Hedge Funds: A Looming Disaster?

Back in November of 2005, I wrote an article for the E-Commerce Times entitled: Hedge Funds: Investor Beware. Before I talk about the most recent hedge fund disaster, the loss by Amaranth Advisors of over US$6 billion and the ramifications thereof, permit me to crow a little.

In my previous article I said the following about why I am so critical of hedge funds:

“First, they are poorly regulated…

“Second, many hedge funds charge extraordinarily high fees to the investor. Not only do they charge a base fee that can be augmented by churning (buying and selling) the securities in the fund, but they also can charge a profit-participation fee based upon a healthy percentage of the fund’s gains. To add insult to injury, the accounting techniques used to compute profit leave generally accepted accounting principles out of the equation. This type of profit participation computation is tantamount to having the fox guarding the hen house. It just doesn’t make sense.”

The Amaranth Fiasco

Now that I’ve gotten that off my chest, let’s talk about the multi-billion dollar loss incurred by Amaranth Advisors. The cause of the loss was an oversized bet on where certain natural gas prices would be at some future time. This type of transaction is called buying a derivative security, a contract between two or more parties which deals with some future, uncertain event.

Listen to Ted di Stefano (7:27 minutes)

In fact, believe it or not, you can buy a derivative based upon weather data at some future point. Yes, I stated it correctly. A derivative could be based upon what the weather will be at some time in the future. Do you call this gambling? I do.

Well, the traders at Amaranth apparently were quite confident that they could predict the prices of natural gas at some future time. The fact is that although this type of bet can often turn out to be true, it can also turn out to be a major strategic blunder for a hedge fund and could actually bring it to its knees. In fact, this is exactly what happened to Amaranth. It is now liquidating its business.

Though some hedge fund managers might regard futures/derivative betting as “investing,” it can really amount to nothing less than gambling, as evidenced by the Amaranth implosion.

Traditional Hedge Funds

Not too long ago, hedge funds were limited to wealthy and sophisticated investors. The operative words here are wealthy and sophisticated. They were never meant for the average person.

For the most part, they did return some very healthy profits to the investors.

What has happened since is that many would-be hedge fund managers realized that the profits to be made in running a hedge fund were tremendous. All they had to do was convince prospective investors to take the risk.

How did they do this? They appealed to the greedy side of human nature. Getting back to my previous article for a moment, I said that “today the market has become so saturated with these funds that the returns have fallen accordingly … chalk that up to Madison Avenue’s marketing of these funds, rather than the actual performance and safety of them.”

Potential Disaster

We have a pretty good idea of the number of hedge funds worldwide (about 8,000) and their assets under management (over $1 trillion). However, the fact is, that I know of no governmental agency that keeps track of the overall size of the derivative markets. Yet we do know that many hedge funds are heavily invested in derivatives.

The potential for losses could be enormous. Compounding this danger is the cross-border investing going on today — the flow of derivative transactions throughout the world. This makes it yet more difficult for us to keep track of the size and potential risks of this hybrid type of investment.

We really don’t have a good handle as to the global size of the derivatives market. That being the case, no one can really quantify the losses resulting from a meltdown. We can only imagine the consequences.

Fixing the Situation

Once again, citing my previous article, we can do the following:

Limit hedge fund investments to high net worth individuals who are presumably sophisticated enough to handle the risk of such investments. We could also limit the amount that institutional investors, like financial institutions, pension funds, etc., are able to invest in hedge funds.

The second major thing that can be done, as much as I don’t like too much government interference and regulation, is to increase the SEC scrutiny of hedge funds and their managers. Hedge funds should become transparent. Unfortunately, today the activities of hedge funds are quite opaque in that the managers are not forced to reveal that much about their owners, investment strategies and financial soundness.

My feeling is that after the multi-billion dollar Amaranth loss, the politicians from both parties will jump on the bandwagon and call for more regulation and severe penalties for those who tend to ignore or violate governmental rules relating to these funds.

It’s going to be interesting to see how this all plays out. In the meantime, I would suggest a thorough review of any hedge fund investments that you or your company may have. Also, remember, some hedge funds make it almost impossible for you to get at your money quickly, either in an emergency or if you become disenchanted with this investment sector generally.

So, read the fine print and decide whether or not you have the stomach for this type of investment.

Good luck!

Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at [email protected].

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