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As the outlook for global economy grows increasingly grim, some of the biggest hedge fund managers, such as George Soros, are reported to be pulling in annual pay packages in the billions.STEFAN WERMUTH/Reuters

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."

Based in Vancouver, Mr. Thompson manages a number of hedge funds after spending several years as a hedge-fund analyst covering roughly 200 alternative strategy funds in Canada and 10,000 in the United States. He says about 40 per cent of all hedge fund assets are in the biggest 100 hedge funds. According to Chicago-based Hedge Fund Research, at the end of 2008 only 4 per cent of hedge funds had assets of $5-billion or more. He says the funds that have the potential to destabilize markets are the few that are over-leveraged, narrowly focused, have little liquidity or are too big to change course. "It's always things at the fringes. Always the 10 per cent that cause problems for the other 90 per cent," he says.

For Alec Young, global equity strategist with S&P Capital IQ, trying to gauge the influence of hedge funds on the broader markets can be frustrating. "We don't have the numbers because it's secretive. Hedge funds don't want to advertise what they're buying or how much of it they're buying," he says.

Capital IQ is a division of New York-based Standard and Poor's, which conducts fundamental and quantitative analysis based on the massive capital flows in financial markets. Its analysis relies on hard data – the sort of details hedge-fund managers want to keep from competitors. Mr. Young says he understands their position, and even points out that hedging provides a benefit to even the smallest retail investor who holds widely traded stocks such as IBM or Apple Computer. "The fact that hedge funds are aggressively trading those names provides liquidity. It tightens the bid/ask spread on those stocks," he says.

"They're providing a community service. That may not be a popular way of thinking about it on Main Street, but that wouldn't be the first time Main Street had an inaccurate impression of something that was happening on Wall Street," says Mr. Young.

Tracking the influence of hedge funds is also difficult for technical analysts, who rely on hard data to chart past price movements to determine future trends. Auerbach Grayson global technical strategist Richard Ross admits large-block hedge trades may skew the data, but considers hedging to be a natural market phenomena.

"The market is a living, breathing organic being that cannot be controlled or unduly influenced by anyone. Even government attempts to intervene through artificial measures are no match for the power of the free market," he says.

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