In light of the Amaranth debacle I thought I’d provide a little more background on what these “hedge funds” are all about.

The executive summary is that they are investment vehicles that employ sophisticated and sometimes very risky investing strategies, are only accessible by wealthy investors or institutions, are largely unregulated, have grown enormously in popularity, have very high fees, and may or may not pose a risk to the financial system.

I’ll go over each of the above in detail, but first let’s start at the start: Why are they called “hedge funds?”

The typical investment approach is to be, in financial market parlance, “long.” This means that an investor buys an asset – stock, bond, or what have you – and holds the asset with the expectation of earning money through income and/or price appreciation.

It is also possible to profit when asset prices decline, which can be achieved by being “short.” One can “sell short” an asset, such as a stock, by borrowing a stock and selling it with the intent to buy it back later at a lower price. Another common way to position oneself for a price decline is to buy “put options,” which give the purchaser the right to sell an asset at a specified price in the future.

Getting to the point, the original hedge funds employed both long and short techniques in order to hedge the risks of a market decline in pursuit of safer and less volatile investment returns. Hence the “hedge fund” name.

The hedge funds of today have kept the moniker, but that doesn’t necessarily mean that they are playing it safe. Many of them employ a lot of leverage, which essentially means that they invest using borrowed money in an attempt to magnify their returns. This is great when those returns are positive, but when things don’t go as planned, the losses can – as Amaranth has shown us – be brutal.

Hedge funds also invest in less conventional vehicles such as derivatives (which are assets that “derive” their value from other assets as with the put options described above) as well as participating in numerous markets like those of emerging market stocks, commodities, real estate, mortgage lending, and many, many more. A recent anecdote gives a flavor for their diversity: after Tom Cruise was fired from Paramount, the hedge fund industry was the first place he went in search of funding for his future movie projects.

Only high-net worth investors or institutions such as the San Diego County pension system can invest in hedge funds. Because such investors are assumed by legislators to be able to look out for themselves, hedge funds are not subject to nearly as much regulation as the rest of the securities industry.

For this reason, it’s sometimes tough to tell what’s going on underneath the hood. But it’s clear that these funds have become a force to be reckoned with in financial markets. Hedge fund popularity has grown substantially in recent times, to the point that the hedge fund industry now manages over $1 trillion in assets – a number that has almost doubled in the past three years. It is estimated that there are about 8,000 funds, although the lack of transparency makes it tough to nail a figure down.

Critics often make note of hedge funds’ exorbitant fees. The typical fund will charge 2 percent of assets under management in addition to 20 percent of whatever returns the fund is able to generate. Some funds are even more expensive – Amaranth charged 2.5 percent of managed assets and 30 percent of profits.

Of course, the rush into hedge funds shows that investors have been happy with their total returns, fees and all. But as more and more such funds proliferate in the zero-sum game that is the investment market, there is serious question as to whether hedge funds will be able to justify such fees going forward, at least on an industry-wide basis.

Hedge funds are the target of a more serious criticism as well. Because of the opaque nature of their transactions and the enormous amount of leverage employed by many funds, some people worry that serious problems at one or more funds could cause a rush to the exits that would destabilize financial markets. They cite as precedent the demise of Long Term Capital Management, the infamous fund whose 1998 blowup sent shivers through global markets and required the involvement of the Federal Reserve and a consortium of banks to smooth over.

Hedge funds certainly have their place, but the Amaranth meltdown will likely spark some serious debate as to whether that place includes pension plans. As a matter of fact, the fur is already flying over at SLOP, where our intrepid Mr. Lewis first started to question the County’s pension investment strategy back in August.


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