Value Investing / Main Index / previous / next

November, 2006


No, it's HEDGE funds...

What did you say!? Speak UP, please... Yes, that's as I say: "What's all this I hear about fudge funds?" I mean, in this day of too many people eating way too much and getting way too big, which can hardly be good for their health, why are people creating special funds for buying and eating even MORE junk food that...

NO, It's H-E-D-G-E funds!

Oh! Hedge funds... That's very different........ NEVERMIND!

Definition: With appreciation to Google for much of this info, a hedge fund is an investment vehicle that is unregulated, mainly limited to wealthy individuals, similar to mutual funds in that the manager(s) may invest other people's money in a variety of assets, for which they receive a fee, but differing in that, first, they may use special techniques to try to regulate risk, such as selling both long and short, buying or selling options, employing derivatives schemes, borrowing significantly against their holdings to leverage the investments, speculating on currency fluctuations, and so on, and, second, the management receives, in addition to a typically large cut of the profits over a certain minimum amount, a rather substantial (normally around 20%) annual portion of the pre-fee realized as well as unrealized returns.

One might ask, if they are restricted to the wealthy, why should anyone else care?

With over 8000 such funds now in existence, far more even than there are individual stocks in the S&P 500 Index and Nasdaq Composite Index combined, and a total market value of well over a trillion American dollars, they inevitably have a lot of influence on the rest of the money world.

It might seem that assets managed to control risk, particularly when their fund managers have strong compensation incentives to assure they are profitable, would be a stabilizing factor in the overall markets, rather like ballast for a ship, keeping things moving along on an even keel. In fact, though, since there are no regulators keeping the managers within any kind of bounds and the activities of the managers or even their holdings are virtually secret, a great deal of risk taking occurs. The strategies normally depend on mechanical systems of risk management that are supposed to work in predictable, and historically profitable ways. Secure in this expectation, managers tend to push the envelope. After all, it is much more lucrative for them if they can use more leverage or emphasize a riskier investment, perhaps boosting annual returns another 25-50% or more, than if they play things conservatively and with a margin of safety in mind. With those kinds of potential gains, the manager him- or herself, in a billion dollar fund might take home many extra tens of millions a year. If they had wanted to just invest conservatively, managers might as well have run a well diversified, fully disclosed, but far more modest fee mutual fund.

One difficulty is that, once riskier strategies are employed, particularly when there is little or no oversight, costly mistakes can occur. Because of the large dollar amounts involved, these may quickly have big repercussions.

In 1998, for example, one hedge fund, Long-Term Capital Management (LTCM), in a very short period lost nearly all of its more than $4 billion in pre-implosion assets, till being shored up by several panicky national central bankers, concerned that the shock of so sudden and substantial a loss might shake the regular equity markets to their core as well. After the bailout, there were more than a few calls for reform, but little if anything has come of them.

Another problem is that the computerized back tests showing what has worked in the past on Wall Street cannot indicate all possible previous or coming scenarios. As someone has said, prediction is very difficult, particularly about the future. So, every now and then, as in the LTCM case, things can go seriously wrong with hedge fund leaders' expectations.

Today, the number of these speculative funds has mushroomed, the total amount invested through them has ballooned as well, ordinary individuals' assets are sometimes directly affected (as mutual fund or pension fund managers and others are investing in hedged assets through "fund of funds" financial instruments), and the risky practices, if anything, are even more extreme as managers compete to show the best short-term gains, making them appear the more attractive to some would-be new investors.

So, it should not be a surprise that this year yet another hedge fund has taken a big bath. It was Amaranth Advisors and, per Roger Lowenstein's December, 2006, issue "Smart Money" article, "Lurking Behind the Hedge," pages 56-58, the losses have so far totaled nearly $6.5 billion. fudgeReportedly, afterward the management of the losing fund said the markets had not acted as they anticipated when they poured billions of other folks' funds into natural gas futures, as though that were a revelation. Well, "duh!" Major victims included many ordinary workers in San Diego whose pension fund managers had invested heavily via "fund of funds" vehicles with Amaranth Advisors. It is irresponsible or delusional to think risk in equity or commodities markets may be completely hedged away.

Intelligent money managers, including Warren Buffett and Charlie Munger, are concerned that the huge array of diverse, speculative hedging systems now being used within our global financial markets, largely in secret and with almost no restrictions, represents a threat to the world's economic stability similar to that prior to the 1929 Stock Market Crash.

What can be done?

Unfortunately, when, as seems to be the case, the likes of Buffett and Munger are being essentially ignored by legislators or regulators, there is no way the "little guy" can effect policy changes that would lead to more responsible measures by which these vast sums might be managed.

At best, ordinary investors can vote for candidates whose approaches would seem to be more fiscally conservative and, in their personal savings and nest egg decisions, choose more wisely, perhaps with a view to the potential for the proverbial 500-year flood.

One might periodically imagine what she or he would do upon suddenly losing half of her or his income and assets. If a person or couple could get by under those circumstances, perhaps they are being sufficiently risk-averse. But in the back of my mind is the awareness that in the Great Depression many folks lost 90% or more almost overnight. (Maybe things will not actually get that bad again, or not in the reasonably near future. We may at least be optimistic.)

Sooner or later, often more frequently than twice each millennium, such catastrophes tend to occur. When they do, and the financial world as we know it collapses, folks will probably once more belatedly make the changes that, if done before, might have prevented their occurrence in the first place.


Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)

Value Investing / Main Index / previous / next