What's the deal with Hedge Funds?

I got some recent questions from friends on how hedge funds work. There is no real answer to this question, so I thought I'd take a stab at explaining why that is. Over the weekend, I was looking around for good articles on hedge funds: somewhat to my surprise, I found that the finance information on wikipedia is not bad (to the extent it is up to date). The article on hedge funds is here.

Many people are surprised to find that many hedge funds don't actually hedge at all. Hedging is a strategy used to buffer against losses; in some sense, a diversified portfolio "hedges" against risk that can be diversified. Hedge funds often do something a bit different: they are looking to hedge against broad market risk, particularly in equity positions. But this too is somewhat misleading: some hedge funds take no equity positions at all. What really characterizes a hedge fund is that the fund is structured to avoid regulation, not its investment strategy.

Typically (as in the referenced article) you'll see that funds are targeted toward accredited investors. This is an allusion to securities regulations. Terms like "seasoned" and "accredited" basically signal that the investor has either savvy or money or both. Securities regulations allow private funds to escape many of the regulatory requirements by selling securities to accredited investors. These investors use their own judgment to determine if the risk in the fund is acceptable. Of course, they expect high returns and are willing to pay out high management fees for those returns. How the fund invests is specific to the fund and fund managers, not to "hedge funds" as a category. Hedge funds are never exempt from anti-fraud provisions of security regulations.

As you might imagine, this has all the hot button issues for controversy: "unregulated", "rich investors", "rich management", "opaque strategies". Hedge funds have been around for a long time. But let's be honest. These funds are putting a lot of pressure for efficiencies on a large scale and that has both good and bad results. As a category, it makes little sense to me to insist on special regulations or caps on management fees. Personally, I wouldn't lose sleep over hedge funds: they aren't new and they aren't sinister. Mostly they are risky bets that have the potential for big payoffs. In some cases, there are really well run funds that deserve a lot of credit. In other cases, they are disasters waiting to happen.

Capital market credit crunch

I've had a bunch of friends asking me about what is going on in the capital markets over the last few days. If you have a wsj.com subscription or can get access to one, there was a very good article on how we got into the current credit market mess. Definitely worth a read.

As usual, there isn't only one element that bears the blame: much of this is a fall out of fed actions dating back to Greenspan's easy money policies after 2001; part of it is desperation for higher yields through fancy and often opaque securities that few purchasers really understand; part is the fact that hedge funds are able to avoid many securities regulations; and part is of course just short-sightedness. It is very hard to say what the ripple effects will be: my own take is that it would be very prudent to make sure you're not carrying variable rate debt and consider using a no-risk interest bearing vehicle for a chunk of liquid capital (the latter is what the CAPM would suggest anyway).

There also seems to be a lot of interest in hedge funds. I'll follow-up this weekend with a brief explanation of US securities laws and how a hedge fund avoids a lot of regulation.