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Hedge Funds

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Thanks Jason - should have done that for myself.

I'm curious about them because I'm not entirely sure why they are free of the rules that govern normal mutual funds. Are the rules there to protect the investors (so hedge fund investors are assumed to understand the risks). Or are the rules there partly to protect the market (because highly leveraged funds and risky investments could collapse with dramatic knock-on effects)?

It seems their main role is to let very rich people get richer by ignoring the usual rules and taking serious risks. I can imagine that now they are so huge, they may make a downturn more serious as their more complicated positions unwind, but I'm not sure I really understand enough about them still.

Any thoughts?

One of the linked definitions had this interesting and rather worrying quote:

"The reader is advised that the technical descriptions above do not begin to do justice to the insanity of the processes they describe. Credit derivatives, for example, do not really provide protection against a default, since the institutions which issue them are often in precarious financial positions themselves, and sell the derivatives because they are desperate for the cash flow. In the current environment, a credit derivative is mainly used to provide the accounting fiction that certain mostly worthless assets on a company's books still have value. The derivatives market, overall, is designed to hide the bankruptcy of the system by providing virtual assets to paper over gaping holes in the system, as well as garnering cash flow from selling mafia-like protection to companies ravaged by market manipulations. One of the chief agencies of such manipulations are the hedge funds, which act as front men for the Anglo-American central banks and their sibling financial institutions. George Soros is a prime example of this phenomenon."

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If you want to really understand how Hedge funds work I suggest you try reading

"When Genius Failed: The Rise and Fall of Long Term Capital Management", by Roger Lowenstein.

A small hedge fund with about 200 employees managed to blow a $1 trillion hole in the worlds financial system, mostly through the use of interest rate derivatives and volatility trades.

It's rumoured that the Federal Reserve actually dropped rates twice to stop this company going down the drain, because the financial fallout would have been too severe.

The staff included Meyron Scholes and Robert Merton, two Nobel prize winners in economics.

http://nobelprize.org/economics/laureates/...es-autobio.html

http://nobelprize.org/economics/laureates/...on-autobio.html

Both men are still widely recognised for the Black-Scholes options pricing model, widely used today.

The company made a massive fortune in it's first few years, basically betting that historical relationships would reassert themselves.

They were completely correct, and using massive leverage were able to produce money from practically nothing.

Unfortunately in about 1997 they made massive bets that the stock markets were too volatile, and started taking out options that would allow them to profit when volatility subsided.

Sadly for them it all went horribly wrong.

You may be pleased to know that the man who created LTCM, John Meriwether, is now running a new hedge fund with a couple of his pals from LTCM, called JWM Partners.

Easy come, easy go...

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The fundemental reason behind the explosion in hedge funds is the ability to borrow money at zero/under real inflation rates, and put the credit into anything which will show a real return. Commodities, stocks, bonds, gold etc...

This is not a new phemonoma - the hedge fund explosion also occured in the free money era of the 1920s. Goldman, Sachs was a partcularly avid issuer of 'levered funds' - and 'levered funds of funds' whereby funds would borrow to invest (lever) in funds which did the same, gaining massive commisions. As prices dropped as fundementals couldn't justify the capital ratio, the levered funds - today know as 'hedge funds' - would then suffer massive losses.

The Bear's Lair: Instruments of Satan

By Martin Hutchinson

UNITED PRESS INTERNATIONAL

Washington, DC, Feb. 28 (UPI) -- For anyone who DOESN'T think the stock and bond markets are currently hopelessly distorted, I recommend taking a long cold look at the hedge fund industry. It is a sobering spectacle.

Hedge funds, originally intended as unregulated investment pools for the very wealthy, have existed for decades but have increased rapidly in size since the bubble stock market of 1996-2000, with assets under management rising from $500 billion to $1 trillion since 2000, according to the Economist. The growth of hedge funds is primarily a result of the enormous computing power now devoted to arbitrage between different instruments, and the deep markets for derivatives contracts, that enable traders to take any risk position they deem appropriate. Access to hedge funds has been made easier for the only moderately well off through legally clever pooling schemes; thus the Securities and Exchange Commission dividing line, separating regulated mutual funds from unregulated hedge funds, sold only to large sophisticated investors, has become thoroughly blurred.

