Hedge funds: rules of the game without rules

Lately, hedge funds have been on everyone’s lips. But what do we know about them, except that they allow us to make profits?

In the late 1940s, Alfred Winslow Jones, a sociologist and publicist from the United States, had the idea of getting rich on investments. He founded A. W. Jones & Co., now called the first hedge fund in history.

Growth stocks

The organization’s original goal was to make enough money to live comfortably. Jones managed his funds and the assets of his friends, taking 20 percent of the profits as his reward.

Today the strategy looks rather trivial, as it consisted of buying securities whose value he thought might rise. In addition, he sold assets which, from the market’s point of view, were unpromising. Such approach made it possible to diversify risks and receive high profits. The financier himself stated that he created a method of tracking and selecting shares with high growth probability.

The fund’s ambitions were modest at the start, but the success of the investment scheme changed the market by the mid-1960s, launching the hedge fund industry.

During the first ten years of operation, the company founded by Jones increased investor capital by 670%, and by another 325% over the next five. Then significant legal restrictions appeared in the USA and some other countries. They allowed only large institutional investors with $100 million to invest in hedge funds. The norms forced financial institutions to flee to “tax havens,” where regulation was more tolerant and loyal.

Despite this, the number of such companies has grown rapidly over the past 15-20 years. Experts estimate that there are about 12,000 of them operating in the world, mostly in the United States, Britain and offshore zones.

The fund with “untied hands”

These high-risk companies accumulate investor money to buy securities or other assets. On the one hand, such activities do little to distinguish them from the same ETFs or mutual funds, but at the same time, they are more free to choose their investment strategy.

Mutual funds are constrained by numerous legislative and normative acts, hedge-funds act with “free hands” and are practically beyond the control of the state. And while the former are limited to investments in “classical” securities (shares, bonds, mortgages), the latter may use other financial instruments (options, convertible bonds, deals with margin, warrants, short sales). This explains their ability to make money on lowering stocks.

In addition, hedge funds can buy “exotic” asset types – art and cryptocurrencies. At times, the strategies they use involve significant risk. But paradoxically, this does not discourage investors.

“Such companies are seen by some as an exclusive club. They have both advantages (for example, the chance for higher returns) and disadvantages. The latter include illiquidity, volatility and risk,” explains Cathy Brewer, president of Your Richest Life.

Membership in these communities is not available to everyone: initial investment amounts range from $100,000 to $2 million.

Not everyone can get in

Another no less important problem associated with hedge funds is the inability to withdraw from them and move into other assets. You can withdraw your money only after selling your share inside the company.

On top of that, hedge funds have a good commercial appetite. As a rule, they charge 1-2% of the invested amount for asset management. Add to that 20% charged on profits, and as a result the fees sometimes “eat up” the total income of the depositor.

Note that the most successful companies in this category, such as Renaissance Technologies, are closed to investors and manage their founders’ money.

Although hedge funds have a certain freedom, in several countries they are regulated by governments. For example, because of the high level of risk, the U.S. Securities and Exchange Commission (SEC) has established rules regarding who may participate in them. Currently, an individual with capital of at least $1 million or annual individual income over $200,000 ($300,000 if the investor is married) may participate in them.

 

The advantages of such companies include the previously mentioned ability to make money not only in rising but also in falling markets. The balance of a hedge fund’s portfolio helps reduce risk and volatility as well as increase profitability. Different investment approaches often don’t correlate with each other – hedge funds allow participants to make strategies as precise as possible. Nor do they skimp on hiring talented analysts, traders, and managers.

However, even with such a policy, an industry investment strategy sometimes leads to significant losses.

Examples of high-profile crashes

There have been several serious incidents involving hedge companies in recent years.

The Bernie Madoff investment scandal is the worst-case scenario for this type of fund. It was essentially a pyramid scheme, promising clients high steady returns. For his 2008 scam, Madoff was sentenced to 150 years and died in prison in mid-April 2021 at the age of 82.

Another example is the company Galleon. It was a very large hedge fund management group before it closed. Corporation CEO Raj Rajaratnam was arrested along with five other members of the group for fraud and insider trading in 2009. Two years later, the financier was found guilty on 14 counts and sentenced to 11 years in prison.

The latest scandal took place at the end of March 2021: Hedge fund Archegos Capital Management and the largest banks of the world that lent it money – Nomura, Mizuho, and Credit Suisse of Switzerland – lost $70 billion. Shares of financial institutions plummeted by 16-20%, the rating agency S&P lowered its outlook on Credit Suisse from stable to negative. The fund itself lost $20 billion.

According to experts, this happened because of its overly aggressive strategy that is almost entirely based on borrowed money.

The question is in the trust

Despite high-profile scandals, hedge funds attract interest all over the world, including the former Soviet Union. To a large extent, they are attracted (unlike mutual funds) by the possibility to operate in markets of other countries, for example, to buy U.S. stocks.
In Russia, the official status of such companies has been fixed at the legislative level since 2008. At the same time the “Regulation on investment funds” was adopted, according to which they were referred to a separate category of mutual funds.

The number of hedge funds in the CIS countries is small, as well as the number of qualified specialists who can manage them.

An important problem hindering the hedging system is precisely the lack of trust in managers on the part of investors. However, experts believe that the situation will improve over time.

The figure

$63.5 billion

earned by the 20 most successful hedge funds in the world in 2020. In doing so, they set a decade record in a volatile environment where tech stocks rebounded sharply after a pandemic-induced se

Leave a Comment

Your email address will not be published. Required fields are marked *