Our previous posts within the series of the book “The Pragmatic Hedge Fund Manager” have now given you enough information to understand what this Fund is and how it is different from other financial instruments. The general perception about Hedge Funds is anything but positive. People who have no idea what Hedge Funds are, think of them as ‘big, bad and the dangerous’ only because of their connection to the 2007-2008 crisis.
However, it is about time that this image of Hedge Funds is cleared. Even in today’s highly informed and tech savvy world, deep rooted myths about Hedge Funds exist that make the general public often cringe just at the mention of this financial investment tool. These myths kill every chance that Hedge Funds be understood for the rich and encapsulating investment options that they are.
It is necessary to debunk several myths regarding Hedge Funds because they form a sizeable part of the investment industry in many developed countries like the United States, Australia, the United Kingdom, France and Portugal. It will take a long and hard discussion to fully eradicate these misconceptions and present answers that satisfy one and all. However, for the scope of this book, some of the most prominent misconceptions have been Top 10 Myths about Hedge Funds
Myth #1: The Hedge Fund Industry is opaque and uncontrolled.
Fact #1: Contrary to this long standing myth, the Hedge Funds industry has always been strictly regulated. Even in the 1940s, when Jones created the first ever Hedge Fund, there were certain regulations that came as part and parcel of the structure of this investment vehicle. Since then, as the industry and market for Hedge Funds matured and increased in size, more and more regulations were added.
Previous regulations were changed, modified and renewed to make room for better rules that suited the economic landscape of the 80s, 90s and the 21st century way better than the old ones. Details about the regulations Hedge Funds are subject to will be provided in later chapters. However, for now it suffices to say that the Hedge Fund industry is watched by Federal, State and National level authorities in a very satisfactory manner.
Regulations like the Dodd-Frank Wall Street Reform 2010 and Securities Act 1933 and bodies like the Commodities Future Trading Commission and SEC are important names in this regard.
Myth #2: Hedge Fund investors always receive superior returns.
Fact #2: Hedge Fund investments are risky and one always hears that high risk equals high return. However, this isn’t always the case. There is a legitimate risk that Hedge Funds can suffer losses and report negative incomes as well. Since many large Hedge Funds were previously often exempted from frequent disclosure, they reported performance only when positive gains were recorded, skipping the years that reported a loss.
A study conducted in 2006 revealed that during a period of ten years (1995-2006), there were many instances when Hedge Funds yielded a return of 9%, while the market index of S&P 500 returned 11.6% annually. This result confirms that while Hedge Funds are known to make profits from market mispricing, they aren’t subject to superior returns all the time.
Myth #3: Hedge Funds are ‘special’ funds, only for investors with high net worth.
Fact #3: The SEC has limited the kind of investors taking part in Hedge Funds a number of times in the past; however, the restriction has eased with the introduction of Funds of Hedge Funds. Accredited investors, those with a net worth of $1 million or annual income of $200,000, were the only ones that a Hedge Fund could contact to raise capital.
Since, Funds of Funds have no eligibility criteria, nor a limit on net worth and individual investors can easily invest in Hedge Funds nowadays. Nonetheless, it is important to understand why the ‘exclusivity’ image has been attached to Hedge Funds since they were created. According to the SEC, less sophisticated investors may lack the expertise, knowledge and even the complicated tools needed to assess market trends necessary to get involved with Hedge Funds.
Hence, the restrictions placed for low net investors only safeguard their interest and that of the general economy as well. If the Funds of funds are expanded, more individual investors can invest in Hedge Funds, but will also be exposed to high risk.
Myth #4: Hedge Funds have no economic value
Fact #4: Hedge Funds invest in emerging markets, private equity, private debt and mergers and acquisitions, all of which are activities of immense economic importance. If these funds do not finance such activities, the economic environment can suffer immensely.
With the means of derivatives, Hedge Funds put themselves in a lot of risk, but help the institution selling derivatives to balance their own portfolios. The same goes for mortgage-backed bonds because they provide a way to raise capital for many individuals and banks. Hence, it would be incorrect to say that the operations behind Hedge Funds have no economic worth. There are two main economic benefits of having Hedge Funds in a market.
Firstly, their operations, and the very nature of their investments, offer yet another avenue for risk management for many institutions who would have very limited options otherwise. Secondly, if Hedge Funds do not finance projects by raising the capital that they do, many major projects in an economy would end up having a very high cost of startup and initial investment.
Myth #5: The interest and risk equation for Hedge Fund managers and investors is well balanced.
