An idiot’s guide to hedge funds

Explaining in simple terms how hedge funds work

As a follow up to recent articles published in this magazine on fund managers, such as Philippe Jabre and Marc Hochar, and the numerous mentions in these articles of hedge funds, we thought we should shed some light on the meaning or definition of hedge funds, their origins as well as their characteristics.

In the financial community, the term “hedging” usually refers to entering transactions that protect against adverse price movements. A “hedge fund” could thus reduce risks through a strategy that acts as an insurance policy, and brings the level of investment risk to a minimum. However, the term “hedging” or “hedge” is very misleading as most hedge funds nowadays use strategies which are not at all “hedged” or without risk. In fact, most hedge funds only “hedge” part of their exposure to a specific market or product (whether its equities, bonds, interest rate products, etc.) and follow specific sophisticated strategies. With time, the investment community started to call these type of funds as “hedge funds”, even when the overwhelming majority were mainly exploiting market inefficiencies through the use of various sophisticated arbitrage techniques.

Their origins date back to 1949, when Alfred W. Jones set up the first hedge fund. His objective was to eliminate part of the market risk involved in holding long stock positions by short selling other stocks. He was also the first to simultaneously use short sales (the act of selling securities you don’t own, by borrowing shares from someone, selling them, repurchasing them at a later date, and then returning them to the original lender), leverage and incentive fees. In 1952, Jones converted his general partnership fund into a limited partnership, investing with several independent portfolio managers and created the first multi-manager hedge fund. By 1966, Jones’ “hedge fund” had outperformed all the mutual funds of it’s time.

A “rush” into hedge funds followed and their number increased from a handful to over a hundred within a few years (remember, this was still the late 1960s). However, there were high losses and bankruptcies during the difficult stock market times of 1969-70 and 1973-74, a period that saw a number of hedge fund managers, with the exception of such stellar luminaries as George Soros and Michael Steinhardt, wiped off the financial map.

80s boom

A new boom in the late 1980s, helped the creation of a great number of new hedge funds and by the mid-1990s, hedge funds were accused of manipulating the market and creating high volatility, although an official inquiry and study by the IMF showed no evidence of such wrongdoings. The collapse of the Asian and Russian markets in the late 1990s ensured the much publicized collapse of LTCM, although the hedge fund industry recovered relatively quickly and is today continuing to boom.

Today, the established definition of hedge funds is “all forms of investment funds, companies and private partnerships that use derivatives for directional investing; and/or are allowed to go short; and/or use significant leverage through borrowing.” Borrowing includes margin borrowing against securities, foreign exchange, credit lines and loans. By significant leverage, we mean borrowing in excess of 25%. Hedge funds have three main features: they charge clients a percentage of the profits; they aim to achieve substantial returns; and they can only take a limited number of investors.

On the map

Hedge funds are characterized by their free choice of asset classes, markets, trading style, and instruments. Most are sold on a private basis and many are incorporated offshore, while for regulatory and administrative reasons, high minimum investment levels are often required. Other characteristics include the infrequent subscription and redemption possibilities, and the fact that managers invest their own capital in their funds. Finally, hedge funds show low correlation to traditional markets and are marketed as being oriented towards absolute performance (performance above zero) instead of performance relative to a certain benchmark or reference index.

With our own Philippe Jabre, it could be said that Lebanon is somewhere on the map of the hedge funds’ world. However, when one realizes that the West had been offering this kind of alternative investment source for more than 50 years, and we in Lebanon are still cogitating about petty political issues with a complete disregard for economic development, then it is understandable why we still have an accelerating brain and youth drain. Pity.