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     overview

This page considers hedge funds.

It covers –

• introduction
• nature - characteristics of hedge funds
• history - emergence of hedge funds as a business genre
• scale - how many funds, how big, how profitable
• issues - criticisms by regulators, politicians and investors
• studies - salient works about the hedge fund industry

The following pages looks at fund management (including questions regarding management fees, liquidity and valuation), at the history of particular funds and at hedge funds in Australia.

The note complements the more detailed examination of private equity funds and the broader guide on capital & investment. A perspective is provided by the discussion of booms, bubbles & busts, of art investment funds and sovereign wealth funds (SWFs).

     introduction

Hedge funds are capital in motion, variously praised as fuelling growth in a borderless global economy, lauded as vessels steered by far-sighted (or merely foolhardy) managers in the service of insurance and pension funds, damned as "locusts" that destroy jobs and hollow out industries, and excoriated as the shock troops of a ruthless and imperialistic Western capitalism.

Malaysian autocrat Mahathir distracted attention from domestic corruption and inefficiency by blaming hedge funds for the Asian currency crisis of the 1980s. Institutional Investor, in contrast, treated hedge fund managers as investment pin-up boys, albeit with twinges of embarrassment over the spectacular failure of funds such as LTCM and Aramanth. Regulators have recurrently fretted over whether they should (or indeed could) more closely regulate major funds and whether the impact of those funds on national or sectoral economies was as benign or malign as depicted by critics that range from Pat Buchanan to Noam Chomsky.

As the following paragraphs note, there is disagreement about the basic nature of hedge funds.

In essence, a hedge fund is a pool of capital that is provided by institutional investors or wealthy individuals/families and that is deployed by a fund manager to produce substantial returns in the short term. Exploiting perceived market inefficiencies – for example through trading shares, bonds, currencies or exotic financial derivatives – may result in substantial rewards for investors and for fund managers. Some funds have boasted that they have consistently produced higher returns than the stock market, with the more fortunate investors on occasion doubling their money within a few years.

Risks, however, can be high – despite claims that trading strategies typically seek to 'hedge' against adverse outcomes so that the investor profits whether a market rises or falls – and some funds have proved to be marvelous devices for making large amounts of money disappear, whether because the managers got it wrong or because they took advantage of 'light touch' regulation by pocketing the proceeds.

In discussing private equity funds elsewhere on this site we have noted that such funds typically seek to exit from an investment (for example buying and then floating a corporation) within three to five years. Hedge funds are even less patient investors and arguably are most usefully regarded as traders, with the turnaround typically being measured in weeks, days or even hours rather than years.

The funds are sometimes differentiated from narrower commodity trading pools, with a similar structure to hedge fund partnerships but typically operated by commodity trading advisors (CTAs) and in principle restricted to trading futures contracts. A CTA is a
corporation or individual that handles capital and advises on trading futures contracts/options.

SIVs (Special Investment Vehicles) are unregulated funds established by investment banks for other investors such as hedge funds that rely on raising cheap forms of debt to invest in high-yielding financial instruments, making money by pocketing the difference. SIV-lites are usually more concentrated on a handful of asset classes. Some have experienced severe pain because their investment centres on residential mortgage-backed securities (RMBS), packaging US and UK home loans. As of late 2006 SIVs were reported to control some US$400 billion of assets, with SIV-lites valued at US$12 billion. Those figures were eroded during the global subprime crisis of 2007, which saw the near-collapse of major UK lender Northern Rock and major injections of capital by SWFs such as Temasek into leading US financial institutions such as Merrill Lynch and Citigroup.

     studies

Works of potential interest include Hedge Funds for Dummies (New York: Wiley 2006) by Ann Logue, Hedge Funds: An Analytic Perspective (Princeton: Princeton Uni Press 2008) by Andrew Lo, William Fung & David Hsieh's 1999 A Primer on Hedge Funds (PDF), Hedge Fund and Financial Market Dynamics (Washington: International Monetary Fund 1998) by Barry Eichengreen et al, Hedge Funds (New York: Irwin Professional 1995) edited by Jess Lederman & Robert Klein, the 2003 SEC report Implications of the Growth of Hedge Funds (PDF) and more succinct note Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds, US Commodity Futures Trading Commission guide to The Language of the Futures Industry, the 2001 paper Hedge Funds with Style by Stephen Brown & William Goetzmann, Hedge funds: crossing the institutional frontier (London: Euromoney Books c2006) edited by Sohail Jaffer, SuperCash: the new hedge fund capitalism (New York: Wiley 2006) by James Altucher, Keith Black's Managing a hedge fund: a complete guide to trading, business strategies, operations, and regulations (New York: McGraw-Hill 2004), Gordon de Brouwer's Hedge Funds in Emerging Markets (Cambridge: Cambridge Uni Press 2001) and the anecdotal but revealing Inside the House of Money (New York: Wiley 2007) by Steven Drobny.

The latter for us was more insightful than Andy Kessler's Running money: hedge fund honchos, monster markets, and my hunt for the big score (New York: HarperCollins 2004), A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation (New York: Wiley 2007) by Richard Bookstaber or the soft focus Hedge Hunters: Hedge Fund Masters on the Rewards, the Risk, and the Reckoning (New York: Bloomberg 2007) by Katherine Burton.






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