Hedge Funds: Are they really what they claim to be?

Well this might be pretty awkward a topic for us engineers. The word funds wont usually
come up in our daily discussions, would it? Well for that matter nothing technical too comes up
in them. Yet youll might question the presence of this article in our magazine which usually
comprises of some good trivia (some tending to be too trivial), some good articles, poems and
sadly some mediocre jokes at times. However this is how every single magazine is from your
Playboys to the more socially respectable ones like Frontline, a well balanced collage of good
and average articles. But I digress. Coming back to the topic, it would be tough to find someone
who hasnt heard about the recession of 2008 termed as the Little Depression along the lines of
the Big Depression for pretty obvious reasons. There have been many theories explaining why
the US economy collapsed thus triggering a chain of similar events in other parts of the world
resulting in a global financial catastrophe, whose effects are yet to be completely recovered
from.In the midst of all this, the word hedge funds kept popping up every now and then. This
got me wondering what exactly is a hedge fund? In the following paragraphs I will be presenting
what all I have learnt about hedge funds along with a few dirty facts about them which the
common man is unaware of and thus making this read worth your while.
First we shall see in brief what hedge funds are, its types and how they function and then we will
see how they are not supposed to function and yet they do.
A hedge fund is an investment fund which is a limited to high net worth investors. It undertakes
a wider range of investment and trading activities compared to other investment funds and pays a
performance fee to its investment manager. Management fee paid annually is usually 1%-2% of
the asset. Performance fee is also paid which will be 20% of the return the manager makes from
the asset.
Each fund has its own strategy which determines the type of investments and the methods of
investment it undertakes. It can be invested in equities, futures, currencies, commodities, bonds,
real estate, even in "Weather Derivatives" (betting on weather conditions) or seed capital for
start-up companies like private equity / venture capital funds. Unlike mutual funds, hedge funds
have no restrictions on "where" they could invest or "in what" they could invest in. This was
exactly the reason why Lehman Brothers went bankrupt, but about that we shall see later.
Many hedge fund companies manage assets worth billions of dollars, excluding leverage. Thats
a lot of money!! These companies dominate certain speciality markets such as trading within
derivatives with high-yield ratings and distressed debt. Their number has also grown rapidly in
the past few years to more than 10,000 funds all around the world and total assets of more than a
trillion dollars. Due to the large amounts involved in the transactions, it is believed to have
influence on the prices and returns of commodities, equities, and securities around the world.

Now you must be wondering what are these derivatives that they keep talking about rite? It cant
be your engineering dy/dx right? Well we all know the Dow Jones Industrial Average which is
reported constantly throughout the day. It is an indicator of whether the stock market is going up
or down. You can 'bet' on the direction of the Dow by buying or selling a 'Futures' contract on it.
This Futures contract is a Derivative (as it is derived from the Dow Index). If you think the
market will go up by the end of the month you would buy the Dow Futures contract. If you think
it will go down you would sell the futures contract. Whether you win or lose depends on the
value of the Dow at the end of the month. You can also get into derivatives of derivatives. For
example you can buy or sell an 'Option' contract based on the Futures contract which is based on
the underlying Dow Index. Where all this unnaturally canny and shrewd betting leads to, we
shall see later again in a section where I would like to discuss about the dirty facts of hedge
funds.
The 3 main types of hedge funds can be identified as macro funds, global funds and relative
value funds, although within these broad categories, there are further sub- categories. We shall
primarily see about macro funds because this is where the maximum money is made and also
where the dirtiest tricks are played. Macro funds take large directional (unhedged) positions in
national markets based on top-down analysis of macroeconomic and financial conditions,
including the current account, the inflation rate, and the real exchange rate.
Macro events are global economic changes that are caused by shifts in government policy which
impact interest rates. These in turn, affect all financial instruments, including currency, stock,
and bond markets. Macro investors anticipate the results of these policies by investing in
financial instruments whose prices are most directly influenced by these macroeconomic trends.
Accordingly, they participate in all major markets (equities, bonds, currencies, and
commodities), though not always simultaneously. Leverage and derivatives are often used with
the intention of greater gains on their market moves. So if you bet right you gain a lot and by a
lot I really mean a lot!! To quote an example, George Soros, a hedge fund manager, bet $10
billion, a large portion of which was borrowed, on the proposition that the British pound
would be devalued. The move resulted to a $2 billion profit for his investors. Whoaa!! Now if
that is not a lot, nothing else is. But its not always so easy to make money and Wall Street
tycoons learnt it the hard way. You almost feel a sadistic pleasure, dont you? Well it served
them right. Have a little patience, this will all be dealt with.
Now you must be wondering why I have taken up this topic as on the face of it, hedge funds just
look like a more sophisticated and exclusive type of our regular mutual funds, right? Wrong!!
The amount of money dealt with here is ten to hundred times more than your regular high end
mutual funds. That itself puts these types of funds in a league of their own with extra-ordinarily
high returns and even higher risks. So obviously when there is a chance to make such
astonishingly large amounts of money, there are bound to be people who would do so by hook or
by crook and this finally leads us to our highly awaited section- How dirty are hedgefunds ?

