When news of the hedge fund Amaranth Advisors’ big losses came out, I thought of British satirist Oscar Wilde. Describing Charles Dickens’ most maudlin scene in “The Old Curiosity Shop,” Wilde said, “One must have a heart of stone to read the death of Little Nell without laughing.”
Similarly, it takes a hardhearted economist to read of a hedge fund losing $6 billion in natural gas speculation without chuckling. These funds might perform a useful economic function, but a lot of people need to understand them better.
The term “hedge fund” is misleading. Traditionally, a hedge is an action to reduce risk. A farmer, processing plant or feed company can set soybean futures contracts to hedge or reduce financial losses if prices move unfavorably.
The farmer wants to reduce the risk of prices moving down, the soybean crusher and feed mill the risk of prices going up. All three are willing to pay money to have someone else absorb the risk. All are hedgers. In effect, they are willing to pay a premium to buy a price-insurance policy.
This meaning of hedge is like people saying they are “hedging their bets” when they rely less on something turning out favorably.
The opposite of hedging is speculating. Some people trade soybean futures even though they neither grow nor process nor use soybeans. They take on risk from others in the hopes of making money. Some make money, and some don’t. But they perform a useful function by allowing risk-averse businesses to reduce their exposure. In effect, speculators sell price-insurance policies hoping to earn high premiums.
Hedge funds do not necessarily try to reduce their risk. Instead, they often take on risk in the quest for high profits. They can be speculators par excellence. So why are they called “hedge funds” instead of “speculation funds”?
The answer is that they basically are mutual funds, however special ones designed to make money when stock or bond markets are either falling or rising.
Like retail funds such as Fidelity or Vanguard, a hedge fund takes money from investors and tries to earn good returns. Bread-and-butter mutual funds follow the same strategy for most individuals. They buy stocks, hoping these will pay good dividends and rise in price. If stock prices fall, fund values drop.
Hedge funds intend to make money even when markets fall. One way is to engage in “short selling.” That essentially involves borrowing shares of stock, selling them in the hope the market will drop and then buying them back at a lower price to return the loan. A short seller makes money if the market falls rather than rises.
A hedge fund also can make money — regardless of which way stock, bond, commodity or foreign exchange markets move — by trading in futures, options and more esoteric financial instruments. Some, like futures and options, are traded on organized exchanges in Chicago, New York, London or even Calgary. Others are arranged in one-of-a-kind deals with large banks or investment firms.
Thus, many “hedge funds” are highly speculative, taking on large amounts of risk and hoping their superior analytic skills and sense of markets will produce high profits.
The irony of Amaranth is that it did not go broke using some sophisticated strategy. It simply let one employee make a huge bet that natural gas prices would continue to rise. That is the sort of mistake made by inexperienced rural elevator operators but not by people purporting to be financial wizards.
Hedge funds always have been limited to large investors. None has small-town sales reps pushing shares to widows and retired farmers. As long as the number of investors in any single fund was less than 100, most Securities and Exchange Commission rules for mutual funds did not apply. Funds generally required large minimum amounts to participate, from $250,000 to more than $1 million. The idea is that the big investors can take care of themselves. They don’t need the SEC to protect them from being bilked.
As long as financial markets boomed, there were few hedge funds. Investors in them were rich and financially sophisticated. As markets fell after 2000, more people sought out hedge funds as a means of maintaining the high returns they grew to expect. More pension plans and charitable or philanthropic endowment funds piled in.
One was the pension fund for Maplewood-based 3M Co., which reportedly lost $92 million in Amaranth. There is nothing inherently wrong with a large company like 3M putting pension money into a hedge fund. As their spokeswoman pointed out, this represents less than 1 percent of 3M’s total pension assets. A large pension fund should make investments covering a broad range of risk — from ultra-safe to speculative.
Financial statements of local foundations show some have over more $100 million tucked away in hedge funds. Also, some private colleges reportedly have invested in such funds.
This doesn’t mean these institutions are putting all their eggs in one tattered basket. Such amounts might be spread across many different hedge funds. Still, the Amaranth debacle reinforces the lesson that seeking higher profits necessarily means taking on greater risk. Over the long run, people who forget that get bloody noses.
© 2006 Edward Lotterman
Chanarambie Consulting, Inc.