Rick Welch: Dollars and $ense

Hedge Funds

Like picking up pennies with a bulldozer.  That proverb was how a finance professor once described the operation of a hedge fund.  The image of a bulldozer digging for pennies is worth a thousand words. As defined, hedge funds are privately managed investment funds that utilize sophisticated strategies, employ excess leverage, use derivatives and benefit from their less regulated nature to generate investment opportunities that are substantially different from opportunities offered by traditional asset classes. The goal of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver large positive returns under all market conditions. Because of their structure, hedge funds are able and often more inclined to dig deeper than traditional investment vehicles, like mutual funds, in looking for investment opportunities. A recent Forbes magazine article said it best in suggesting that “unlike mutual funds, which are highly regulated, hedge funds are unconstrained investment vehicles. This allows them to target investment opportunities that may be too illiquid, small or complex for traditional investment vehicles like mutual funds. By utilizing certain investment tools, techniques and trade structures that are unavailable to traditional mutual funds, hedge funds are able to engineer return streams that look much different than traditional stock or bond allocations.”

It is with these tools, techniques and trade structures and how they are employed within a fund that we can differentiate one hedge fund from another.  Early hedge funds were based on the concept of arbitrage which is an attempt to earn risk-free returns from the simultaneous purchase and sale of identical positions trading at different prices in different markets.  The offsetting positions resulting from the purchase and sale formed a hedge.  Hedge funds of today cover a much broader array of strategies including arbitrage, high speed trading, short sales, distressed investments, market timing, derivatives and leverage.  It is through the excessive use of leverage and derivatives that hedge funds are able to magnify the usually smallish gains (the pennies) that hedged strategies often generate.  Think of the hedging strategy then as the means by which the bulldozer picks up all those pennies. 

Hedge funds remain today the domain of the high net worth investor, pension funds, endowments, insurance companies and private banks.  Entrance to this corner of the investing world comes with a steep price as hedge funds typically charge a management fee (generally 2% to 3%), which is a flat charge on the assets of the hedge fund, and an incentive or performance fee, the latter which is earned by the hedge fund manager if the fund makes money.  The performance fee (generally about 20%) can be quite lucrative for the manager.  In researching this article, the highest performance fee uncovered was 44% which was on top of that funds 5% management fee.  Today, there are over 10,000 active hedge funds with approximately $2.0 trillion under management.  As a group, hedge funds at $2.0 trillion may seem like a minor role player, especially when compared to the almost $14.0 trillion currently managed in traditional domestic mutual funds.  Do not let the size disparity fool us.  The magnification of their bets (through excessive leverage and the use of derivatives) and the high levels of trading volume that they generate in underlying asset markets means that their impact may well be disproportionately large.

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