SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 26)

Hedge Funds

by

Charles Lamson

Historically, a hedge fund was a nontraditional investment fund formed as a partnership of up to 99 "accredited" investors who invested in a variety of often risky securities. An accredited investor was one who had at least $1 million in investable assets. In April 1997, the SEC expanded the rules by allowing some hedge funds to raise money from 499 "qualified" investors. In this case, a qualified investor is an individual who has a minimum net worth of $5 million or an institution such as a pension fund or mutual fund with at least $25 million in capital. Today both types of hedge funds exist.

For all hedge funds, a general partner usually organizes the fund and is responsible for making day-to-day trading decisions. Limited partners put up most of the funds, but have limited or no say in the day-to-day decision making. Partners who buy into the hedge funds are wealthy individuals and institutions---minimum investments can start around $250,000, and many hedge funds have much higher minimum requirements. Hedge funds may also limit withdrawals or require that funds be invested for a minimum time period, such as ten years.

Because there are a limited number of wealthy investors, hedge funds are not regulated in the same way that traditional investment pools or mutual funds are. They are not required to file a registration statement and may engage in many trading strategies from which traditional mutual funds are barred. These strategies include borrowing funds to invest, purchasing many types of option and derivative instruments, short selling, and dealing in real estate and commodities.

Hedge funds attempt to earn high or maximum returns regardless of whether prices in broader financial markets are rising and falling. The funds trade securities and other creative financial instruments and try to outperform traditional investment funds by employing novel trading strategies.

In general, hedge funds use riskier investment strategies than traditional mutual funds, although some are less risky than others. As we have seen, the funds often rely on borrowed funds (leveraging) as well as the funds of the partners. This leverage increases the potential for losses. Short selling to take advantage of falling prices, and the use of some risky financial instruments, can also result in large losses if prices do not move in the anticipated direction. In general, hedge funds outperform other mutual funds when markets are falling.

Traditionally, hedge funds charge high fees and take a large percent of the profits. For example, some charge a 2 percent annual management fee and take 25 percent of the profits. The remainder of the profits is distributed to the partners based on their percentage of ownership in the fund.

Although the first hedge fund was established more than 50 years ago, the number and assets of hedge funds have grown tremendously since the mid-1990s. Domestic hedge funds now number over 3,000. Offshore hedge funds are located outside the United States, and they are difficult for most U.S. investors to invest in because of certain tax consequences. The number of partners in offshore hedge funds is unrestricted.

A fund of hedge funds invests in multiple hedge funds, each usually employing a different investment strategy. Because of pooling, they have lower required minimums for participation and offer less risk due to diversification into many hedge funds.

To summarize, some of the strategies employed by hedge funds include the following:

1. Selling borrowed securities (short selling) in the hopes of profiting by buying the securities at a lower price at a future date.
2. Exploiting unusual price differences between related securities in anticipation of making a profit when the prices come into more traditional alignmment.
3. Trading options and other derivatives.
4. Borrowing to invest (leveraging) so that returns arer increased.

Real Estate Investment Trusts (REITs)

Real estate investment trusts (REITs) are a special type of mutual fund that pool the funds of many small investors and use them to make investments. Whereas other mutual funds invest only in financial instruments. REITs may invest in real property as well. Their funds are used to buy or build income property or to make or purchase mortgage loans, unlike those of traditional mutual funds. Another difference is that to some extent, they also raise funds by taking out bank loans or issuing debt. REITs are pass-through enterprises in that rents from income property and/or interest income from the mortgages are passed through to shareholders. Shareholders are also entitled to any capital gains from the properties that the REITs own.

Recap

Hedge funds are a type of mutual fund that has fewer than either 99 or 499 wealthy investors. The SEC does not regulate them. Hedge funds attempt to earn high returns for their investors regardless of whether financial prices are going up or down. Hedge funds engage in risky investment strategies. REITs are a type of mutual fund that pool the funds of many small investors and use them to buy or build income property or to make or purchase mortgages. They are pass-through institutions in that the rents from the income property and/or the interest income from the mortgages are passed through to shareholders. Whereas other mutual funds invest only in financial instruments, REITs may invest in real property as well as financial instruments. Shares of REITs are traded on organized exchanges. By law, REITs must return 95 percent of their income to shareholders each year. REITs allow for the integration of commercial real estate markets and capital markets.

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 360-363*

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