Understanding Hedge Funds

Highwaymen of the global economy was Malaysian prime minister Mahathir Mohamad's description of hedge funds after the devastation of his country's currency and stock market in 19978, which he blamed on them, particularly the fund led by George Soros. The near-collapse and $3.6 billion bailout of John Meriwether's Long Term Capital Management (LTCM) by fourteen Wall Street banks and brokerage houses in the late summer of 1998 did little to restore the reputation of these shadowy investment vehicles. What are they all about?

Hedge funds typically pool the capital of no more than a hundred high net worth individuals or institutions under the direction of a single manager or small team. Their name originally comes from the fact that unlike most institutional investors, they were able to deal in derivatives and short selling in theory to protect or ''hedge" their positions. But having begun as a way of minimizing risk, the conservative activity of hedging has become the least important of their pursuits.

Usually based in offshore tax havens like the Cayman Islands to escape the regulators and the standard reporting requirements of mutual funds, hedge funds use their freedom to borrow aggressively, to sell short, to leverage up to 20 times their paid-in capital (though LTCM had somehow borrowed over 50 times its capital base) and generally to make big but highly risky bets. They tend to focus on absolute rather than relative returns, aiming simply to make money rather than to beat an index.

But the only real difference between hedge funds and other funds are their compensation strategies. Hedge fund managers tend to be paid for performance, with a modest management fee but a substantial share of the profits the fund makes typically 15-20% though LTCM charged 25%. Otherwise, hedge funds are a diverse grouping of independent asset managers pursuing a variety of investment strategies, usually with minimal disclosure to investors and regulators, and most operating in a niche where they feel they understand the "rules of the game" better than anyone else. Consultancy Financial Risk Management categorizes them into four main groups in a comprehensive overview of the hedge fund market produced with investment bank Goldman Sachs.

First, there are the macro-funds of which Soros's fund is a leading example. These indulge in tactical trading, one-way speculation on the future direction of currencies, commodities, equities, bonds, derivatives or other assets. Their most-publicized activities involve speculation on exchange rate movements, usually shorting the currencies of countries whose economic policies look questionable and whose ability to maintain an exchange rate peg is weak (see Short Selling). Macro-funds constitute the most volatile hedge fund sector in performance terms and their correlation with traditional bench-marks is low.

Second, there are the market-neutral or relative value funds, the kind of fund LTCM described itself as. These funds are supposedly low risk because they do not depend on the direction of market movements. Instead, they try to exploit transitory pricing anomalies, regardless of whether markets rise or fall, through an arbitrage technique called convergence trading: spotting apparently unjustified differences in prices of assets with similar risks and betting that the prices will revert to their normal relationship. For example, LTCM was betting that historically wide spreads between emerging market and US assets and between corporate bonds and US Treasuries would narrow. Of course, as it turned out, history proved no guide to the future as spreads widened and everything moved in the wrong direction at once.

Third, there are event-driven funds, which invest in the arbitrage opportunities created by actual or anticipated corporate events, such as mergers, reorganizations, share buybacks and bankruptcies. Merger arbitrage, for example, involves trading in the stocks of both bidder and target on the assumption that their prices will converge if the deal goes ahead.

Lastly, there are long-short strategy funds, which combine equities and/or bonds in long and short positions to reduce market exposure and isolate the performance of the fund from the asset class as a whole.

Given the lack of a strict definition of hedge funds and the fact that they file no reports, it is difficult to estimate the extent of their activity. Figures for 1998 from the Hedge Fund Association suggest there are between 4000 and 5000 funds with total assets in excess of $250 billion; while according to TASS, a performance measurement firm, there are only 3000 funds but with over $300 billion in assets. But as the experience of LTCM shows, the total assets may not be a true representation of the amount of money dedicated to short-term trading activity since the funds frequently borrow substantially in order to make leveraged bets.