How dirty is the hedge fund business? Filthy would be a fair assessment. After all, a 2004 cover
story by Forbes magazine, titled "The Sleaziest Show On Earth," profiled USAS many
transgressions--from bogus performance figures and nonexistent audits to outrageous fees and
outright theft. Now if making money in this business relies on sound betting, well you really
wouldnt leave anything to chance, would you? So in a way you really wont be betting or
gambling with your money. Thats what most Wall Street tycoons like Lehman Brothers, Merrill
Lynch to name a few did. They would have inside information on things like future government
policies, foreign policy and thus they already had a fair idea as to what would transpire in the
future and investing was thus a piece of cake for them. Pretty dirty, right? Well the affluent
usually make most of their money this way. We had talked about derivatives above, hope youll
still recollect that since this essay has been a continuous barrage of intricate details. Anyways
talking about derivatives, let me quote an example of Lehman Brothers and Goldman Sachs
misuse of what many economists term as information imbalance, to make billions of dollars.
They already had inside information that the real estate boom would not last long. Yet they asked
innocent people like you and me to invest in the shares of real estate companies saying that all is
well and that the investors would make a lot of money. The typical middle class family believed
these top honchos blatant lies and poured in their lives savings into these shares. Now what
these heartless Wall Street biggies did is that they bet against these shares doing well since they
knew for sure that they wouldnt. And voila!! The real estate market crashed and all the money
that scores of people had invested in them went down the drain. However there was a certain
group of people who were rejoicing and going berserk with glee. You pretty much know whom
im talking about, right? Thus the hedge fund that these biggies had made using their money
along with lots of borrowed money had done really well. This was good times for them. Well
karma really comes back to you and when it does , it usually comes with interest.
I have continuously mentioned this point-borrowed money. In the case of Lehman Brothers ,
who had a net worth of around $78 Billion and liabilities in the range of $700 Billion, it couldnt
be all their money right? It included a lot of their own and borrowed money put together and the
money that they borrowed usually came from various foreign governments, the general publics
money and from other investment banks like themselves, Goldman Sachs and Morgan Stanley,
to name a few. It all seemed to be going well for them before things suddenly went haywire. Or
did they? Nothing can ever go haywire so suddenly that a company goes bankrupt in a week. So
what were the causes behind this sudden bankruptcy? Poor investment choices? Bad luck? Well
poor investment choices were definitely an important cause no doubt but definitely not bad luck.
They had caused their own downfall just like Bear Stearns had (we shall look at this case soon).
There was also a case of false or overvalued assets. The same as in the case of Satyam. However
in the case of Lehman Brothers it wasnt caught. People kept pouring in their money seeing their
high profits. But the fact was that they were never capable of handling such large amounts of
money and they had borrowed way too much money for their own good and when their
investments went bad, they lost so heavily that they went bankrupt.

In a paper published by Eagle Rock Diversified Fund, There are lots of reasons why hedge
funds fail, in almost all cases it comes down to poor performance resulting from inadequate
people managing the funds. In other words, operational problems and poor execution can damn
good strategies which repeats my point - trying to do way too many things which might be out
your league leads to certain failure.
Bear Stearns, a particular hedge fund, had borrowed around thirty times its own money to make a
hedge fund. Investors were petrified by this fact and pulled out from this fund and Bear Stearns
collapsed.
What I would like to say in conclusion is that hedge funds are a powerful tool for making lots of
money quickly and hence needs to be used with prudence. However cheating and manipulation is
second nature to us humans and that is the reason most of these funds fail when they might have
had the potential to do reasonably well and make money for everyone and not only for a select
few. Hedge funds are intricate and not many people understand its nitty-gritties clearly, not even
those who manage these funds. Through this essay I have tried to bring to you the concept of
hedge funds and how and why they usually fail since knowing about them is important as they
are the future of big risk based investing.