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What’s wrong with hedge funds today?

By : Ziad K. Abdelnour| 1 December 2010
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For those of you who don’t know; a hedge fund is basically a pooled investment vehicle (like a mutual fund) where there are absolutely no constraints on what the investment portfolio manager can do with the money.

Sociologist, author, and financial journalist Alfred W. Jones is credited with the creation of the first hedge fund in 1949. Jones believed that price movements of an individual asset could be seen as having a component due to the overall market and a component due to the performance of the asset itself. To neutralize the effect of overall market movement, he balanced his portfolio by buying assets whose price he expected to be stronger than the market and selling short assets he expected to be weaker than the market. He saw that price movements due to the overall market would be cancelled out, because, if the overall market rose, the loss on shorted assets would be cancelled by the additional gain on longed assets and vice-versa. Because the effect is to ‘hedge’ that part of the risk due to overall market movements, this type of portfolio became known as a hedge fund.

Estimates of industry size vary widely today due to the absence of central statistics, the lack of an agreed definition of hedge funds and the rapid growth of the industry. As a general indicator of scale, the industry may have managed around $2.5 trillion at its peak in the summer of 2008. The credit crunch has caused assets under management (AUM) to fall sharply through a combination of trading losses and the withdrawal of assets from funds by investors.[ Recent estimates suggest that hedge funds have more than $2 trillion in AUM. A recent survey of hedge fund administrators indicates single manager hedge funds have over $2.5 trillion in assets under administration

As to returns, it has been pathetic to say the least. Take a close look at this latest article from AR Magazine (owned by Institutional Investor) http://www.absolutereturn-alpha.com/Article/2720404/Hedge-fund-IRR-has-been-pathetic.html and see for yourself.

Bottom Line:

Hedge funds started out being viable investment vehicles for those with enough resources to hedge against adverse market moves. Today, most investment managers are though taking advantage of the regulatory loophole to open hedge funds not using any hedging strategies at all. These “fake” hedge funds are what this blog is all about.

Hedge funds were initially designed to be “market-neutral” by always holding investments that will go up when the markets go down. This means that no matter what the markets do, you should always make money via the spread, which is usually substantially more than the T-bill rate. Hence, even if the stock markets went down 20%, you’d probably stand to make about 5%. True hedge funds still follow this strategy. This investment methodology, and the investor net worth restrictions, allows them to circumvent SEC regulations on pooled investments (via the Investment Company Act).

So all of the rules, regulations, and safeguards designed to stop abuse placed on traditional investment managers are today null and void with hedge funds. In simple English, if you give your money to a hedge fund manager, they are allowed to put 100% of your money into pork belly futures one day, and then the next sell all of that to speculate in the oil markets, and then the next day speculate on emerging markets distressed debt.

As you would imagine, this is a recipe for disaster – which is pretty much what’s been going on since hedge funds have mutated from their original purpose (to hedge against down markets), and have proliferated to the point of being the gigantic world-eating monsters that they are today (credit default swaps debacle version 3.0).

Marketers quickly realized all the ways tons of easy money could be made by not having to abide by any rules. So they quickly set up thousands of “fake hedge funds” that do not follow market-neutral methodology (which require actual talent/wisdom/experience that these scammers do not have). This is why there are now more of these hedge funds than mutual funds.

People can just make a hedge fund by spending a couple hundred bucks filling out SEC forms, and then market it as if it were a real hedge fund. Then they can buy and sell things willy nilly until all of the investors’ moneys are lost, then they fold up shop, and start over with a new one.

Because they primarily use market timing techniques, which don’t work at all, they will lose your money faster than a drunk in Las Vegas. So most of the people making any money at all on fake hedge funds, are the managers themselves.

Because hedge funds use mostly technical analysis to time markets. In order to make money like that, you need to make money on four correct decisions: You need to sell something (#1 – what to sell out of all of the things you currently hold) at the right time (#2), to drum up the money to make the new purchases (#3 – what to buy) at the right time (#4).

