Capital Markets

Hedge-Fund Scrabble

Finance executives who want to find out what the darned things are might have to shuffle the tiles a little.
Alan RappeportMarch 22, 2007

The language of finance can mislead even the best-trained ear. A hedge fund, for instance, might sound like the last type of investment vehicle to strike fear in the hearts of regulators or central bankers with wobbly economies. After all, a hedged bet is supposed to be a safer one. Yet even the Securities and Exchange Commission, charged with keeping tabs on hedge funds, seems to find hedge funds hard to define.

Indeed, in Goldstein v. Securities and Exchange Commission, a widely discussed appeals court decision last year that struck down the SEC’s hedge-fund-registration rule, Circuit Judge A. Raymond Randolph complained that hedge funds are “notoriously difficult to define. The term appears nowhere in the federal securities laws, and even industry participants do not agree upon a single definition.” The judge’s ruling cited a reference to the existence of 14 different definitions for the term in government and industry publications.

Why is it so hard to get a verbal handle on an industry that now has $1.4 trillion in assets under management, according to a recent U.S. Treasury estimate? One reason is that hedge funds are best described by what they are not. For instance, they aren’t required to register with the SEC or make periodic reports. They’re under the radar of regulators. And they’re not advertised or intended for the casual investor.

Another difficulty is that fund forms are ever evolving and—as they become ever more fashionable—often emulated. Generally, hedge funds are lightly regulated, private pools of money placed in markets not subjected to the movements of traditional securities and bonds. Hedge-fund managers tend to look for investments in far-flung places or niche markets like art and wine, often using derivatives and hefty amounts of leverage to maximize returns while dampening risk. The classic hedge-fund position, dubbed “market neutral,” uses a combination of long and short sales to balance risk in case equity or bond markets tumble. Hence the “hedge.”

The definition has become even more elusive as the industry has split into myriad investing strategies. In recent testimony before the House Financial Services Committee, Kenneth Brody, co-founder of Taconic Capital Advisors, which manages seven hedge funds, couldn’t provide a definition without first issuing a caveat. “Some use mathematical models to determine investment strategies, while others rely on human judgments on which securities to buy or sell,” he said. “Some sell securities short while others do not. Some use significant leverage while many do not use leverage. The differences that exist among hedge funds are too numerous to list.”

Different specialties come with assorted levels of risk. According to the Hedge Fund Association, there are 14 different common hedge-fund strategies with different degrees of volatility. The riskiest funds rely on market timing, investment in emerging markets with volatile growth, and short selling, which attempts to anticipate earnings disappointments. Playing both sides in situations such as mergers, takeovers, and buyouts is considered a more conservative strategy, as are investments in “funds of funds” which blend multiple methods and asset classes.

Some industry players also try to describe hedge funds by the kinds of businesses they invest in. At the same session before the House Committee on Financial Services, Jeffrey Matthews, of the hedge fund Ram Partners, opined about how hedge funds have branched out to focus on everything from sub-prime debt to uranium ore to grain silos. But that approach fails to encompass hedge funds that can switch the industries that dominate their portfolios a number of times in a trading day.

Nevertheless, there’s one widely accepted commonality: how fund advisers are paid. Typically, they’re compensated according to the “2 and 20” rule, in which advisers charge a 2 percent fee for the assets they manage and take 20 percent of the profits. With many managers seeing such happy returns, some have deemed hedge funds as a “compensation scheme masquerading as an asset class.” Of course, compensation varies depending on the hedge fund’s specialty—but heavily invested managers do tend to work hard for their clients.

Hedge funds also tend to be defined by their clients. An investor must have a minimum net worth of $1 million to enter the game—although the Securities and Exchange Commission is trying to bump that up to $2.5 million—and the average investment is nearly $500,000. The funds usually implement a “lockup” period of at least a year, under which investors can’t pull out. Further confounding the picture is that more and more funds are catering to pension funds and other large institutional investors in addition to the wealthy individuals they’ve traditionally courted.

The perception of hedge funds as a business that poses risks to the global economic system has brought calls for tighter regulations. If implemented, these could change how hedge funds behave and how they’re defined. Perhaps such regulations will even make them easier to define—without having to hedge.

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