Hedge Funds Aren’t Worth The Risk Part 1 – What Are Hedge Funds?

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Some days saving money under the mattress or in the tin can buried in the back yard sounds pretty good.  At least they are easy to understand. But most investors appreciate the alternatives that offer some kind of growth on their investment, where their money works hard for them while they work hard for their money. Regretfully, some of the investment options are hedgehogs in sheep’s clothing – specifically, Hedge funds. This week will explain what Hedge funds are. The next three will unveil their flaws. The final week will address what they are doing right.

Why so much attention to Hedge funds?  Since the market peaked in 2000 they have doubled in size and number accounting on some days for more than half of the daily volume on the New York Stock Exchange. There are currently about 8,000 Hedge funds, about the same as the number of mutual funds. They have become a force to be reckoned with on the market. But, for the most part, they are not for everyone. Hedge funds are supposed to qualify their investors. To qualify, you must have an annual income of $200,000 ($300,000 for a couple) for the past two years or a net worth over $1 million (including your home). But marketing finesse and savvy lawyers have combined their skills to create funds of Hedge funds that can now include almost everyone.

Investments 101: Stocks give you an equity interest which returns capital gains and/or dividends. Bonds are debt instruments giving you a promise of interest on money you have loaned others. Mutual funds pool individual securities giving you the safety in numbers approach to investing in stocks and bonds. All must register and are regulated by the Securities Exchange Commission (SEC). But Hedge funds and their mangers are not required to register with the SEC, are subject to very few regulatory controls, and are not subject to regular SEC oversight. These facts alone should raise the red flag high enough to signal, “Run for your life” but there is more.

Because of their regulatory freedoms, investors can be kept in the dark, not allowed to know what strategies their Hedge funds are using. The fund managers assure the curious that their secrecy is the key to the success of their strategy. (As an aside, I appreciate the advice of my father who told me never invest in something you can’t research and understand.)

Hedge funds also escape the regulators and standard reporting requirements of mutual funds by basing their operations in offshore tax havens like the Cayman Islands, freeing them to borrow aggressively, sell short, and leverage twenty to fifty times their paid-in capital. Unbridled, they take massive high risk bets. When they win, they win massively and publicize broadly. When they lose, the voices of the few don’t carry very far.

And yet Hedge funds continue to grow in popularity. Beware of following the lemmings. Remember the four flaws of the foolish investor: greed, pride, fear and ignorance (article “How to Adjust Risk Appropriately for Retirement“). Greed is the flaw with Hedge funds. The rest of this series will dispel ignorance as an excuse.

Hedge funds 101: Many Hedge funds use a variety of non-traditional strategies in an attempt to minimize downside risk, a technique called hedging, hence their name. The most popular Hedge fund technique is short selling.  Short selling can be illustrated with the following example. Your elderly neighbor needs a ladder. After collecting $50 from him, you promise to deliver the ladder to him in 3 weeks. The ladder he wants costs $50 today. If you buy it for him today everything is even, $50 comes into your wallet from your neighbor and $50 goes out to the store selling ladders. But you decide to take the risk of selling short. You hold the $50 and wait. You have 3 weeks for the price of the ladder to move. Good news (in this story). Two weeks later the ladder goes on sale for $35. You pay $35 for the ladder, pocket the $15 savings and deliver the ladder to your grateful neighbor before the deadline.

Using just the financial verbiage (spiced with our illustration), short selling is the selling of a security (ladder to a neighbor) that the seller (you) does not own, or any sale that is completed by the delivery of a security (ladder) borrowed by the seller (you). Short sellers assume that they will be able to buy the stock (ladder) at a lower amount ($35) than the price at which they sold short ($50). Short selling is one of the defining characteristics of Hedge funds.

Hedge funds claim to be arbitrageurs, purchasing securities on one market for immediate resale on another market in order to profit from a price discrepancy. But it is generally agreed that there are relatively few real significant arbitrage opportunities. As Hedge funds increase in activity the opportunities for arbitrage opportunities decrease in value.

Historically, hedge funds have offered some high returns at the expense of destabilizing whole countries and markets that are not equipped to cope with mass selling of their currencies and equity markets. George Soros, one of the gurus of Hedge funds once shorted the British Pound and in one day realized a gain in excess of a billion dollars.

In summary, while spending and saving wisely, a diversified and balanced portfolio, invested for long term growth can help any investor achieve their financial needs. Hedge funds don’t invest in growth, they speculate on change. Hedge funds are not illegal, just different. Rather than investing in the growth of the market, they invest in the fluctuations of the market, within relatively small windows of time. The next three articles will expose in more depth the dark side of many Hedge funds.

Photo by Maxwell Young on Unsplash

Go to part:
  1. Hedge Funds Aren’t Worth The Risk Part 1 – What Are Hedge Funds
  2. Hedge Funds Aren’t Worth The Risk Part 2 – Poor Performance
  3. Hedge Funds Aren’t Worth The Risk Part 3 – Poor Compensation Structure
  4. Hedge Funds Aren’t Worth The Risk Part 4 – High Fees and Poor Regulatory Control
  5. Hedge Funds Aren’t Worth The Risk Part 5 – What Hedge Funds Do Right
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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.