Hedge funds have their own fishing technique. They know how to hook a big fish even in shallow waters. However, regulators around the world feel that hedge funds make the water dirty. Even the slightest hint of trouble draws the needle of suspicion in their direction. Fear of even one hedge fund going bust is enough to cause tremors in the financial markets. Names of failed hedge funds such as Long Term Capital Management and Amaranth spark instant recollection. So how do hedge funds operate in spite of so many probing eyes? Maybe our friends Jinny and Johnny will be able to throw some light on this subject:
Johnny: Hi Jinny! It’s so nice to see you back after a refreshing weekend. But why are you clenching your fists?
Jinny: Well, I want to start my day by hitting a punching bag. It instantaneously releases all tension. Why don’t you also try?
Johnny: But from where did you get this unique idea of releasing tension?
Jinny: I have seen regulators around the world whipping hedge funds for releasing their tension. What’s wrong if I use a punching bag to release my tension?
Johnny: Hedge funds? Their name sounds familiar. I think you referred to them a few weeks ago while talking about participatory notes. But why are hedge funds being used as a whipping boy?
Jinny: Nothing wrong with their name. However, in the minds of many in the financial community, they conjure the image of an underground secret society raking billions of dollars of profits by using a formula nobody is able to digest. Many a time the markets blame hedge funds for causing loose motion. Such is their notoriety.
Johnny: Well Jinny, I feel having a loose motion is better than having a financial constipation. Anyways, tell me more about how these hedge funds tickle the bowels of financial community.
Jinny: Let me give you a brief idea about their antecedents first. I hope you know that the literal meaning of the term ‘hedge’ is to eliminate risk. True to their name, hedge funds started their life as a device for hedging risks. One Harvard graduate, Alfred Winslow Jones, is credited for starting the first known hedge fund in 1949. Jones used a strategy that may look ultra-simple by today’s standard. He short-sold certain stocks, which he thought would fall. At the same time, he purchased certain other stocks, which he thought would rise. Jones kept the value of buys and sells equal in order to hedge his risk. In a shortselling, as you may be aware, a seller does not own the shares at the time of sale. He expects to purchase the same subsequently, hopefully at a lower price, for meeting the delivery requirements. Shortselling as a market technique was not popular at that time. Jones’ formula depended on picking the right stocks at the right time. Soon this formula of success leaked out. Many hedge funds, working as an exclusive club of ultra-rich people, came into existence. Rich people don’t mind if a couple of million dollars slip through their fingers.
Risk taking has become the new mantra.
Johnny: But what kinds of risks do hedge funds take?
Jinny: Well, you can have a truckload of case studies on financial leverage and arbitrage strategies of hedge funds. But let us understand their funda differently. Suppose you have one umbrella and four people want to share it at the same time. How would you do that?
In such a situation, a hedge fund would ask the four men to sit on top of the shoulders of another man one by one. The man sitting at the top holds the umbrella and thus everyone shares it. Financial pundits would call this leveraging of resources. The problem with this kind of leveraging is that if one man sneezes the whole structure may tumble down. Hedge funds are able to do all sorts of financial acrobatics without falling under any regulatory net.
Johnny: Oh, I see! But I was just wondering, why are hedge funds not regulated?
Jinny: Most hedge funds are organized like limited partnerships. Only high net worth individuals and institutional investors invest through them. They do not solicit investment from retail investors. Since the number of investors is not more than 100, hedge funds don’t get registered with the Securities Exchange Commission like mutual funds under US laws. In the UK also, the Financial Services Authority (FSA) does not regulate hedge funds. However, FSA does authorize and supervise advisers and managers of hedge funds. In India, the Securities and Exchange Board of India is interested in registering offshore hedge funds just like foreign institutional investors. Many experts feel that putting too many regulatory nets over the hedge funds would kill their investment instincts. However, others favour putting some sort of regulatory framework in place sooner than later.
Johnny: Till that time, I hope the hedge funds will continue using their fishing technique without being bothered by any regulatory net.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at email@example.com