Hedging the way to a very risky future

If investors were gladiators, they'd be dead. The coliseum would be littered with the bodies of day traders, stockbrokers and mutual fund managers alike. Technology has turned the most highly praised, popular and traditionally effective investors -- and their war strategies -- into business page obituaries. However, out from the rubble, one cadre has remained standing -- hedge funds. And they have become the talk of the town. Hedge funds have traditionally catered to the extremely wealthy. By default, that quality allows them to take financial risks with relatively little overall financial downside. They are totally private, their positions are generally a mystery even to their investors. They move nimbly, jumping in and out of markets and positions with a speed and liquidity designed to take quick advantage of minute-by-minute movements. And due to their unique qualities, hedge funds avoided the market's latest downturn -- smartly, they hedged their exposure. As a result, populist financial service institutions like Prudential are beginning to market hedge funds to the masses. They are selling hedge funds as good, strong investment diversification tools; that they provide a safeguard against bear markets like the one we're in. But just because some hedge funds are actually making money does not mean that they are either a good or a safe investment. To unknowledgeable investors, hedge funds sound like they try to remain market neutral. The word "hedge" suggests protection -- they "hedge" their bets to minimize potential downside. But the label for hedge funds couldn't be more misleading. Different hedge funds do different things -- they cannot be defined by risk. They don't work within strict rules, and aren't limited to particular markets or instruments. Some hedge funds are merger and acquisition funds, meaning they look for price differentials in buyout deals between the existing price and the proposed price; other funds make macroeconomic bets; while some invest solely in emerging market debt, always a risky investment. However, almost all hedge funds do share one thing in common -- they promise investors the ability to withdraw their money on a quarterly timetable, which means their positions must be liquid. This eliminates the ability to make long terms investments, like venture capital companies, where exit events might take years and depend heavily on market conditions. Hedge funds can be freewheeling, volatile and extremely diverse. Yet they have been misrepresented -- and consequently new investor groups that traditionally couldn't afford or access them may become misinformed about the nature of their investment. That means people will never be able to understand how and why their money multiplied or disappeared. Mutual funds and retirement plans can be explained to a farmer in Kansas relatively easily. But try to tell him about exploiting relational price differentials between Eastern European debt instruments and South Asian currencies, or the logic behind the bet that significant price spreads between German treasury 30-year notes and 10-year notes might contract, and it might take a little longer than an afternoon. But that has not stopped some firms from aggressively pushing hedge funds to the middle market investment community -- presently a win-win move. Small investors seem happy because they get to invest in something new and cool. Hedge funds are pleased because, unsurprisingly, they generally like more money. The larger the fund, they bigger positions they can take. The bigger their positions, the more money they make on each and every trade. In short, hedge funds are totally scalable; running a $3 billion fund requires the same amount of working knowledge as running a $500 million fund. If you want to see where the next hot problem lies, look no further than the small-time American investor owning a piece of a hedge fund. Sell somebody a financial product, which might go up or down but that people can never understand, and you'll find trouble. The results could be bad. One example: middle Americans losing their money in hedge funds could spark Congressional inquiries resulting in fundamental reforms like investor disclosure or ceilings on leverage, which would truncate the business and original purpose of hedge funds. While investors should take note of the warning flags, the financial services business bears the brunt of responsibility in this case. Financial service companies should think twice before hastily marketing this product to a new type of buyer. And hedge funds -- after their role in the Russian and Asian meltdowns, as well as Long Term Capital Management debacle -- should be careful about upsetting the people and their representatives.

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