Hedge funds are primarily speculative investment vehicles which employ a myriad of aggressive investment techniques to magnify returns. They usually consist of high end clients, due to the strict criteria that each investor has to fulfil in order to partake in hedge funds. The disadvantages of hedge funds have come to light recently with them appearing in the news for all the wrong reasons. Hedge funds have been blamed for magnifying the impact of the recession and also propagating it to major parts of the globe. Here we examine the reasons behind these accusations and try to uncover the truth about the functioning of hedge funds by taking some real time examples of the same. The disadvantages of hedge funds and their repercussions mainly revolve around the strategies used by them.
Since the regulations regarding hedge funds and their functioning are not very stringent, these could be regarded as a major reason behind the risk associated with hedge funds. Some of the important and risky strategies employed are described below.
Equity Long Short Strategy
An equity long-short strategy works just the way its name suggests – some of the stocks whose value is predicted to increase in the future are taken on a long position while those whose value is expected to fall, are taken on a short position.
When an investor take a long position on his stocks, they are simply bought with the expectation that their value with increase in the future, escalating the value of the investor’s portfolio along with it. On the other hand, when a short position is taken, the investor borrows the concerned stock (usually from a broker) at a particular price and sells it in the market. When the value of the stock falls (as predicted), the investor purchases the stock again at the lower price and returns it to the broker. Thus the investor/trader who carries out this transaction will book a profit equal to the difference in prices at which the stock was sold and then bought (less the interest payment to the broker).
However, the risk incurred while shorting stocks is that of infinite losses. The investor may enter the arrangement with a small sum of money which is not enough to buy the stock in the first place; and when the price of the stock does not fall as expected, the investor has to repurchase the stock at a higher price than the price at which it was sold, thus incurring huge losses. Also the small time period available to the trader to carry out the transaction (3 days in the US) works to a disadvantage in this strategy.
Leverage, is the process of borrowing money to trade. Usually a hedge fund deploys a very small sum of its own money and borrows the rest.
This makes it a popular tool for arbitrage as the hedge fund is able to magnify its returns with a relatively small capital investment. Since hedge funds like to resort to strategies that would give sure shot returns, the profits recorded are minimal, and employing leveraging results in returns which are a higher percentage of the assets of the fund.
The obvious downside to leveraging is that losses are magnified as well. In case the fund records losses on its transactions, it still has to pay back the lenders the original amount along with interest. This makes the loss amount all the more intimidating.
Hence, both of these strategies involve a considerable amount of risk and are popular among hedge funds around the world. It follows that some caution needs to be taken while judging which hedge fund to invest in by examining the strategies it employs. This could work out as one of the disadvantages of hedge funds as risk-averse investors would shy away from such situations.
Hedge Funds and financial crises
According to data made available by HFR (Hedge Fund Research, Inc), hedge funds in 2011 just ended one of the worst quarters in their history with losses across almost every strategy. Equity hedge strategies and Emerging Markets funds took the biggest hit and fell by huge values.
Due to their secretive and non-transparent nature, hedge funds pose some inconveniences to clients. Most hedge funds have a three-month delay on redemption requests. They often have special investor restrictions or “gates” which limit the amount of withdrawals from the fund during a redemption period. Though these provisions are meant to protect other clients who are still invested in the fund from sudden withdrawals and disposal of assets, they are usually seen as a negative event. In extreme situations, the hedge funds can also impose redemption suspensions resulting from the inability to meet redemption demands, thus preventing the investors access to their money. These restrictions make it difficult for investors to get their money out in times of a crisis. Thus ironically, this makes it more risky to invest in hedge funds in times of financial volatility.
These funds also employ leveraging as one of their investment strategies. This measure while having a multiplicative effect on gains also multiplies losses in case the hedge fund is on the wrong side of the bet. Long Term Capital Management, a speculative hedge fund based in the US has been cited as an example on how leveraging losses can be deadly. The Financial Times (26-27 September) detailed how this high leverage was secured: "LTCM was able to borrow such large sums of money by operating a merry-go- round: assets were used as collateral to borrow money with which more assets were bought which were then used as further collateral to borrow more money and so on." With liabilities of over $100 billion and an effective leverage ratio of 250-to-1 in late 1998, the fund was bailed out and finally closed in early 2000.
Thus the role of hedge funds in providing financial insulation is debatable as there are many industry statistics to support both sides of the argument. It is safe to say that while they do not provide a complete hedge against market volatility, they do limit losses to a certain extent.
Hedge Fund Debates
It may be a good idea to spend some time assessing the various investment options that are available through hedge funds. Due to the fact that hedge funds have high capital requirements, they require all the more time and thought. Hedge fund investments have their set of pros and cons. Listed below are some of the glaring disadvantages of hedge funds.
- Most hedge funds levy high commission charges.
- Hedge funds are not accessible by individuals other than accredited and institutional investors.
- Hedge funds employ a number of risqué trading strategies which are not subject to full disclosure making them a risky undertaking.
- Hedge funds are not sufficiently regulated allowing them to invest their clients’ money in various aggressive strategies which may not be completely safe.
- There are no standard measurement indices to gauge the performance of hedge funds since they are not obligated to report their returns.
The disadvantages of hedge funds are important and cannot be overlooked by any serious investor. While starting out as investment vehicles which were meant to hedge risk and provide consistent returns, they are become increasingly profit-maximisation oriented. For this purpose they deploy a number of aggressive strategies which may not appeal to many risk-averse investors. Hence, while they may be attractive investment opportunities to some investors, the risky strategies pose a major drawback to others.
Thus, in conclusion, the disadvantages of hedge funds need to be considered well before investing in them.