Fact #5: While both entities, managers and investors, have to work in unison for a Hedge Fund to succeed, their interests are in no way completed aligned. A manager’s interest alignment depends on the dollar value of the investment coming in. If the fee charged by him varies with the investment amount, a manager may be ready to take additional risk to maximize his own return.
Another aspect of Hedge Funds, or any other investment house for that matter, is the presence of Agency Risk. Agency Risk is a result of the compensation structure of most Hedge Funds. Since managers make their money from a flat 20% incentive rate, their remuneration isn’t subject to risk, per say. Investors, who have put in huge amounts of money, are left alone to bear all the risk should something go wrong with the market.
This instance is the best example of Agency Risk that is caused as a result of an agent abusing his power in the Hedge Fund. The same is also imminent, when managers of Hedge Funds become complacent and do not work towards improving the fund’s performance because of a definite incentive fee.
Myth #6: Hedge Funds are highly leveraged and all leverage is bad.
Fact #6: The extent of leverage taken by Hedge Funds solely depends on the investment strategy they follow. While some believe in high leverage, others don’t. Those who don’t, maintain moderate levels of leverage, i.e. debt instruments in their portfolios, because the underlying asset itself has a high return.
Therefore, it would be incorrect to say that all Hedge Funds are highly leveraged. Similarly, not all leverage is ‘bad’ leverage. Leverage simply means the amount of capital you have raised using long term and short term debt. If this is a sizeable amount, a Hedge Fund will be called highly leveraged. It should be remembered that leverage itself isn’t bad; the way it is managed is what makes or breaks an investment strategy.
Banks are usually leveraged to a ratio of 20:1, while Real Estate is levered by at least 5:1. Consequently, a certain level of leverage is actually essential to maintain stable operations.
Myth #7: Hedge Funds use strategies that are unique to the market in general.
Fact #7: According to a school of thought in investment circles, Hedge Funds aren’t much different from other investment houses, albeit their ‘accredited nature.’ For many people, these funds are a privatized version of investment banks because the activities the latter have performed for years are now being done by Hedge Funds with more publicity and marketing.
Hence, the strategies used by Hedge Funds cannot really be termed as unique. Alternative Investments like private debt, equity and derivatives have been in use for many years in one form or the other. However, previously when investors put money in these instruments individually, losses incurred were kept hidden to prevent negative word of mouth.
With Hedge Funds, the losses incurred as a result of the same instruments are reported and recorded with due diligence.
Myth #8: The failure of one Hedge Fund can cause havoc in the industry.
Fact #8: While this myth is certainly just a myth, there is some reality in it as well. Modern Investment Theory suggests that smart and skillful investors should never have a huge chunk of their wealth invested in one Hedge Fund only. Instead, they should diversify and choose a handful of funds to make investments.
Taking this view forward, the fall or liquidation of one Hedge Fund is definitely a matter of concern, but not so much that the stability of the entire Hedge Fund industry can be questioned. Since its inception in the 1940s, many Hedge Funds have fallen, many are falling and still others will liquidate and fall in the future owing to a number of reasons; however, they do not reflect the conditions of the industry at large.
In the recent years, investors learnt one important lesson after seeing the failure of many Hedge Funds and the demise of many investors’ early careers, i.e. never to hold a single large portion of wealth in a single Hedge Fund.
Myth #9: All Hedge Funds use derivatives that are a recipe for disaster.
Fact #9: Not all Hedge Funds use derivatives. Investment strategies like merger arbitrage, distressed securities and emerging market equities are some of the most popular ones with Hedge Funds. Hence, it is incorrect to think that the foundation of the operations of all Hedge Funds is built on derivatives.
If a Hedge Fund is using derivatives, it is not justified to think that it will fail or pose an extraordinary risk to investors. Accepted that derivatives are risky instruments, however, their usage has proved to be quite rewarding for many funds who have excelled far above those who have no derivatives in their portfolios.
Myth #10: Hedge Funds are used to diversify and move away from the stock market.
Fact #10: This is a long standing myth that affects less sophisticated investors’ decisions to take part in Hedge Funds even today. A correlation is a relationship that two markets have with each other. It means that if one under-performs, its effect on the other is also visible.
While Hedge Funds do diversify portfolios, they do not move away from the stock market because the two are highly correlated. Many strategies adopted by Hedge Funds involve equity and the performance of the stock market is a big determinant. Strategies like mispricing and merger arbitrage are all performed keeping in mind how the stock market is working.
Moreover, completely relying on Hedge Funds for much needed diversification is also not a very advisable course of action because there are periods in which the fund imposes ‘lock downs’, making it impossible for investors to move their money.