Apart from their lack of regulation, hedge funds have three characteristics that differentiate them from conventional mutual funds. First they can go both long and short in an asset, thus being able to "hedge" the risks in the portfolio. Second, investors' money is frequently locked into the fund for a period of several years -- nominally because the funds take illiquid positions, but in reality providing additional protection for hedge fund managers. Finally, the fees hedge funds charge are much higher than those on mutual funds; generally including a payout for the managers of 20 percent or even more of all profits made by the fund. This is supposed to compensate for their "superior" management, but as the amount of money devoted to this sector has increased in recent years, the percentage of hedge fund managers who are truly superior must necessarily have diminished.

Many such funds, such as Long Term Capital Management, the notorious 1998 bankruptcy, depend on risk management techniques that are themselves faulty, allied to excellent borrowing facilities in enormous amounts. Others depend on a sophisticated martingale strategy, appropriately leveraged, by which the fund's portfolio is designed to give a high probability of a modest profit and a low probability of total or near-total loss. If in a particular year the value of a $1 billion fund has a 60 percent chance of rising 20 percent, a 20 percent chance of falling 20 percent and a 20 percent chance of falling 80 percent, and the manager is remunerated at the standard rate of 1 percent of the fund's year-end value plus 20 percent of the profits, then even though the shareholder's expected return is minus 8 percent, the manager's expected fee has a 20 percent chance of being $2 million, a 20 percent chance of being $8 million and a 60 percent chance of being $52 million -- an excellent return on effort if the office costs of the fund are low, at around $5 million or so, with a net expected value of $33.2 million.

Thus even modest out-performance of the market can attract huge amounts of funds, and pay out great wealth to fund traders and managers. The illiquidity of many hedge fund positions, and the self-dealing of hedge fund managements in valuing them at year-end, when so much bonus money is at stake, increase the risk and murkiness of the sector still further.

It's very clear why ambitious hot-shot traders and speculators want to run hedge funds, what is not so clear is why anyone would invest in them. The rush into hedge funds, perhaps more than any other investment feature of recent years, is a clear sign that the market remains in a bubble state, and that the huge wave of cheap money injected into the U.S. economy since 1996 continues to have a distorting effect. Investors, including a large number of institutions, are so convinced that hedge fund managers can be magically superior to managers in other sectors that they are prepared to pay them a large percentage of any possible profits, in a completely unregulated murky sector. Such investors are not merely lacking in normal risk aversion, they are actively risk-seeking, in the same way as eager visitors to the more unpleasant attractions of Las Vegas. Pension fund managers, in particular, are asking for a fiduciary class action lawsuit if they make a large investment in a hedge fund that goes wrong.

The very capable and experienced William Donaldson, former founder of the investment bank Donaldson, Lufkin and Jenrette and now SEC Chairman, is trying to take steps to increase investor protection in hedge funds, initially by simply making them register with the SEC -- without such registration, nobody knows exactly how many hedge funds there really are, and the chance of investor fraud is multiplied once more. Naturally, his efforts are being met with furious opposition from the hedge fund industry, but registration, at least is due to come into force in 2006. None too soon, but a closure of the loophole that has allowed hedge funds to expand their activities to less wealthy investors, and a clarification of the fiduciary duty of pension fund and insurance company managers not to throw money down a rathole would also be welcome.

Hedge funds don't have to report their performance, so in general they don't do so unless it's good. One particular feature of the genre is that, unlike a regular mutual fund, when things go wrong they go very wrong indeed and very quickly. Hedge fund traders who find themselves losing money tend to double up their bets, whether or not controls nominally exist against their doing so -- if they don't make money they're out of a job anyway, so better bet the farm and try to get back into the black. Thus losing hedge funds tend to enter a rapid death spiral, reporting their demise in the smallest possible typeface at 5 a.m. on a public holiday. Only one quarter of the 600 funds that reported results in 1996 still exist; you can bet your bottom dollar that almost none of the disappearances represented a successful wind-up with a good profit for investors -- and that's in a period of easy money during which the Standard and Poors 500 share index almost doubled.

The next question is, why does this matter? Long Term Capital Management's collapse allegedly nearly brought down the U.S. economy in 1998, but Fed Chairman Alan Greenspan organized a bailout, so that potential disaster was avoided. No doubt if, as appears inevitable, there is another large crisis in the hedge fund industry, another bailout can be arranged, and so only the suckers who invested in the busted fund -- and their unfortunate probably unknowing fiduciary beneficiaries, if any -- will lose their shirts.

The real importance and danger of hedge funds is their size, and the nature of their investment portfolios. While hedge funds like to brag about their ability to spot unexploited arbitrage opportunities, in reality there are no unexploited, unknown markets that can provide a home for anything like $1 trillion.

