The Hedge Fund Debacle

August 28, 2007 by Joe Ponzio

How about a round of applause for Wall Street? Once again, they’ve managed to sell the dream, and are failing to deliver. Hedge Funds-unregulated mutual funds-have been the talk of the town for years. That is, of course, until their hyper-aggressive, no-fear strategies hit a market that was…volatile?

I’ve said it before: More risk usually means greater losses. When you focus on short-term results instead of the fine print or the strategy, don’t be surprised when you can’t protect your portfolio from harm. There’s a new scandal brewing on Wall Street-hedge fund investors may not be able to pull their money out. I smell losses, lawsuits, and new regulation. Still, investors are to blame.

A Bit of Hedge Fund Knowledge

Q: What is a hedge fund? A: An unregistered mutual fund. How do hedge funds and mutual funds differ? We’re all familiar with mutual funds: pools of investor money that is invested for growth which usually lag behind the returns of the market.

Hedge funds are the same thing except they are not regulated by the SEC and they are not stuck investing in just stocks, bonds, CDs, and other securities. That is, a $1 million hedge fund can borrow $10 million and bet it all on a penny stock, a piece of real estate, or a private business.

Not All Hedge Funds Are Created Equal

Hedge funds don’t have to take a ton of risk. In fact, many hedge funds are formed because an investment adviser or stockbroker wants to manage one portfolio for growth rather than juggle hundreds of individual portfolios.

Then again, some hedge funds are formed because they can be formed…because someone knew how to sell hedge funds and trading strategies (whether or not they knew how to invest). And those hedge funds, and hedge fund investors, are getting destroyed right now.

Give Me Your Money

For the past few years, the hedge fund sales pitch has gone something like this:

Fund Manager: I run a hedge fund. We’ve been averaging 30% a year for the past three years.

Investor: Here’s all my money.

Of course, hedge funds had to get their billions somewhere. That pitch was a bit different:

Fund Manager: I run a hedge fund. We’ve been averaging 30% a year for the past three years.

Brokerage Firm: Here’s our clients money. We want 50% of your management fee.

Give Me My Money

Ahhh, but things are different now. The markets pulled back and credit dried up a bit…and hedge funds are losing money in a cash crunch. Now, investors want out-investors who didn’t read the fine print.

Most hedge fund documents allow investor to request a redemption (or cash out) every three months. In addition, most hedge funds are happy to fulfill that request. That is, of course, until most investors want out of most hedge funds.

The fine print-that small text next to the “We’ll redeem your shares quarterly” statement-says that redemptions are in the sole discretion of the all-powerful manager and that market conditions or illiquidity in the portfolio may force the manager to halt redemptions.

What’s This Have To Do With Me?

Once again, Wall Street took a good idea and turned it into a profit center at the ultimate expense (or demise) of investors. And guess what-zero accountability. But Wall Street may learn their lesson this time. The hedge fund investors were/are their largest, richest clients. Now, they’re pissed, which is likely why all the big brokerages are pumping their own money into these funds to maintain the accounts of their big commission and fee-paying “best” clients.

Funny, I don’t remember them doing that when Average Joe’s mutual funds were losing 50%, 60%, 70%, and more in the early 2000s. I remember them enticing us to invest. I remember them happily selling investors the dream.

If you chase returns, you’ll get burned when they turn south. If you believe that Wall Street is in it for you, you’ll get burned when they try to protect their name and future profits. Know what you’re buying and why-or own an index fund and forget about it.

A Note From Joe Ponzio

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