The Hedge Fund

The Hedge Fund

Question :What is in a name ? Ans : AN ERROR.

Recently the hedge funds are in the news, but this time all for the bad reasons. There has been news about imposing more regulations on it and The Security Exchange Commission Investigation for some reports of insider trading. In this article a take an effort to explain the hedge funds.

What exactly is a Hedge Fund ?

Well to be very honest, the name hedge fund is a misnomer. Hedging is a financial jargon used for the investment procedure by which we minimize the risk associated with the investment. But let me caution you, the hedge fund is the riskiest investment and with greatest return.

The Hedge Fund is formed by pooling the money from High Net Individuals (HNIs) rather Ultra HNIs and some other financial investors like pension fund etc. once the money is pooled it is invested into various financial instruments to earn some extraordinary profit. Well! so far it sounded like a Mutual fund investment ? True! But its similarity with the mutual fund ends here itself.

Hedge Fund Vs Mutual fund

The most important difference between Hedge Fund and MF is that the Hedge Fund is not regulated where as the MF is. This means that the area of investment in case of MF is well defined and the investment is confined there. For example is the scheme of mutual fund is to invest in fixed income scheme like bond and debenture, the MF can’t invest in equity. But in case of the Hedge Fund there is no such fix area. It can invest where ever it like to, be it equity, debt, derivatives or even any instrument which promises to pay high like , who knows even they can gamble J .

1998, the hedge fund called Long Term Capital Management Company made a loss of $2 bn and Amaranth made a loss of over $3 bn. Now for the positive note, the return on such investment sometimes is more than 50-60 %. So, what is that makes it so risky and an investment of high return?

J High Return :

Hedge Fund created includes pooling money from accredited investors. Accredited investors are those investor who themselves have collected money from retail investors with a promise to pay them some return, like pension funds. As the accredit investors have to pay some return to the retail investors as well as to have some return for themselves, they want to invest in fund that give them higher return. Also, the Hedge Fund themselves want some return which make expected return from the investment by

the Hedge Fund very high. Therefore the investment is made by the Hedge Fund in only those instruments which promises high return.

Various strategies adopted by the Hedge Fund to get higher return:

i) Opportunistic Hedge Fund: In this strategic investment the company invests in long and short equities. Short equities are equities whose price is expected to fall in near future. HF borrow such securities from some investors at some price and sell it in the market, and once the price come down it is bought back at lower market price and returned back to the lender of security. The gain is the decrease in price of share minus the charge paid to the investor who lends security. Long equities are those whose price is expected to rise up. For these type of equities the Hedge Fund buys it today and sell it later when the price climb up, thereby making profit.

ii) Venture in Hedge Fund: The investment is made in those equities whose price is going to fluctuate because of some major events like merger and acquisition, buy-outs or any major change in the company itself or the company is in some kind of distress but is expected to do well later etc.

iii) Relative Value Hedge Fund: This is slightly complicated to explain. Layman like me can me explained like there is difference in valuation of instrument giving same return. With same return they are being sold in market at different price. For example a convertible bond is giving same return to a combination of debt and security but price of bond is less than the D/E combo. So the Hedge Fund will sell the D/E combo and buy the bond. The return will be same for both combination and gain will be the difference in price the two structure.

L High Risk:

The investment is always exposed to BLACK SWAN EFFECT. European always believed that there are only white colored swans in the world as they had never seen any other color swan. Until 1698, when they found Australia and black swan they thought there were no black swans. Same is the case with investment. Since some risk has never occurred doesn’t mean that it is not there. The Hedge Fund say that there is no big risk. But they can’t hide the fact that every high return is associated with very high risk quite contrary to their claim. The advisor with foreign accent can easily convince the fallible investors.

A 32 year old made billions of profit though HF by expecting that price of natural gas is going to sky rocket. He took debt and invested in the natural gas. The next year Katrina occurred, wiping out islands. Prices shot up and the idea clicked. He sold natural gas at very high price and paid back the debt and earned return. The very next year a company called Amaranth invested on the same assumption and weather remained calm and pleasant and prices didn’t come down. This time the company was wiped out, not by the Katrina but by the stability in the price of natural gas.