Hedge Funds – Boon or Bane?

Anyone following the financial news has likely heard opinions right and left about what’s behind the current crisis. In addition to the usual suspects—Wall Street greed, lack of oversight, and predatory lending—you’ve doubtless seen fingers pointed at other culprits, such as short selling and hedge funds.

Let’s take a closer look at those last two subjects by answering these questions: What exactly are hedge funds? How do they work? Who is eligible to invest in them? And finally, why have these funds been grabbing headlines during the recent Wall Street crisis?

First, let’s examine what they are and where they came from.

Hedging against risk

Back in 1949, Alfred W. Jones, a sociologist, author, and financial journalist, came up with a revolutionary idea for an investment fund. To hedge against potential losses for investors, Jones combined leverage and short-selling of securities. He was so successful at hedging the market, his fund outperformed the mutual funds of the day—and the term “hedge fund” was born.

Despite his success, hedge funds didn’t really get traction until the 1960s when wealthy entrepreneurs like Warren Buffet and George Soros got on board. Suddenly hedge fund became a Wall Street buzzword, and by some estimates, these funds currently manage close to $3 trillion in assets.

While Jones's strategy focused on short selling and leverage, there are a variety of other methods today’s hedge fund managers use.

Bigger risks, bigger rewards

Hedge funds are a bit like exotic mutual funds, but with bigger downside risks, and greater upside rewards. They’re similar to mutual funds in that hedge fund managers pool investors’ money and re-invest it in hopes of getting a positive return. But that’s where the similarity ends.

Unlike most security offerings, which are tightly monitored and regulated, hedge funds are not required to register with the Securities Exchange Commission (SEC) or to file periodic reports. Hedge fund managers aren’t even required to disclose what they’re doing with investors’ money. In fact, what they’re doing is investing in everything from stocks and futures to commodities and currencies, real estate, art, even website domain names — not to mention other risky investments. There’s no regulatory body overseeing hedge funds, so investors are virtually unprotected.

It’s an environment that attracts the wealthy in search of higher than average returns—investors who may even prefer the lack of government oversight. Hedge Fund managers have free rein to take risks tightly regulated mutual funds cannot. To do so, they use a variety of sophisticated investment strategies. Two of those strategies are short-selling and arbitrage.

Short Selling is like placing a bet that the stock price will go down. The hedge fund manager borrows shares of stock he feels are about to slide and immediately sells them on the promise of returning the shares later. If the manager’s assumptions were correct, he can purchase the shares back at the lower price and keep the profit before returning the stock to the lender. Short selling on a massive scale upsets the balance and order of the market.

Arbitrage takes place when you simultaneously purchase and sell the same investment to take advantage of inefficient markets. Here’s a simple example: A hedge fund manager buys securities in one country and immediately sells them in another, to take advantage of a lag in foreign exchange rate adjustments (and possibly different time zones). This risky technique requires careful monitoring of global currencies.

Who’s eligible to play this high-stakes game?

Unlike mutual funds, hedge funds are small, private partnerships with stringent eligibility requirements. The widespread availability of hedge funds has changed a lot since Buffet and Soros first favored them, but one thing hasn’t changed. These funds are still for big hitters only—institutional or individual investors with deep pockets, wealthy enough to absorb heavy losses and savvy enough to understand the risks.

Typically, a pool of investors in a single hedge fund may be comprised of 100 "accredited investors" or an unlimited number of "qualified purchasers." To join the ranks of qualified purchasers, you typically must meet these criteria:

• An individual with investments worth at least $5 million including those held jointly with a spouse.

• A family-held business with $5 million or more in investments.

• A business with control of at least $25 million in investments.

• A trust sponsored by qualified purchasers

The requirements to qualify as an accredited investor are similar, but typically apply only to individuals, not businesses or trusts:

• An individual with a net worth in excess of $1 million—or that amount when combined with a spouse.

• One who has had an individual income, excluding spouse’s income, of more than $200,000 in the previous two years with reasonable expectation for same in current calendar year.

• A married couple with joint income of more than $300,000 in the previous two years and a reasonable expectation for the same in the current calendar year.

Minimum investments:

The minimum investment is set by the General Partner (GP) and varies between funds, but $250,000 or $500,000 is the typical amount for a new fund. Minimums for established funds can run as high as $10,000,000. Generally the GP can waive the minimum if he wants to accommodate those investors that pledge to invest that amount over time.

Hedge funds get in trouble

The strategies hedge funds use are designed to work to the investors’ advantage whether markets are rising or falling. In fact, these funds usually thrive in volatile markets because they can capitalize more fully on market opportunities using leverage, short-selling, options, futures, arbitrage and other strategies.

But now even hedge funds are struggling to hang on as they ride the financial roller coaster. Before the Wall Street meltdown and $700 billion bailout for financial institutions, hedge funds were already seeing their worst year on record. By the 2nd quarter of 2008, the average fund was down nearly 5 percent — a bitter pill to swallow when average annual returns on investment were often in the double digits.

No one can afford to be invested in an underperforming hedge fund right now — and half of the hedge funds in America are underperforming. Even billionaire Boone Pickens, founder of BP Capital LLC, who lost more than $1 billion of his own money in energy trades this year, reports that 15 percent of his hedge funds’ holders opted to cash out.

Most hedge funds set a quarter-end deadline for clients to request having their money returned. If the predictions are accurate and hedge fund investors want out en masse, it will push fund prices down far enough to force many smaller and poorly managed hedge funds out of business.

That won’t happen overnight, of course. The wave of closures would be gradual and most likely span a six month period. Experts predict the wave could kick off in November and December at the end of the typical 45- to 65-day waiting period, when fund managers must return investor money.

Many financial analysts predict the demise of as many as 2,000 smaller hedge funds between October 2008 and March 2009. Fear over a mass investor cash-out have become far more worrisome to hedge fund managers than the recent temporary worldwide bans on short-selling that hamstring trading strategies such as arbitrage.

Those bans were put in place in late September when, in an effort to quell market volatility, the SEC banned short-selling in 799 financial stocks and required hedge-fund managers to disclose their short positions.

Disclosure? That was a first! Naturally there was immediate pushback, with some arguing that asking a hedge fund to reveal its inner-workings is like asking Coca-Cola or Colonel Sanders to reveal their formulae.

The expanded and extended no-short list now covers nearly one-fifth of regularly traded stocks listed on U.S. exchanges. The ban is expected to be in place until mid-October.

It remains to be seen how all of this shakes out and how the hedge fund industry will survive this major upheaval in the financial markets.