The true profitability of hedge funds arises from the ability to leverage; if, as has been the case for the last 4 years, short term interest rates are lower than long term interest rates, then a hedge fund can lock in a guaranteed profit by borrowing short term money (by repurchase agreements or interest rate swaps, lubricated by the Fed's tide of easy money) and investing in long term Treasury securities or, more likely, mortgage backed debt securities. Provided interest rates don't rise, a hedge fund can thereby make a profit in today's market of 2 percent per annum, multiplied by the number of times it wishes to leverage its portfolio. The $1 trillion of investment in hedge funds is not like an equivalent amount in mutual funds, because it is leveraged; their true distortion of the markets is thus several times that amount.

Given the amount of money involved it is likely that this investment, and not Asian central bank purchases, is the true support for the extraordinarily low yields in the Treasury bond market, now close to or even below the anticipated rate of inflation. The official consumer price index rose in the last 12 months by 3 percent; it does however significantly underreport true inflation, because of the hedonic pricing scam, so true consumer price inflation is now around 4 percent and rising -- which doesn't leave a lot of room for real yield on a 10 year Treasury yielding 4.2 percent.

On the equity side, hedge funds can also achieve a guaranteed return by arbitraging between stocks and futures, and can leverage it likewise. Here, however, there is an even more attractive possibility. If there is a speculative stock like Google or Sirius Satellite Radio, with relatively little "float" and no well established valuation, hedge funds can themselves move the stock price as far as they wish to, simply by borrowing money and investing it in the stock. With $1 trillion in hedge fund money, and relatively few popular speculative plays, it's almost a no-lose scenario, at least in the short term, which is all the hedge fund manager cares about. Eventually, the stock will crash and the hedge fund investors will lose their money, but not before the fund managers have accumulated quite a few nice 20 percents of the nominal profits -- which, of course, there is no question of them paying back when the profits turn into losses.

It is in the market itself, therefore, that the pure perniciousness of the hedge funds manifests itself. Like the margin traders of the 1920s, but on a hugely larger scale, their activities are propping up fashionable, hugely overpriced stocks. Unlike the margin traders of the 1920s, they are also further inflating the housing bubble and depressing the dollar by keeping long term interest rates artificially low.

If Satan wanted to destroy the U.S. economy, and ultimately the capitalist system, he would devise an enormous mechanism whereby money would be poured into long bonds and speculative stocks, distorting both markets, causing a huge misallocation of capital, and leading to a crash that made 1929 look like a picnic. In the unlikely event that Satan exists, hedge funds are thus unquestionably His instruments.

--

(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

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If you want to really understand how Hedge funds work I suggest you try reading

"When Genius Failed: The Rise and Fall of Long Term Capital Management", by Roger Lowenstein.

A small hedge fund with about 200 employees managed to blow a $1 trillion hole in the worlds financial system, mostly through the use of interest rate derivatives and volatility trades.

It's rumoured that the Federal Reserve actually dropped rates twice to stop this company going down the drain, because the financial fallout would have been too severe.

The staff included Meyron Scholes and Robert Merton, two Nobel prize winners in economics.

http://nobelprize.org/economics/laureates/...es-autobio.html

http://nobelprize.org/economics/laureates/...on-autobio.html

Both men are still widely recognised for the Black-Scholes options pricing model, widely used today.

The company made a massive fortune in it's first few years, basically betting that historical relationships would reassert themselves.

They were completely correct, and using massive leverage were able to produce money from practically nothing.

Unfortunately in about 1997 they made massive bets that the stock markets were too volatile, and started taking out options that would allow them to profit when volatility subsided.

Sadly for them it all went horribly wrong.

You may be pleased to know that the man who created LTCM, John Meriwether, is now running a new hedge fund with a couple of his pals from LTCM, called JWM Partners.

Easy come, easy go...

The real irony is that the bets they made which finished them off were in fact correct in the medium term. Unfortunately in the short term the markets had a 'flight to liquidity' and all of their positions (which they had believed were uncorrelated) went bad on them at the same time.

As Maynard Keynes said: The market can stay irrational longer than you can stay solvent.

cheers, Phil

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Thanks Brainclamp and Bandwagon - really useful information.

Confirms my gut feeling that they're an accident waiting to happen, but I hadn't really thought through how much they must be distorting the market on an ongoing basis. I get the feeling that if things go horribly wrong people will be looking back at hedge funds as instruments of Satan as Martin Hitchinson suggests...

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  • 301 Brexit, House prices and Summer 2020

    1. 1. Including the effects Brexit, where do you think average UK house prices will be relative to now in June 2020?


      • down 5% +
      • down 2.5%
      • Even
      • up 2.5%
      • up 5%



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