Meltdown 101: How does a hedge fund work?

Date: Friday, October 23, 2009
Author: Candice Choi, AP

The arrest of a billionaire in an insider trading case last week drew new attention to hedge funds — investment firms that, for many, evoke an exclusive world where the super rich use exotic investing techniques to grow yet richer.

The understanding usually stops there.

In the case against Raj Rajaratnam, federal prosecutors accused the portfolio manager for the Galleon Group of using a powerful Rolodex of contacts to acquire insider information to trade securities. Five other hedge fund managers and corporate executives were charged in the case, and prosecutors suggested the problem could be more widespread.

On Thursday, a lawsuit was filed claiming that Rajaratnam also used his money to help finance Sri Lankan rebels.

Most people who've heard about hedge funds know that a whole lot of money is involved. But what exactly are they, and how do they work? Here are some questions and answers.

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Q: First of all, what is a hedge fund?

A: Hedge funds are privately held investment partnerships that are exempt from regulation by the Securities and Exchange Commission because of their limited size and the profile of their investors. So unlike mutual funds, which are generally restricted to trading select securities such as stocks and bonds, hedge funds have the freedom to invest in pretty much any financial instrument on the market.

Hedge funds also aren't required to disclose the details of their assets and liabilities to regulators or investors. Mutual funds such as Vanguard and Fidelity, in contrast, must issue financial reports on a regular basis.

All that may soon change, however. The details are still up in the air, but Congress is now debating legislation to bring hedge funds and other private pools of capital under government supervision.

Q: Why do hedge funds have such a reputation for exclusivity?

A: To be exempt from securities laws, hedge funds are limited in the number and type of investors they can have. Depending on their structure, they generally have no more than 99 or 499 investors.

Investors in hedge funds with no more than 99 clients need to have a net worth of $1 million or an income of at least $200,000 ($300,000 for married couples). The requirement is intended to ensure only experienced investors participate, said Meredith Jones, a managing director at PerTrac, which tracks the hedge fund industry.

For the larger hedge funds, clients must have a net worth of $5 million.

Another reason hedge funds might seem so secretive is that securities law prohibits them from advertising. As a result, many rely on word-of-mouth recommendations for clients.

Q: Aren't there different kinds of hedge funds?

A: Yes. Hedge funds vary greatly in size and investing style. Some employ conservative strategies, while others are much more aggressive in pursuing higher returns.

"There's one for every appetite. It's not a homogenized group," Jones said.

To give you a sense of the diversity, PerTrac estimates there were 22,350 hedge funds at the end of last year. The majority of those funds had less than $25 million in assets under management, while a small slice had more than $5 billion.

Hedge funds will typically build their reputation on a specific investing strategy. For instance, a firm might specialize in "merger arbitrage," which means the manager trades stocks of companies that are being taken over or bought out. Different hedge funds will vary in how much disclosure they give clients about investing tactics.

Q: What are the risks of investing with a hedge fund?

A: If you follow the adage that you should only trade in what you understand, hedge funds probably aren't a good fit for the average investor.

"Clearly there are some good hedge funds out there. But people need to do an enormous amount of due diligence, and only very sophisticated investors might be able to understand the strategies and risks of hedge funds," said Eric Tyson, author of the book "Mutual Funds for Dummies" and a former management consultant to financial services companies.

Another barrier is that some funds lock up your money for a year or more, meaning you can't make withdrawals in that time.

The other big concern, of course, is transparency. The lack of it means there's a greater potential for fraud, especially since hedge funds aren't regulated by the SEC.

Even if a firm says it uses a specific investing style, for instance, you might not be able to verify that the fund manager is sticking to that strategy, said Brian Bethune, an economist at IHS Global Insight.

"Generally, there aren't a lot of safeguards," Bethune said.

Q: If they're not regulated, why would anyone risk putting their money in a hedge fund?

A: Since they can employ a greater arsenal of financial instruments, hedge funds say they have the ability to bring greater returns and minimize losses — or even turn a profit — when the market declines.

For example, hedge funds often engage in short selling, which is when money is made off the decline of a stock price.

"Hedge funds are not limited in what they can invest in," said Jones of PerTrac. "They have more options available to them. For better for worse, they can maneuver around a lot more."

Mutual funds, meanwhile, are generally dependent on the performance of the equity and bond markets, she noted.

Hedge fund managers also typically get 15 to 20 percent of a fund's profits. That's on top of the manager's fee of about 1 to 1.5 percent. Some say the commission gives hedge fund managers a greater incentive to reap returns, although that might be a bit disingenuous.

"It's a case of heads, every one wins. Tails, and only the investor loses. The manager still gets the management fee of 1 to 1.5 percent," Tyson said.

Q: What role did hedge funds play in the financial meltdown?

A: Hedge funds no doubt traffic in the complicated and even risky financial instruments that hastened the financial crisis. But few would place the blame for the economic meltdown on hedge funds alone.

There were many players that contributed, including investment banks, national banks, insurance giants, mortgage brokers, ratings agencies and others.

It should also be noted that the crisis has altered how the hedge fund industry operates. In the wake of the all the financial scandals, many funds now make a point of offering greater transparency, Jones said. This might be through a monthly newsletter, or the disclosure of audited financial statements.