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Hedge Fund Mysteries

When the investment fund called Long-Term Capital Management almost collapsed last August, the event sent tremors throughout the financial world. Many feared that Long-Term Capital’s problems would spread to other institutions as the prices of financial assets generally fell. Suddenly attention was concentrated on the arcane and mostly unregulated investments known as hedge funds; they apparently have much more influence over global financial markets, and indeed the economic lives of most people, than was generally realized.

A hedge fund is a limited partnership which, unlike a traditional mutual fund, has no restrictions on the types of investments it can buy and sell other than those its managers impose on themselves. It can also borrow several times its capital to make these investments. Long-Term Capital Management was one of the nation’s largest hedge funds. Headed by John Meriwether, formerly of Salomon Brothers, and with two Nobel Prize winners in economics among its partners, it was also one of the most respected. After it lost most of its $4.8 billion in capital last summer—at the time when worldwide markets were falling in reaction to financial turmoil in East Asia and Russia—the Federal Reserve decided that it had to mobilize private resources to save the firm. More than a dozen banks and other institutions were asked to invest in it and take over its operations, and they put up some $3.6 billion to do so.

Because Long-Term Capital had borrowed extensively, its actual investments may have amounted to as much as several hundred billion dollars, if not more. With the value of financial assets in general falling, the turmoil could have spread well beyond the investors directly involved with Long-Term Capital to many other domestic and international institutions. In fact, major commercial and investment-banking firms in Europe and the United States reported losses of hundreds of millions of dollars that were related to hedge fund activity. Several major hedge funds, including two of the largest, Julian Robertson’s Tiger Fund and George Soros’s Quantum Fund, also reported substantial losses of billions of dollars.

There are probably about fifty hedge funds today with capital of more than $100 million and some three hundred with $50 million or more. There may well be several thousand funds in all, many and perhaps most with capital of no more than $1 or $2 million. Precise data are not available because hedge funds are generally unregulated. According to federal law, if the funds have fewer than five hundred investors, each with a minimum net worth of $5 million, the disclosure and other regulatory requirements the Securities and Exchange Commission (SEC) imposes on mutual funds do not apply. For any individual, the minimum investment in one of these funds is $500,000. The government has concluded that investors with sufficiently high net worth are sophisticated enough or rich enough to afford expert advice, making basic protective measures unnecessary.

Many American firms also run off-shore funds, also unregulated, which are generally closed to American taxpayers, in which the minimum for investments is much lower. In general, small investors cannot invest in hedge funds, notwithstanding the frequent claim that they are the most profitable way to invest over the long run.

In the last twenty years, hedge funds have become increasingly popular because many of them have produced significantly higher returns than stock market indices, such as the Standard and Poor’s 500 Stock Index, or most mutual funds. The best-known of these funds, George Soros’s Quantum Fund, an offshore fund, has produced gains that average 30 percent a year, as have some other funds. Only in the last three years of an exuberant stock market has the average mutual fund been able to equal or exceed this performance; in fact, during these years, many mutual funds have done so well that even the best hedge funds have generally not matched their returns. Still, the services that tabulate fund results find that for the last ten years or so hedge funds have performed better than the average mutual fund and have been less volatile.1

During the late 1960s there was no more than $2 billion invested in hedge funds. Today, hedge funds have between $200 billion and $300 billion in capital. This remains a small percentage of the more than $3 trillion under management in mutual funds. But because hedge funds can invest a great deal more than their capital by borrowing—that is, they can “leverage” their capital—they can effectively buy far more in securities than they could pay for in cash. They can also trade in options and futures contracts, which are known as “derivatives.” These contracts enable them to buy or sell securities in the future at a fraction of the cost of the securities themselves. (The contracts are called derivatives because they fluctuate in value with the price of the underlying security.)

In fact, most hedge funds borrow very little, if at all, to make investments. But many of the biggest hedge funds have investment positions of five times their capital and sometimes more. Perhaps no other hedge fund borrowed as aggressively as did Long-Term Capital, whose investment position was many times that. Hedge funds are not entirely free of reporting requirements. For example, every calendar quarter they must report the amount of equities they own to the Securities and Exchange Commission. But they need not report how much they have borrowed or most of the trading they undertake in the many exotic derivatives and other investment instruments now available to them.2

As a senior partner of Oppenheimer & Co., Leon Levy started the first mutual fund that could adopt several of the same practices used by hedge funds in the 1960s. Levy and his partner Jack Nash sold Oppenheimer in 1982 and founded the hedge fund Odyssey Partners, which was one of the most successful of such funds until its recent liquidation. Leon Levy remains chairman of the board of trustees of Oppenheimer Funds based in New York. He is also president of the Institute for Advanced Study in Princeton and vice-chairman of the Jerome Levy Institute for Economic Research at Bard College.

