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HEDGING BETS

Hedge Funds have always seemed to garner more than their “fair share” of publicity, be it the spectacular, yet mysterious, Long Term Capital Management [LTCM] - allegedly caught up in a Russian bond default in the late 1990’s; or more recently – Amaranth – whose ill fated [or ill timed, perhaps?] bets on the wholesale price of natural gas led to their undoing.

With Hedge Funds back in the news – front-and-centre - recently, it seemed that a market wrap dealing with some Hedge Fund basics was in order.

I’ll assume most folks have a general understanding of what Mutual Funds are and do, but in case you are not, you may want to read up on Mutual Funds here.

Hedge Fund vs. Mutual Fund

As mutualfunds.about.com explains, 

“When the stock market is doing poorly, talk of using hedge funds tends to increase. Although hedge funds are not mutual funds, people often mistake them as such. The word "hedge" implies defensive management or insurance against bad times, but the truth is hedge funds come in hundreds of varieties and often use leverage.”

Mutualfunds.about.com then goes on to categorize the broad differences between these two types of investment vehicles under the following headings;

For the uninitiated, some of the most scrutinized differences listed above include regulation, availability, short selling and leverage:

Regulation:      While the Securities and Exchange Commission [SEC] provides regulatory oversight for the mutual fund industry in the United States, no such oversight exists for the Hedge Fund Industry.  Proponents for the Hedge Fund industry remaining in the realms of the “unregulated” have included none other than Sir Alan Greenspan himself, claiming serve a useful purpose in disseminating risk,,

“The new instruments of risk dispersal have enabled the largest and most sophisticated banks, in their credit-granting role, to divest themselves of much credit risk by passing it to institutions with far less leverage. Insurance companies, especially those in reinsurance, pension funds, and hedge funds continue to be willing, at a price, to supply credit protection.”

Others feel that some regulatory oversight would not impede the ability of hedge funds to disseminate risk at all and would provide a degree of transparency to the process of how these secretive institutions invest client funds.

Availability:     Availability tends to work hand-in-hand with issues involving minimum amounts.  Because Hedge Funds lack oversight and have such broad or loosely defined mandates – they tend to all be lumped in the category of being very risky investments.  As such, regulators have mandated that only persons with “substantial” means [determined by a means test – net worth - which determines whether or not an individual is an accredited investor].  As such, Hedge Funds tend to be the “playground” of the rich.

Short Selling:  As outlined above, Mutual Fund managers have strict limits on the amount of the fund’s proceeds that can be utilized to sell short.  Hedge Funds may be long or short any percentage of their fund’s proceeds.

Leverage:        This issue does not arise so much in the Mutual Fund arena because there are very strict limits on these types of funds using any leverage.  But Leverage, perhaps more than anything else, is what tends to set returns of different Hedge Funds apart.  The reason for this is really quite simple:  If you can imagine a fund that has 1 million in proceeds – with zero leverage – and their investments take a 10 % hit or loss, the fund would still have proceeds of 900,000.  Now consider the same Fund [1 million in proceeds] but they have now borrowed 4 million in addition to their initial 1 million and they invest the same way [aggregate 5 million].  A 10 % drop in value on a 5 million investment – invested the same way - would leave the Fund with “net equity” of only 500,000.

So, you see folks, all Hedge Funds are not created equal – in terms of risk or what they invest in.

The reasoning as to why they are used at all tends to stem from the theory that they, or their returns, are supposed to be negatively correlated to that of the general stock and bond markets.         

So when included in a well constructed investment portfolio, the [hopefully] positive returns of a Hedge Fund can “offset” or smooth out the negative returns of a poorly performing stock and bond market.  Funny thing, or perhaps not, this is exactly the function that precious metals used to perform in a properly constructed investment portfolio – and some would argue still should – but my, oh my, how times have changed.

Today’s Market

The Japanese stock market was closed today for health-sports day while Canada’s Toronto Stock Exchange was closed for Thanksgiving.  Meanwhile the DOW added 7.60 to 11,857.81, the NASDAQ was up 11.78 to 2,311.77 and the S & P was ahead by 1.08 to end the day at 1,350.66.  NYMEX crude oil futures were up .20 ending the day at 59.96 per barrel.

On foreign exchange markets the U.S. Dollar Index managed to eke out a small gain of .05 to end the day at 86.25.

The U.S. Bond Market was closed today in observance of Columbus Day. 

Precious metals reacted with a stiff initial rally late last evening when the Korean nuclear test news first broke.  COMEX gold futures prices remained elevated until N.Y. opened this morning when prices were hammered [or was that Hanked, perhaps?] back to almost unchanged before closing up about 5 bucks on the session – at about 580.00 per ounce. COMEX silver futures added .21 to close at 11.36 per ounce.  The XAU managed to lose .61 to 123.53 while the HUI lost 1.74 to 290.21.

On tap for tomorrow the U.S. Treasury Dept. is due to release Sept. budget [deficit] data – expected 55.0B vs. prior 35.7B.  At 10:00 a.m., the Census Bureau is due to release August Wholesale Inventory data – expected +.8 % vs. prior +.8 %.

Wishing you all the most pleasant of October evenings and happy and prosperous tomorrow!

Rob Kirby

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