Usually a mistake is made on one of the four decisions, and those losses wipe out the all of gains on the one correct decision. If that weren’t true, then someone would have figured out how to make market timing work, and they would on TV all day every day. Nobody can predict the future no matter what computer models they use, so that’s why you never see the same market timing guru on TV for more than a couple of years. It’s usually the one that got lucky recently. Then when their luck runs out, they’re off the air, and a new one is on

They get very rich very fast even if they lose, because of the very high fees – typically 20% of the profits and/or 2% annual fees are at the bottom of the range. This is a very powerful incentive for literally thousands of people to set up new fake hedge funds every year – and most have no experience running money whatsoever. Just for the record, about half of the number of new hedge funds created each year go under each year (around 2,000 new ones open and around 1,500 close).

The SEC did recently start to regulate hedge funds under the Investment Advisors Act (not the Investment Company Act). This helped keep people with criminal records out, but that’s all it does. It basically makes sure convicted criminals are not running money, and forces the actual managers to disclose who they really are, but it does nothing about how the money is run and how it’s labeled or marketed – which are the main problems.

Why has this gone on so long with no end in sight?

Because only people with so much money that losing some of it won’t matter, can invest in them. The SEC feels that if these people are so dumb as to give their money to wild west fly-by-night money slingers, then they deserve to lose it. If it were the regular public that were losing their life savings, it would be different story. But since it’s only “stupid rich people” that are getting hurt, things will probably continue this way forever. Unfortunately, as we’re all finding out from the Great Recession of 2008-20xx, when all of the stupid rich people lose their money, the rest of the world economy suffers as well.

This is why something real needs to be done about fake hedge funds.

What needs to be done to solve this problem?

We at Blackhawk believe the SEC should require all hedge funds to operate in a true market-neutral mode, or not be allowed to call themselves hedge funds. Then another kind of unregulated pooled investment vehicle should be created for the scammers to market to stupid rich people that like losing their money to market timers. So just make a new name for the vehicle (Fund for Stupid Rich People) and make all fake hedge funds use that name instead.

But since there is no public outcry, the regulators are up to their ears dealing with other scams against the public, their buddies are getting rich from this, payoffs, kickbacks, and just politics as usual, nothing will probably ever be done. It’s capitalist caveat emptor (buyer beware) at its best.

As people put more and more money into hedge funds, another 1998 Long-term Capital Management debacle is just waiting around the corner to ignite another global financial crisis, requiring taxpayers to spend billions bailing out all of the firms that shouldn’t have been investing in them in the first place. This is why former SEC Chairman William Donaldson, CFA, has said this is the most distressing period since 1929 – As hedge funds struggle to achieve returns, I think there’s a tendency to skate on thinner and thinner ice, and it’s kind of an accident waiting to happen.

Due to persistent flat-down financial markets, billions are still flowing into hedge funds. Over $5 trillion will soon be invested into them. This is a recipe for a global financial disaster many times the size of LTCM, which only had $5 billion in capital, but $125 billion leveraged. All it would take is a bad market timing move, and the whole global financial system could be taken down in a matter of hours. And since the vast majority of market timing moves are bad, this could happen at any time.

So the bottom-line on hedge funds folks is to do the usual due diligence, but also make sure the fund is a real hedge fund and not a fake one.

Just ask to speak to the manager (not sales) and ask, What’s your current strategy to maintain a market neutral posture? How do you plan on making 5 – 10% in the current year if the S&P500 is down 20%?

If they don’t explain why you’d make safe money if the markets go down, or you don’t understand, then it’s probably a fake hedge fund.

Just say no to fake hedge funds. All it takes is one bad call, and you could lose a large chunk of your money in moments.

Find a real market-neutral hedge fund instead or just stop wasting your time and your money dealing with this dying breed.

Your feedback as always is greatly appreciated.

Thanks much for your consideration.

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Comments

  1. Neil KillionNeil Killion

    Yes, my financial advisor put me in a hedge fund supposed to double in 7/10 years, but I was pleased to get out of it without any losses a little while ago. If the money was in the bank I would at least have made a return.

  2. MattMatt

    Ziad, Nice perspective on how all those “fake hedge funds” were fooled by randomness when they had amazing returns for a year or two prior to the downturn and then lost it all when credit crisis moved against them.

  3. Steven CSteven C

    I can not understand why in a free nation only certified millionaires are allowed to invest in hedge funds. The ability of the average person to be able to pool their money and hire the services of a competent investment manager, instead throwing money away into 401k plansk,stock market or insurance companies, would do more to create jobs, products, companies, and wealth in this country than anything else I can think about.

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