Hedge Funds Semantics

Hedge funds are very risky investments. They invest in derivatives, employ unconventional trading strategies, and are usually greatly leveraged... All for the pursuit of extraordinary profits. A lot of hedge funds have come and gone and the survival rate is not encouraging. So why are they called "hedge" funds in the first place?

When we hear the word "hedge" we usually think of protection and safety. In finance, a hedge, usually in the form of derivatives, is used to protect an investment from loss. But it also limits the gains of the position as well. This makes potential earnings predictable and constant. Risk is eliminated since risk is defined as "uncertainty".

But looking at the hedging instrument individually, it is just as exposed to losses as other instruments. Moreover, derivatives are leveraged and losses are potentially greater than conventional assets. The hedge only takes shape if the hedging instrument is taken together with another position, and their reaction to changes in market factors should cancel each other out.

Hedge funds act in the same way. Taken alone, hedge funds are risky investments. But when combined with conventional funds, they can provide diversification benefits and even enhanced returns due unconventional strategies and assets employed. These unconventional strategies and assets result into low correlations with conventional funds.

I guess a lot of people assume that hedge funds are supposed to be safe investments because of the word "hedge". But if these funds are meant to safe in the first place, they should be called "hedged" funds instead.

Tags: finance derivatives hedge funds investments

Are fund managers really overcompensated?

CFA Magazine recently published an interview with Barton Biggs in its July-August 2006 Issue. Mr. Biggs has been with Morgan Stanley for 30 years acting as chief global strategist and is well respected by Wall Street. In 2003, He retired from Morgan Stanley to form Traxis Partners (hedge fund) with colleagues. In the interview, the following quote struck me the most...

"The hedge fund is another way for people to run money. It happens to be a way in which there are high fees charged. Eventually, the sheer size of the money going into hedge funds and the number of hedge funds that exist are going to inevitably result in a decline in hedge fund fees. In fact, my guess is that compensation across the investment management business is beginning a secular decline. It's the most overcompensated business in the world. Never have so many been paid so much for adding so little. It's an evolutionary process."

I am aware that competition forces fees in a downward trend and compensation will surely follow. But I still don't see the evidence of this happening at the moment based on the postings I see in jobs boards and the number of fresh grads wanting to go into the business (because it pays well).

I think it's all a matter of supply and demand. As more and more fund managers are needed, it becomes more difficult to get really good managers. The lack of supply raises the price for talents. The lack of supply also forces some funds to employ sub-standard managers (whether intentional or not) which results into Mr. Biggs observation of so little value added.

Some articles about Barton Biggs:
Morgan Stanley
Turtle Trader
Weeden & Co.

Tags: finance investing hedge funds CFA