aggressively managed portfolio of investments that uses advanced investment strategies ... with the goal of generating high returns."
In other words, hedging is simply the practice of attempting to minimize risk by either buying another equity to balance the one you have or initiating a futures position.
A simple example of hedging is as follows. Say you are the head of a school district that has to buy gasoline for school buses. You decide to purchase a futures contract to mitigate the risk in the change in gas prices. This contract allows you to lock in a certain price for gasoline that will remain the same regardless of fluctuations in the market price. Should the market price exceed the price locked in by the contract, the school district is protected from paying the high prices and has used hedging for its benefit.
The risk analysis and hedging done by hedge funds is more complex, but the underlying principal remains unchanged. By hedging risk, these funds aim to deliver large returns to their investors. But investing in a hedge fund is not for the amateur. For legal reasons, hedge funds generally can have no more than 100 investors. Therefore, those 100 investors must have a lot of money for the fund to function efficiently; accordingly, funds only accept wealthy individuals. Also, hedge funds can be risky, as can be seen in the current financial crisis. Though hedge funds do hedge to protect against risk, they also leverage to maximize their investments. Because of their ability to leverage, unlike mutual funds - perhaps a topic for another article - they can be hurt more by downturns. Thus, only high net worth individuals - those who could potentially lose a lot and not be critically affected - invest in them.
But let's say that for your 21st birthday, you get a check for $5 million - maybe your parents won the lottery - and you decide to invest in a hedge fund. How would you do that? First you have to consider that each hedge fund is different and has its own strategy. Some specialize in investing in specific areas such as developing countries, while others focus on a specific type of equity such as currencies, commodities or options.
Once you find a hedge fund to invest in, you also must pay fees. Management fees average 2 percent, while performance fees are significantly more, around 20 percent. Managers only can collect performance fees if their funds collect money, however, and they do not collect a performance fee if their funds lose money.
Those are the basics of hedge funds. But if hedge funds are essentially like mutual funds for high net worth individuals, then why is there such controversy surrounding them? Well, first of all, because hedge funds are private, they are not regulated by the Securities and Exchange Commission as heavily as mutual funds would be. Because of this lack of regulation, they do not have to release financial information. After the SEC ignored multiple warnings and let Mr. Madoff's Ponzi scheme blow up, the government is eager to change this policy and begin to regulate hedge funds.
Also the nature of hedge funds invites calls for increased regulation. When the market turned sour in 2007, hedge funds shorting stock - that is, they sell a stock and buy it back at a lower price to make a profit - drove down share prices of many companies and exacerbated the already poor market conditions. The biggest threat to hedge funds during the next few months will come from Congress. In the eyes of the government - and most of the public - hedge funds are just too mysterious to let go unregulated, even though many of them undergo voluntary auditing. Gun-shy from the crisis, the Obama administration has proposed legislation that would prevent large "too-big-to-fail" financial institutions from financing or managing hedge funds. But Commerce Prof. Robert Webb explains the unintended consequences of such a policy. Restricting regulated banks from trading for their own accounts (i.e. proprietary trading) or managing or investing in unregulated hedge funds may reduce transparency in financial markets, as more trading activity shifts to unregulated hedge funds or trading boutiques and away from banks, which do face some regulation.
Though that legislation is more geared toward restricting banks in their dealings with hedge funds, some proposed regulations will impact hedge funds directly. The more direct legislation calls for hedge funds with a certain level of assets under management to register with the SEC. Despite the possibility of increased government oversight, Richard Bookbinder of Bookbinder Capital Management, a New York-based hedge fund, seems optimistic about the future of hedge funds. He believes proposed legislation might be a brief "pain in the neck," but the proposed legislation "will not present a major cost to the majority [of hedge funds] in the field." Despite whatever unknown economic conditions await us in the future, we can be sure that hedge funds will continue to be an integral part of the market.
Harrison's column runs biweekly Thursdays. He can be reached at h.freund@cavalierdaily.com.
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