A hedge is nothing more than a defense or protection against financial losses. Someone may “hedge” in order to reduce their exposure to risk while trying to maximize returns. Thus the idea behind the name of a hedge fund came about. Although a hedge fund is just like any other fund, its name tricks investors into thinking that it is a safer bet while simultaneously ensuring higher returns for the amount of risk that they are exposed to. Hedge funds, then, can be described as aggressively managed investment funds only available to an elite few (wealthy and presumably informed investors) that utilize sophisticated strategies designed to deliver positive returns under all market conditions. The best money managers on Wall Street usually end up in these extremely profitable hedge funds dealing only with wealthy, intelligent investors so it is generally expected that the returns generated will also be higher than those of other investments. One such investment, a mutual fund, may have lower returns because they don’t have the same skills or tools that are being utilized by hedge fund managers. Due to the expected superior returns, hedge funds are able to charge fees not only on the money that they generate but simply for the opportunity they give investors to be in the fund. Although such an investment opportunity sounds worthwhile (it isn’t a matter of if you will win, but a matter of how much you will win by), things that sound too good to be true usually are. Like any other fund or collection of financial instruments, hedge funds can only reduce their risk to a certain extent based mainly on the diversification of their portfolio. In addition, their inaccessibility to the general populace reeks of injustice and allows for huge wagers (we’re talking about a trillion dollar industry) to be put into place which create high volatility and instability in the overall market.
Hedge funds utilize many different strategies to achieve above average returns. Such strategies include but are not limited to: relative value (arbitrage), event driven, directional, neutral, and global macro. These strategies, plus high levels of leverage, are the recipe for a high rollers game that could either result in riches beyond imagine or total disaster. In the case of Long-Term Capital Management L.P., the company’s utilization of an absolute-return trading strategy, such as fixed-income arbitrage combined with high leverage, led to initial success of annualized returns of over 40% after fees in its first year. A few years later, following the Russian financial crisis in 1998, it lost $4.6 billion dollars in less than four months and by early 2000 the fund closed. While a few strategies employed by hedge funds, like relative value, are neutral (meaning they have more stability than directional strategies which depend on the market’s ever changing direction), most of the strategies are anything but market neutral. Global macro investing, for example, is directional because it takes large portions of bond or currency markets in anticipation of global events to earn a risk-adjusted return. Event driven strategies find opportunities to earn returns through consolidations, acquisitions, recapitalizations, bankruptcies, and liquidations. This strategy allows managers to capitalize on valuation inconsistencies. It is also a very common strategy because hedge funds have the expertise and resources to analyze such events for opportunities while other smaller investors do not. With so many of the common strategies classified as directional, it is easy to see how aggressive trading that results in higher than average returns most of the time could signal or encourage others to follow suite. As a result, this creates a sort of frenzy underlined by a general misunderstanding of the complex instruments being traded within our financial system.
Also known as the shadow banking system, hedge funds are not held to the same regulations that other public funds and entities are held to. If the incentives in place are to reward managers for taking more risk, they have virtually unlimited finances for their investments, and there are less stringent regulations on their actions, it is no wonder that they can create so much volatility within the market. Therefore, when they lose, they lose big. Hedge funds have historically been exempt from almost any regulation because only qualified buyers were admitted as investors. Hedge funds were not required to submit any reports on their earnings, what they invested in, or even how they invested. The public was even left in the dark about the kind of returns that most hedge funds received, except whenever some would randomly show up in financial journals. If the goal of a hedge fund manager is to maximize returns with little regard to risk (because it is assumed risk will be minimized through taking both long and short positions) or being held to the same regulations as other investors, then taking highly risky, aggressive stances is ideal. The problem arises whenever one considers that every action has an equal and opposite reaction. Not only do their positions affect other’s investments but other investors will watch and emulate the actions taken by the hedge fund managers in the hopes of earning the same returns. This creates an enormous pendulum that grows until it endangers our entire financial system.
The National Bureau of Economic Research and the European Central Bank knew that hedge funds posed systemic risk to the financial sector back in 1998 after the failure of hedge fun Long-Term Capital Management. Wide- spread concern about the failure of its counterparties alerted officials to the gravity of the situation. The SEC issued a rule change in December 2004 that required hedge funds with 14 investors managing $25 million or more in assets to register with the SEC by February 2006 but when challenged by investors, it was overturned in the US Court of Appeals. After the housing bubble of 2007 that has led to the global financial crisis that we find ourselves in today, the Dodd-Frank Wall Street Reform Act of 2010 was passed in hopes of increasing regulation in financial companies to avoid another meltdown. The act requires advisers managing $150 million or more in assets to register with the SEC and be held subject to their rules and regulations as of July 21, 2011. Those who fall under the financial bar will be held accountable by state legislation. The act also requires increased transparency by providing information about portfolios and trades to aid in monitoring and regulating systematic risk, which will be performed by the newly founded Financial Stability Oversight Council. While all of these acts are improvements to what was previously in place, I remain skeptical as to the long- term impact and benefits that will result from these actions. By my estimation, the very nature of hedge funds goes against value investing, which is to not simply bet on a future outcome but to analyze financial fundamentals of a company in order to invest money long term if it is deemed undervalued. While hedge funds continue to charge exorbitant fees and promise unending returns, the resulting risk and volatility will continue to leak over into other financial sectors and destabilize our global economy.
Hedge funds, by promoting better returns than everyone else in the market, will tend to engage in risky behaviors such as high leveraging. The claim is the long and short positions within the fund minimize or even cancel out risk. Not only is this not true, but their actions affect other’s investments in the financial world. In addition, the average investor with limited means (meaning a few million rather than a few hundred million) is kept out while those few that are wealthy enough to be part of the hedge fund increase their wealth dramatically. The gap between the wealthy and the inconceivably wealthy has grown dramatically from the 1980’s up to today because of this unfair practice. As a nation founded on the idea that every man and woman should have equal opportunities and chances towards the pursuit of happiness (in this case wealth), hedge funds do not align with our national values. Even those with above average intelligence and finance smarts will struggle to follow the class act of a hedge fund because they simply don’t have the same type of resources, creating a dangerous crack the whip effect. Until the incentives that drive hedge fund managers are fixed in order to reflect the risk that comes along with their investing strategies and results, no regulations will ever be able to solve the underlying problem. The most they could hope to do would be to treat the resulting symptoms.
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