Debunking the myths: Hedge funds are still a good bet when investing

Date: Monday, November 2, 2009
Author: Rebecca O’Brien Radford and Clair E. Pagnano, Boston Herald

Hedge funds are the redheaded stepchildren of the investment world. Most media tend to portray them as deliberately secretive, wildly speculative investments sealed off to all but the wealthiest investors and managed by aggressive, risk-taking cowboys who earn large incentive fees from well-heeled clients.

Underlying this bad press are myths that blame hedge funds for the present economic conditions, and the stigma of high-profile scandals, most notably the $65 billion Ponzi scheme run by Bernard Madoff and the collapse of Long Term Capital Management in 2000.

The truth about hedge funds, however, holds far less intrigue. Simply put, hedge funds are private pools of money that buy or sell assets and take a position on whether the prices of those assets will fall or rise.

They have existed since 1949, and many have long provided steady returns, tolerable volatility and low correlation with the stock markets even amid downturns.

Their investors tend to be institutional clients – big investors with lots of money to move around – like pension funds and college endowments, but wealthy individuals also contribute.

Though hedge fund managers do speculate and use a variety of tools to achieve absolute returns, they are not always betting on bad results for the financial markets.

Managers make money by taking risks, being correct about their predictions and earning fees on the funds’ performance.

Unbridled aggressiveness is not the strategy most successful hedge funds undertake. They know that such strategies have caused some of their competition to blow up.

Managers of successful funds tend to be skilled measurers of risk who gauge where the most returns are and the best times to invest in and exit those areas.

Managers generally aim to build imperfect hedges in which long positions on equities, for instance, will outperform the short positions.

Meanwhile, hedge funds have no choice but to be shrouded in secrecy. As unregistered securities targeted toward only highly sophisticated investors able to withstand the investing risks, hedge funds are required by law not to solicit the general public.

They also cannot be transparent about their investment strategies, because unlike traditional funds, they use short positions more often.

In a short position, the investor sells a stock borrowed from a broker, expecting its price to decrease. If the price falls, the investor can repurchase the stock to return them to the broker, making a profit on the difference.

Such investments require more prudent treatment than long positions, so while less mystery would improve the funds’ image, their reticence about revealing such sensitive strategies and inadvertent solicitation keeps them away from the spotlight.

Unfortunately, the Madoff scandal has been linked to hedge funds, even though Madoff was not a hedge fund manager – in fact, some of his victims were hedge funds.

Madoff conducted a Ponzi scheme over decades, causing investors to lose money. A Ponzi scheme pays returns to initial investors from their money or money paid by later investors, rather than from any actual profit.

Madoff concealed his fraud in a number of ways, including creating a random-number generator to make it appear that trades were being conducted, and building a phantom computerized trading platform in case investors or regulators requested to see the firm’s trading activity.

Such behavior is the work of a convicted felon, not a typical hedge fund. Hedge funds themselves suffered losses from the mortgage-related securities that caused the financial crisis.

Still, because managers hedged their investments, hedge funds outperformed the market. The industry was down more than 23 percent by late December 2008, according to Hedge Fund Research, while global shares fell 44 percent.

This year, the Credit Suisse/Tremont Hedge Fund Index showed hedge fund assets rose 2.5 percent in July, contributing to a 9.9 percent climb over the first seven months of 2009 and the best year-to-date results since 1998.

Nevertheless, because of fears that frauds like Madoff’s could reoccur, hedge funds’ big investors are calling for more regulation.

Likewise, U.S. and European regulators intend to bring hedge funds under more stringent supervision.

The Obama administration has proposed legislation to implement regulatory reform that would bring almost all advisors to hedge funds and other private pools of capital under the Investment Advisers Act, thus requiring them to register with the Securities and Exchange Commission.

Additionally, the legislation would demand greater transparency by increasing recordkeeping, disclosure and reporting obligations.

Some lawmakers from both sides of the aisle would like to take government supervision even further, introducing bills that would have hedge funds themselves register under the Investment Company Act and thus increase their transparency requirements as well as their regulatory oversight.

The SEC has been doing its part through increased staffing and enhanced fraud-detection training for its examiners.

The commission has proposed regulatory changes that would increase controls on hedge funds, such as making short-selling more transparent to institutional investors and requiring broker-dealers to cover their bets immediately; annual surprise examinations of hedge fund managers by independent public accountants; increased disclosure requirements; and limiting “flash trading,” whereby some hedge funds have gained advantage by using computers to make instant, high-frequency trades.

The results have been dramatic, with 358 investigations opened as of June, compared to 292 for the same period in 2008.

Though these changes are geared toward reining in what many deem the unruly world of hedge funds, in fact other proposals are expected to affect the firms at the center of the market meltdown: mortgage lenders and banks.

The Federal Reserve remains in control of some banks, which face forced limits on executive compensation, scrutiny of their investments and possibly higher capital holding requirements.

However the regulations affect hedge funds, their masterful balance of risk and return will remain carefully considered, so it’s about time to give these redheaded stepchildren a respected seat at the dinner table.