Hedge Fund
From FXPedia
Alfred W. Jones (1900 – 1989) is credited with founding the first hedge fund in 1949 – or as he insisted – a hedged fund. He formulated a trading strategy designed to minimize risk through a careful hedging of exposures in both gaining or losing markets. It was this approach that differentiated his fund from other investment funds available at the time.[1]
Jones started his professional career as a sociologist and worked in the U.S. Foreign Service in Europe shortly after the second world war. During this time, he began contributing to Fortune Magazine centering on the rebuilding efforts underway in Europe and the convergence of finance and politics in the region at the time.
Jones became increasingly interested in the idea of a fund making use of leverage to maximize buying power combined with short-selling to hedge his long positions. Serving as the fund’s Managing Partner, Jones invested his own money and convinced a handful of his friends to also invest in his new venture, which evolved into the A. W. Jones and Co.[2]
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Jones’ Hedged Fund Approach
While Jones understood the importance of market analysis to forecast market conditions to identify investment opportunities, he still felt that despite the best efforts of most investment professionals, their actual track record left much to be desired. Jones reasoned that trying to predict the market as a whole was unreliable, but a system ensuring maximum investment of capital in specific stocks and sectors, while hedging market exposure through a series of off-setting short sell orders to protect against a market downturn, would result in superior investment performance.[3]
Jones determined that he could meet his objective of a protected (i.e. hedged) fund by following two objectives:
- 1. Buy securities on margin to ensure maximum leverage of investment capital, and
- 2. Hedge liabilities by shorting selected securities to offset long exposures
Taken separately, each action involves considerable risk. Buying on leverage carries the risk of being unable to pay back creditors which could cause the fund to collapse if sufficient liquidity is not maintained. Selling short can lead to a similar fate if the price of the shorted stock increases and the investor is forced to purchase shares at a higher market price than the price received when the stock was shorted.
Jones believed that his fund’s focus should lie with individual stock selection rather than trying to predict changes in the direction of the overall market. He postulated that he stood a greater chance of success with identifying stocks expected to increase in value, and these he would buy using a high leverage ratio to maximize the buying power of his fund’s investment capital. To hedge these long positions, he would short stocks in a similar sector that he expected to lose value.
His long positions would naturally earn income if they increased in price, as would his short positions if the stocks lost share value. However, if for some reason the sector in which he had invested suddenly reversed course and his long positions lost money due to a contracting market, his short positions (i.e. those stocks he already expected would do poorly) would certainly continue to lose money thereby providing the hedge for his long positions.
With this strategy, Jones believed that his fund could produce positive results under most market conditions[4]. You can read more about this approach to hedging in Stock Price Hedge Using a Pairs Order.
Risks Associated with Leveraged Investing
As noted above, leveraged investing is not without its risks and one of the highest profile examples of a heavily-leveraged hedge fund failing occurred in 1998 when Connecticut-based Long Term Capital Management (LTCM) collapsed after failing to repay its creditors. LTCM took the investment world by storm when it began operations in 1993 until it suddenly faltered in 1998. It was subsequently bailed out by the Federal Reserve but was finally wound-down for good in 2000. During its brief existence, it managed incredible returns and attracted some of the biggest names in the industry to both its payroll and its list of investors.
Hedge Fund Rules
Hedge fund investors are typically high net-worth individuals with a sophisticated knowledge of the markets and market risk. The aggressive nature of hedge funds makes use of “riskier” investment options including futures and swaps derivatives and, of course, the staple of all hedge funds, short selling.
As the popularity of hedge funds grew, the traditional investor – or “client” (the term used by hedge fund managers to avoid legal implications) – changed and began to include public entities such as pension funds and charities looking to maximize returns.
To offer a greater level of protection to this new class of investors, the Securities Exchange Commission (SEC) in the U.S. passed an amendment to the Investment Advisors Act of 1940 that changed the term “client” to mean the same as shareholders, limited partners, members, or beneficiaries of the fund. This amendment – passed in 2005 and known as the “hedge fund rule” – required hedge fund managers in the U.S. to register with the SEC and subjected the fund to increased compliance with existing fraud and practices rules. Similar regulations have been added in other jurisdictions as well, but despite these changes, hedge funds still have fewer restrictions than most other investment options.
Fraud Cases Involving Hedge Funds
There have been several instances of fraud associated with hedge funds with some court cases still pending as of June 2008.[5] The private nature of the hedge fund industry combined with fewer regulations may contribute to this to some degree, so investors – as is the case for any form of investing - must be prudent.
However, when it comes to hedge fund fraud, the Bayou Hedge Fund is generally the first example that springs to mind. As if the nearly half billion dollars involved in the swindle were not enough to ensure that the Bayou Hedge Fund would always have a place in infamy, then the events that unfolded on Monday, June 9th 2008 would cement its reputation forever.
Samuel Israel III and Daniel Marino wove a complicated series of management firms including a fake accounting firm to cover up the theft of an estimated $450 million of investor’s money. Both principles were sentenced to twenty years in prison, but on June 9th, 2008 as Israel was due to surrender to authorities to start his sentence, his vehicle was discovered abandoned on a bridge with the words “suicide is painless” written in the dust. A search of the river below failed to find his body.[6]
While Israel has not been spotted since, authorities have not ruled out the possibility that this is merely an attempt to fake his own suicide. On Wednesday, June 11th, U.S. officials placed Israel on Interpol’s “Most Wanted” list and asked police forces around the world to watch for any attempts Israel may make to enter a foreign country.[7]
Update - July 3rd, 2008
On Wednesday, July 2nd, and after nearly four weeks of hiding, Samuel Israel surrendered to police in Southwick, Massachusetts.
Hedge Fund Market Size
Attempts to determine the total value of the global hedge fund industry have proven difficult as there is a wide discrepancy in reporting guidelines and even the way various funds measure their total assets. Some hedge funds report the total amount of investment money they have attracted to their fund as their total value – but in fairness, some other types of funds do this as well. Additionally, some hedge fund managers also include the borrowed funds (i.e. the leveraged portions of their fund) when quoting market value.[8]
Neither practice is illegal but nor are they consistently applied so it is a little like comparing apples and oranges. Nevertheless, there have been some “educated guesses” as to the total value of the global hedge fund industry.
In June of 2007, Chicago-based Hedge Fund Research Inc. placed total assets under management at $1.74 trillion, while Credit Suisse Tremont felt it was closer to $1.25 trillion. HedgeFund Intelligence of London placed the value considerably higher at nearly $2.5 trillion.[9]
Related Links
References
- ↑ History of the Firm – www.awjones.com
- ↑ History of the Firm – www.awjones.com
- ↑ History of the Firm – www.awjones.com
- ↑ Learn About Hedge Funds – sterlingfunds.ca
- ↑ FBI Warns of Hedge Fund Fraud – National Post, April 17th, 2008
- ↑ Yahoo News – Jun 9th, 2008
- ↑ CNBC News – June 11th, 2008
- ↑ Hedge Funds: Leveraging the Number – The Wall Street Journal, November 24th, 2007
- ↑ Hedge Funds: Leveraging the Number – The Wall Street Journal, November 24th, 2007
