What are hedge funds ?

• Money, money, money, It is a rich man's world - Swedish group Abba's famous song in the 1970s.

In mid April 2008, the New York Times reported that one hedge fund manager took home a compensation of more than USD 3 billion in the year 2007. It is a mind boggling sum and many poor countries do not have their GDPs equal to it. Billion dollar salaries have become a distinct possibility in managing hedge funds as there are many such fund managers. If a fund manager can earn that kind of money in a year, what would be the earnings of the investors in such funds ? Even giant corporations do not make that kind of profits. Immediate question that is raised is what are hedge funds ? We wrote our article on the subject in November 2006, under the title 'Money Management as a lucrative business' and giving below a brief outline from it on hedge funds.

Hedge Funds The term 'hedge' literally means a fence or a perimeter, normally of thorny bushes, which protects a garden against an unwanted intrusion by stray cattle. Similarly, a hedge fund is a lightly regulated private investment fund for high net worth investors, often characterized by unconventional investment strategies and making use of legal structures (sometimes offshore) to mitigate the effects of local regulation and tax régimes. They are exclusive and keep the ordinary and small investors away. In contrast to regular investment funds, which are usually limited to only being able to "go long" (buy) instruments such as bonds, equities or money markets, hedge funds also have the ability to "go short" (sell) instruments which they believe will fall in price. In this way, hedge funds are able to create more complex investment structures which can profit in times of market volatility, or even in a falling market. They are primarily organized as limited partnerships and previously were often simply called "limited partnerships" and were grouped with other similar partnerships such as those that invested in oil exploration and development. Hedge funds are normally open to institutional and/or accredited individual investors.

Origin and development The term hedged fund dates back to a fund founded in 1949 by one Mr. J W Jones, a fund advisor. The fund advisor was to sell short some stocks while long on others, thus some of the market risk was hedged, which meant that the risks were slightly protected. The term "hedge fund" has today become the accepted vernacular, though most such funds are not actually hedged in the literal sense. Before these terms gained wide financial acceptance, they were referred to as "investment pools", "investment syndicates", "investment partnerships" or "opportunity funds" or "growth funds". While most of today's hedge funds still trade stocks both long and short, many do not trade stocks at all. For U.S.-based managers and investors, hedge funds are simply structured as limited partnerships or limited liability companies. The hedge fund manager is the general partner or manager and the investors are the limited partners or members respectively. The funds are pooled together in the partnership or company and the general partner or manager makes all the investment decisions based on the strategy it outlined in the offering documents. In return for managing the investors' funds, the hedge fund manager will receive a management fee and a performance or incentive fee. The management fee is computed as a percentage of assets under management and the incentive fee is computed as a percentage of the fund's profits.

Comparison to private equity funds Hedge funds are similar to private equity funds, in many respects. Both are lightly regulated, private pools of capital that invest in securities and compensate their managers with a share of the fund's profits. Most hedge funds invest in very liquid assets and permit investors to enter or leave the fund easily. Private equity funds invest primarily in very illiquid assets such as early-stage companies and so investors are "locked in" for the entire term of the fund. Hedge funds often invest in private equity companies' acquisition funds.

Hedge fund privacy As private, lightly regulated partnerships, hedge funds do not have to disclose their activities to third parties. This is in contrast to a fully regulated mutual fund (or a unit trust) which will typically have to meet regulatory requirements for disclosure. Hedge funds have to file accounts and conduct their business in compliance with the less stringent requirements of these offshore centers. Investors in hedge funds enjoy a higher level of disclosure than investors in mutual funds including detailed discussions of risks assumed, significant positions, and investors usually have direct access to the investment advisors of the funds. This high level of disclosure is not available to non-investors, hence the notion of privacy attached to hedge funds. A byproduct of this privacy and the lack of regulation is that there are no official hedge fund statistics. The combination of privacy and rich investors means that hedge funds are a target for criticism by many.

Summary & Conclusion Hedge funds are private investment funds for high net worth individuals and institutional investors. They form 15 to 20% of the total available funds, as against the mutual and pension funds sector which meets the balance securities market and is highly regulated. The hedge funds take higher risks and may even fish in troubled waters. The hedge funds managers get paid for performance by the investors who provide the funds. The general tendency of hedge funds is to invest partly in developing and overheated economies because the rate of return is far better, as compared to developed economies. The amounts may not be large by hedge funds standards but are very large amounts in local weak currencies. They are often referred to as 'Hot-Money', as flight of capital can take place at a short notice. Hedge funds are largely to be blamed for the Asian Financial Crisis a decade ago, because flight of capital took place. The economies of so called 'Asian Tigers' went for a tailspin. Hedge funds are loyal to themselves and to their investors. If the going is not good, they will exit at the earliest opportunity. They are not bothered about the resultant consequences to the local economy, loss of jobs, shattering of lives etc., The volatility in the stock markets can be directly attributed to them. Many small investors get burnt. As a result, most governments and regulators look upon hedge funds with suspicion.

Hedge funds are involved in securities, options & futures, commodities and FX markets by adopting strategies which are very complicated and will not suit conservative or novice investors. A lot of money is made by hedge funds in crude oil options and futures, due to the high price that prevails in the market. To a large extent, they are responsible for the fluctuating oil prices along with the oil cartel like OPEC, because they bet large amounts in oil futures and options. They are privy to a lot of inside information. Hedge funds are the playgrounds of the rich, powerful, famous and people in high places. Money attracts more money. The law of magnetism does not apply to money. The objective of hedge funds is to make a quick buck on anything and everything in a short time. They make money in an unstable and volatile market. They are short term players. This is the reason they prefer to be based in low tax regimes because of high capital gains in a very short time. Short term capital gains are taxed heavily in most countries.



© Copyright. Written on April 23, 2008. Without prejudice. All rights reserved

What are hedge funds ? - To learn more about this author, visit Madhavan T Gopalachary's Website.

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