The world loves to hate hedge fund managers.
And why not? As the outlook for global economy grows increasingly grim, some of the biggest hedge fund managers, such as George Soros and John Paulson, are reported to be pulling in annual pay packages in the billions. Of course, the dollar figures are hard to substantiate since hedge funds are exempt from many of the disclosure rules that bind bankers and other fund managers.
Those pay packages are just a sliver of the estimated $1.4-trillion global hedge fund industry – a leverage-fuelled money churning machine that implements complex and mysterious strategies aimed at turning a profit, whether the broader markets are up or down. Often they succeed. Sometimes they fail.
That makes hedge funds an easy target for regulators and politicians looking for someone to blame for the wild market swings that led to the 2008 global financial meltdown. The Dodd-Frank Wall Street Reform Act in the U.S., for example, now requires hedge funds to disclose private pools of capital exceeding $150-million and provide information about their trades, portfolios, strategies and leverage. Similar restrictions have been placed on hedge funds operating out of Europe.
“I think people [who] don’t understand things always look for scapegoats,” says Friedberg Mercantile Group head bond trader Michael Hart. This Toronto-based hedge fund firm manages $2.4-billion in an array of hedge strategies. In a year of dismal market gains, Friedberg’s multi-strategy Global Macro Hedge Fund returned over 50 per cent in the first nine months of 2011.
Mr. Hart says the bulk of the blame is directed at short sellers – investors who borrow shares to sell into the market in the expectation they will fall, then buy them back at the lower price. In other words, they make money when a stock falls. Big hedge funds have the ability to grind a company’s falling stock into oblivion. In his 26-year career, Mr. Hart took heat from some of his Bay Street colleagues for holding some short positions, including the famous Nortel Networks plunge in 2000 that brought the stock from more than $120 down to pocket change. “The short seller is not responsible when equities get way overpriced,” he says.
He admits the few hedge funds with “casino mentalities” should be reigned in, but says most attempts to regulate the industry are rooted in ignorance. For starters, the basic intent of hedging is to actually reduce risk. To put it in its simplest terms, we all hedge risk when we get into a car and take the time – and added expense – of using seatbelts. Similarly, investors will hedge big positions by diversifying a portfolio with investments that tend to move in an opposite direction.
Over the past few decades, hedge strategies evolved into hedge funds that mostly took short positions to counter risk. Other strategies emerged, such as merger arbitrage, where simultaneous positions were held in two merging companies. Another arbitrage strategy involves companies that list on more than one global exchange. If there is a price discrepancy from one exchange to the other, the hedger purchases the company shares on the exchange when the trading price is lower and sells it on the exchange offering the higher price. Exchange arbitrage provides global price consistency.
There are also strategies to hedge against currency fluctuations and interest rate spreads on bonds. “Hedge funds plug holes in the financial system,” says Canaccord Capital portfolio manager Bob Thompson. “When spreads widen, hedge funds can close that gap and bring things back into order.”