In late October and early November, I talked to Levy about hedge funds, their investment strategies, and their influence over the financial markets and, ultimately, the world economy.

—J. M.

Jeff Madrick: So many hedge funds have been able to produce above-average returns for investors that they became enormously popular as investment vehicles for the wealthy over the last ten or fifteen years. But these funds were originally designed to control the size of potential losses in several ways, especially by using sophisticated financial instruments to their advantage. Recently some of them seem to be taking inordinate risks, and they may have put the world financial system in jeopardy.

Leon Levy: It is important to realize that, as a limited partnership, a hedge fund has virtually no investment restrictions, except those that the people who create the hedge funds choose to impose on themselves. A hedge fund can buy stocks, bonds, commodities such as gold or oil, international currencies, and so on. It can also borrow to invest. It can invest in futures and options—which people now call derivatives—which allow a manager to put up a small fraction of a security’s value in order to buy or sell it. And it can also sell short, that is, sell stocks and other investments that it doesn’t own if the manager believes they will go down. (To sell short you borrow a stock and sell it at today’s price. Then later you buy it back at a lower price, return it to whomever you borrowed it from, and keep the profit.)

Such possibilities can reduce as well as increase risk. By selling short—or using other hedging techniques to accomplish the same thing—you can concentrate on picking individual stocks without having to worry as much about which way the overall market is going. No matter how good you are at picking stocks, a sudden downturn in the market can undo all your good analysis. How better to protect yourself in a falling market than to be able to sell short? For example, the hedge fund manager might think most stocks are going up. Or he might own a lot of individual stocks that he thinks are undervalued. But in case he is wrong, or if the entire market suddenly falls, he might also sell short certain kinds of stocks that seem to him particularly overvalued at the time. Even in the same industry. For example, the manager may own some drug company stocks he thinks are cheap and sell other drug stocks short that he thinks are overpriced. If he turns out to be wrong, and stocks in general go down, he will still make some money on the short sale to offset some of the losses on his portfolio. He is hedging. Of course this is not fool-proof. We have seen managers who have occasionally both owned the wrong stocks and shorted the wrong stocks. And they lost money on both sides of the transaction.

So hedge funds have many more ways to make money than mutual funds, and perhaps the most important thing about hedge funds is that they take the responsibility away from the investor for choosing what market to put money in and place it entirely in the hands of the money manager. He or she can be in any market at any time.

J.M.: But if the stock you sold short keeps going up in price, and does not go down as you expected, the risk can be enormous. You never know how high it can go.

L.L.: That’s right. If you don’t cover your short—that is, buy the stock back—and the price keeps rising, losses can be quite grand. So it depends on how you use these investments. The same with borrowing. Most hedge funds do not borrow very much, do not use much leverage at all. But if you borrow wisely, it can improve your profits. You can hedge with derivatives, also. In fact, fund managers now largely hedge in derivative markets. For example, by using futures, you can sell the entire S&P 500 index or the Dow Jones average short while putting up very little money.

J.M.: Such derivatives are seemingly mysterious vehicles because we don’t know who has invested in them, and to what extent, at any given time. But don’t they also incur great risk?

L.L.: Yes, they are risky because you are putting up much less money for the securities than if you had to buy or sell the same portfolio of stocks. But they are also effective methods for protecting against down markets. You can buy a “put” option, a contract that gives you the right to sell a stock at a certain price within a specified amount of time. For $5, for example, you can pay for a contract by which another investor will buy a stock from you for $50 at any time over the next three months, even if it goes down to $30. He keeps the $5, but you may be able to buy the stock for $30 and sell it to him for $50. So you’ve made $15 on your $5 investment. You’ve tripled your money. A “call” is the opposite. You can buy a security for a fraction of the price.

  1. 1

    See “The U.S. Offshore Funds Directory,” Antoine Bernheim, New York, New York. Also, LJH Global Investments, Naples, Florida.

  2. 2

    Hedge funds must report their transactions in futures contracts on formal exchanges to the Commodity Futures Trading Commission, a government agency. Much and perhaps most such trading is not done on exchanges but in over-the-counter markets, for which there is no reporting requirement.

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