Regulation of Hedge Funds

Hedge funds are secretive, private pools of money that use either a specific strategy or strategies to make, theoretically, lots of money. Hedge funds are named as such because they hedge against the market, in an attempt to reduce beta (the correlation of a fund's performance in relation to the market). They make money in confusing ways: some hedge funds trade and purchase derivative contracts, others buy stocks long and short-sell as well (making money when stocks go down, not up), other use exotic futures and other mechanisms to make money. But one thing all hedge funds seek to do is obvious: they all seek to make lots of money. They attempt to do that by exploiting a niche in the market that is under-utilized by others, and when they find that inefficiency hedge-funds happily pile in.

This, by nature, makes the market more secure and less risky. The act of locating inefficiencies makes the actor lots of money, but also makes the market more stable by not letting the inefficiency (disparity between value and price) get too large. This is why leaders should hesitate against blindly regulating hedge funds. Currently it's in vogue to criticize the world of hedge funds: jealousy at some hedge funds' ridiculous profits combined with misunderstanding due to hedge funds' secretive nature creates a flow of misinformation about what exactly hedge funds are and, specifically, the good they do for the market and for average, every-day people.

The truth is, most people can't invest in hedge funds. In the US, laws forbid average individuals with a net-worth of less than multiple-millions of dollars to invest, and most hedge funds themselves have minimum investments of anywhere from $500,000 to $5,000,000, making them far too expensive for the average retail investor. But forget the laws: most average people wouldn't even know where to go to get into a hedge fund, even if there was no law. Marketing materials are privately sent to already established individuals and groups. There are no public announcements of results or invitations for capital.

Instead, extremely wealthy individuals, endowments, not-for-profit institutions, capital-pooling companies and some pension funds are the primary investors in the funds. This may raise some eyebrows, especially in the case of endowments, not-for-profit institutions and pensions funds. But the truth behind these organizations is that they invest in hedge funds to diversify and actually reduce risk; they hedge against the market, protecting investors when big standards like the NYSE and S&P 500 go south for a few years. Because they allocate small amounts to these so called "alternative investments," (the broad category in financial-speak where hedge funds fall) should a hedge fund collapse, as Amaranth Advisors did a year ago, it would create but a ripple in the fund and average investors wouldn't notice a change. News readers probably didn't realize that when the stock market tanked between 2001 and 2003 hedge funds were enjoying three years solidly in the black (as was Warren Buffet's Berkshire Hathaway). As middle-class Americans watched their pensions falter and savings decrease, those who owned investments which had diversified parts of their portfolios to hedge funds didn't feel quite the sting.

Because of their secretive nature, there exists much misinformation about hedge funds. But the truth is hedge funds seek to be independent of the market, unlike the major indices and investment houses, making money by using a strategy not overused in the financial sector. This helps hedge funds make profits even when the market is bearish, because generally the strategies are isolated and not entirely correlated to general market performance. An article posted below notes that in the crash of 1988, the biggest buyers in the market were hedge funds (presumably not allowing the market to crash further). And despite the terrible downturn of 2001-2003, the market returned to life in 2004 with hedge funds leading the charge. Huge disparities between price and value like those in 1929 would be difficult to find today, because savvy hedge-fund managers are seeking to make money from incorrect valuations and would undboutedly short-sell overvalued stock, bring the price back down more gradually than a massive decline when retail sellers decide to rush for the exits.

An excellent article on hedge funds was recently printed in the January/February 2007 edition of Foreign Affairs. It's entitled "Hands Off Hedge Funds," and elucidates much more clearly the points I try to make in this article. It can be found here http://www.foreignaffairs.org/20070101faessay86107/sebastian-mallaby/hands-off-hedge-funds.html