What is a Hedge Fund?

I'm currently on vacation at my new in-laws, so my posting will be little off this week. New posts will be up before the Tuesday/Thursday promise, but (as in this case) sometimes that might mean a day early.

I fondly remember the Super Mario Bro's Show while growing up. It was a hilarious show that began and ended with two guys dressed up as the world's most recognized italian plumbers. In between they would show an animated sketch that usually starred Mario, Luigi and the other denizens of the Mushroom Kingdom. However once in a while they would replace the Mario cartoon with a cartoon based on The Legend of Zelda, a complete change of direction and arguably more exciting.

In honor of that most notable show, I too like to stick mainly with my bread and butter, namely real estate, landlording and dishonest "gurus". But every once in a while I like to go off in a somewhat random direction and talk about other things. Today is one of those days and I want to discuss a little bit about hedge funds.

Most people even remotely interested in money have heard of hedge funds. They are the investment vehicle of the rich, glamorous and exciting, they routinely bring about returns higher than 25%... right? Let's start with a little history lesson.

Every investor knows about risk, but in the late 1940's an investor named Alfred Winslow Jones came up with the idea of hedging certain risks in the stock market. When you "hedge" an investment, you essentially bet on both sides of an issue so that you don't lose or win regardless of the outcome.

Let's say that I buy two investments. The first investment is tied to interest rates so if they climb, the investment loses value. The second investment is tied to interest rates so that if the rates climb, it gains value. Now, no matter what the interest rates do, I don't lose any money. I've hedged myself against the interest rates.

But why would you do that? After all, if interest rates move you don't gain any money either! That's 100% true, but the interest rate isn't the only variable that affects my return, it's only one. The goal of hedging your investments is simply to limit the number of variables that can impact your portfolio.

Let's say that you believe that Volkwagon is going to post huge gains this year. You want to buy their stocks but you are worried. What is the euro falls against the dollar? If Volkswagon gains 20%, but the euro falls 20%, you've just seen all your gains wiped out by a currency change. So you buy the Volkwagon stock, but then also short the euro (shorting is an investment where you essentially gain if the investment falls in value). If the euro stays strong and Volkswagon succeeds, you will make money from the stock and the euro breaks even. If the euro falls and Volkswagon succeeds, you'll make money from the short on euro, and the stock breaks even. Essentially the euro no longer matters in the equation, you'll only lose if the Volkswagon stock falls.

That is hedging. Unfortunately for most mutal funds, hedging often involves shorting stocks and leveraging positions (taking loans to buy investments), something that mutual fund managers are not allowed to do by SEC regulations (or at least not do freely). So around the 1980's some enterprising finance whizzes came up with a way around it. They would invest outside of SEC regulations, but still within the law. And hedge funds were born.

Hedge funds can only allow accredited investors to buy in. An accredited investor is someone who has a net worth of at least $1 million, or has earned at least $200,000 a year for the past two years. Why does the government do this? Why does it prevent poorer people from buying into the investments of the rich?

Simply put, accredited investors are people who are allowed to invest money in schemes that are not regulated by the SEC. Because these schemes are unregulated, they can often be extremely risky, and contain all manners of undisclosed issues. The government coined the term accredited investor to represent someone who had enough money to be aware of the risks inherent in unregulated investing. In other words, the government is limiting the risks that poor people can make with their money (yet government still encourage lotteries... more than slightly hypocritical).

Early on, hedge funds enjoyed tremendous gains (as is typical whenever a new successful niche is discovered). For many years hedge funds were able to generate huge returns by eliminating un-wanted risks and focusing their growth on variables that they could predict. However, as with all new successful markets, competition sprung up all around them. Profits became harder to find, but the investors still expected mammoth returns.

Due to the lack of regulation by the SEC, the hedge funds began to leverage themselves more and more, and instead of eliminating risks they began to gamble. They would leverage huge amounts of money on "almost sure things". Of course, as I've written before, when playing with leverage, you only have to lose once to destroy yourself.

This happened to a company named Long Term Capital Management in 1998. For the first four years of it's existence, LTCM returned nearly 40% a year. At first everything was great because they had found a very profitabler niche in the market. But as their niche lost it's profitability, the firm found itself under pressure to continue with it's extrodinary gains. They took risker strategies and undertook an enormous amount of leverage. When the market turned sour in 1998, they lost $4.6 billion in less than 4 months and had to be bailed out by the US government (actually the bail-out was private, but organized by the government).

So there you have it. A hedge fund is simply a vehicle (like a mutual fund) that is allowed to undergo risky strategies because it's somewhat on the outside of SEC regulations. Some hedge funds put togeher extrodinary returns, but just as many fail miserably. While hedge funds retain their name from the time when they actually hedged against risk, today they are simply specialized investment vehicles open only accredited investors.


The strategies that are available to hedge funds allow them to earn slightly higher returns than mutual funds, but that gain is apparently over-stated and comes with extremely high risk. Barclay's Bank (a major British Bank) did some research into the "average" results that were compiled by hedge funds indicies and found:

Barclays outlined a series of methodological failings by index compilers,
including survivorship bias — the tendency to ignore funds as soon as they close
or fail. This alone added between 2 and 4 per cent a year to index performance
figures, according to academic studies, Barclays said.

And there's good news for average joe's who wish they had the the complexity of hedge funds available. Due to leveraging and shorting becoming more and more common-place in the market today, the SEC is considering allowing regular mutual funds the freedom to place limited leveraged positions and shorts. So soon these techniques will be available, in fund form, to everyone.