The murky world of hedge funds

They are the super stars of the investment world. But very little is known about their behaviour, other than that they make lots of money.

They are hedge funds – managed funds for the rich. But their shadowy past may have ended as politicians say they finally need some oversight.

There are about 50,000 hedge funds in the US$2 trillion industry, most of which are in New York and London. They range from the small to the super large which are run by experts like George Soros and John Paulson.

Their insightful analysis and gambling on the financial markets allows them to stay ahead of the mainstream investors, resulting in some managers making over a billion a year.

The name hedge fund comes from the early days when they were designed to hedge, or offset, risk through investing.

But these days, hedge funds are simply finely-tuned investment vehicles for maximising the amount of money other money can make.

They are similar to managed (or mutual) funds where a group of investors get their money invested on their behalf by a professional.

This pooling of money allows the fund to make bigger investments, save money on transaction costs, and employ the expertise of someone with the knowledge and time to make good investment decisions.

Such investments are mostly in assets like equities (shares), bonds (fixed-interest loans) and commodities.

But to invest in a hedge fund, you have to be an ‘accredited investor’ – someone with a net worth of more than US$1 million or who has earned over $200,000 in the last two years and likely to do so in the current year.

Accredited investors also include pension funds, banks, insurance companies, investment companies and any company or trust with assets worth over $5 million.

And because these ‘sophisticated investors’ know what they’re doing, as opposed to the mum and dad or small business investors that deal with managed funds, there are less rules and requirements about what hedge funds must do.

Unlike managed funds, they don’t have to provide investors with all the information about what they’re investing in, and they don’t require trustees to oversee their work.

Consequently, hedge funds can invest in largely whatever they want, take larger risks and make a lot more money.

These risks include ‘shorting (betting on an asset’s demise) and investing in the highly controversial $600 trillion derivatives market.

Furthermore, they can distribute the income how they like (individual fund managers usually take 20%) and investors are often required to commit to a year or more before they can touch their money.

But many worry that in their pursuit for maximum profit, hedge funds create risk not just for themselves and investors, but for society.

The most recent and apparent example is the Greek government.

Because their finances were in such bad shape, hedge fund managers bought credit default swaps on loans (bonds) given to the Greek government.

The managers were essentially betting that because the government was so poor, the loans would default and they would make money from the credit default insurance.

This lack of confidence meant the Greek government had to pay more for borrowed money, making the likelihood of defaulting even higher, and increasing the odds that the hedge funds get their insurance payout.

But the hedge funds say it’s only when they put financial pressure on governments to fix their problems that the problems actually get solved. So they’re actually doing society a favour.

As the head of the Hedge Funds Standard Board Antonio Borges says, “the Silicon Valley of finance” is needed to point out weaknesses (and strengths) in financial markets.

Nevertheless, the morality of hedge funds has been questioned.

Earlier this year, major hedge fund owner John Paulson was discovered to have fixed odds in a bet with another party over assets that he had deliberately (and secretly) chosen to fail.

This lack of transparency for the sake of profit is what concerns government officials.

For over a year, the EU has been negotiating a new set of rules for the hedge fund industry.

France and Germany want stricter rules including limits on managers’ compensation, blocking EU and non-EU funds from taking stakes in each other, and requiring funds to provide more information to investors about risks and to have more cash on hand.

The hedge fund industry and the UK are happy with the idea of giving investors more information but they are firmly against the compensation and non-EU stakes proposals.

80% of Europe’s hedge funds are in London and Mayor Boris Johnson says these uncompetitive rule changes will mean many of them will leave for the US or Switzerland.

The EU was supposed to be voting on the rules next week but it has been delayed until early or late October due to infighting.

Unfortunately though, due to the complexity of the debate, it will likely remain out of the public domain, despite it being such an important one.

By The Casual Truth