Hedge funds are getting a lot of press these days. It seems that hedge funds are in the news every day and not for good reasons. In the current financial downturn, hedge funds are collapsing left and right. If you’re like a good portion of the general public you have no idea what a hedge fund is. So let’s answer the question: What is a hedge fund?
My first stop in any research is usually Google. However, more and more, Google's top results take me right to Wikipedia as a source for information. It’s just more convenient to use Google to search Wikipedia that it is to use Wikipedia’s own search.
Wikipedia defines a hedge fund as “a private investment fund that charges a performance fee and is typically open to only a limited range of qualified investors.” Let’s analyze this definition and pick out the words that really define hedge funds, at least as they are referred to in the financial news.
First the term private; you just can’t open an account online and start investing in a hedge fund with ShareBuilder. These funds are not open to the general public and that’s a good thing.
What about the performance fee? The typical hedge fund manager charges about 20% for performance fees, meaning they keep 20% of the profits if they make any. This can vary quite a bit for 20% is the number typically reported. The fund can also charge management fees on top of performance fees.
Finally what is a qualified investor? Under federal law in the US a qualified investor is referred to as an accredited investor. To be an accredited investor you need a net worth of at least $1 million. You also need an income of $200,000 ($300,000 if you’re married). You need to have earned this level of income for at least 2 years and have the expectation of earning it again this year. Wouldn’t you love to be an accredited investor?
Because a hedge fund markets to accredited investors only, it is free from direct regulation. These funds are then able to engage in highly speculative activities. Again according to Wikipedia, “Hedge Funds dominate certain specialty markets such as trading in derivatives with high-yield ratings, and distressed debt.” The Intelligent Investor would not probably look there for a good safe investment.
The term hedge fund is bit of misnomer (unsuitable name) because modern hedge funds do not actually hedge. You’ve probably heard the term “hedge your bet.” Hedging usually means that you are taking some action to mitigate (reduce) your risk. Modern Hedge Funds do the exact opposite. They actively seek risky investments that have the potential for above average returns.
We have enough information to define a hedge fund in our own terms. A hedge fund is a financial scheme wealthy people use in an attempt to beat the market. So the average investor would think they don’t have much to worry about when a hedge fund closes or folds. However hedge funds are a major player in the investment world.
Consider this:
Hedge fund activity in the public securities markets has grown substantially as it constitutes approximately 30% of all U.S. fixed-income security transactions, 55% of U.S. activity in derivatives with investment-grade ratings, 55% of the trading volume for emerging-market bonds, as well as 30% of equity trades.
Anything that large has a major impact on the market.
It’s amazing to me how Wall Street seems to behave like a small child so often until the parents (regulators, government) step in to put an end to the shenanigans. Considering the problems with financial derivatives and the few rational voices that speak against them, you’d think hedge fund investment would be rather limited. However, from the statistics above we can see that hedge fund activity is huge.
If enough of these things close down and burn the wrong people, wealthy people who have the direct line to their congressman, you might see some changes in regulation.
At this point the average investor can only watch the carnage unfold and hope the damage can be contained.
Wikipedia's Hedge Fund Article
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Comments
1 Comment so far
Two things jump out at me and are very worrying when taken together (make that horrifying!); Hedge funds are essentially unregulated! And hedge funds account for somewhere between 30 and 55 percent of trading in some major areas! So, between 30 and 55 percent of trading volume in those areas is, in effect entirely unregulated.
What I find astounding is that ANY unregulated trading should be allowed to take place at all. I remember reading a book by Kenneth Galbraith where he stated something along the lines that the dislike for regulation, the perception that it was old fashioned and unnecessary was very dangerous. He was right. I fear that unbridled greed has replaced most other qualities (if that word is not a misnomer) that define bankers. I also think that the "subprime problem", which is itself a euphemism for bad lending is probably the product of that greed; I suspect that any serious investigation would uncover the fact that banks were selling debts they knew to be effectively guaranteed to default, but making billions doing it and gambling that they could get out before the bubble burst. They generally did not get out in time, and now everyone will be paying for their greed.
I am actually of the opinion that regulation on banks needs to be tightened dramatically and they need to be overseen by an external, independent (read uninfluenced or corrupted by the banks) and determined authority that can (and will) take unpopular and direct action. Hedge funds? They, and the often unfathomable and rather shady derivatives should be outlawed. If it is not regulated and understandable, it should not exist. Innocent people's money and livelihoods are at stake here.
I am a conservative; I firmly believe that real growth is infinitely better than imaginary growth and I have, for years stated that the housing bubble was just that. Essentially I believe that "if it sounds too good to be true, it is too good to be true". When house prices were rising by multiples of economic growth, where was the gap in funding coming from? We now know; the twilight zone of banking greed.