How does a "hedge fund" work?

[kentuck]

Should hedge funds be illegal?

Most of the arguments that you hear, mostly from people making money off of hedge funds, say they are a vital part of the markets operation. But are they really?

In the case of Goldman Sachs, they permitted John Paulson to pick over the worst mortgages, those behind in payments and questionable for the future, and put them in a basket to sell to unsuspecting buyers around the world. Of course, they had to get them rated AAA before they sold them. That was the first step in the fraudulent activity.

The experts say they then bet against those same "baskets" that they were selling to the unsuspecting buyers. How did they bet against them?? Is that why they bought insurance from AIG? How did that work?

At the least, it is very unethical, in my opinion. At the worst, it is fraud. But from the beginning, when the bad mortgages are chosen, there is the intent to deceive. That is the entire purpose of hedging on the bet. How easy is it to offer a mortgage to an unemployed person if you know you are going to sell that mortgage to someone else?

Of course, Goldman Sachs was not the only one doing it. There were probably four or five banks that were more involved than Goldman. It is a widespread scandal. It continues as we speak. It did not end with the collapse in 2008.

In fact, Goldman Sachs just reported a record quarter for profits. They are handing out huge bonuses once again. Some might call that "hush" money? If your employer gives you a million-dollar bonus, how likely are you to spill the beans? And what is the capital gains tax on these "bonuses"? What should be the capital gains tax on these profits?

What type of "reform" can we expect from the White House and the Congress? Will the taxpayers still be vulnerable after reform is passed? This is a test for the Democratic Party. We know where the Republicans stand.

[AngryAmish]

1. outside of googling, hedge funds are investment organizations for sophisticated investors

They can short stocks, which mutual funds cannot. Fewer protections of investors in hedge funds since they have to be certified sophisticated investors.

No shorting means ceaseless bubbles. They serve a function.

BTW, Al Gore runs a hedge fund. Is he a crook?

[kentuck]

3. Well, if they are complex and sophisticated....

there is nothing we can do.

:sarcasm:

[Statistical]

7. Mutual funds short stock all the time,

Some even short the entire market.

Still you are right the concept of a "hedge fund" isn't bad it just happens to be some hedge fund manager who are bad/reckless/dangerous/stupid.

[AngryAmish]

9. Well, I stand corrected then.

I thought that was where the hedge in hedge fund came from.

[Statistical]

10. Yeah initially hedge funds were desigded as hedges against the market.

They were used by rich people (and other entities) to provide protection. However the hedges tend to be more complicated using derivatives and other investments to provide a hedge larger than the investment.

So say you had a a million dollars you could put 10% in a hedgefund designed to provide 10:1 downside leverage. Now if market keeps rising then the hedge "costed" you 10% of what you could have made however if it went down their your entire portfolio was protected. I am vastly oversimplifying but hopefully it works as an exmplantion.

So that is where the word "hedge" in hedgefund comes from. Today however that distinction is long since gone. Many hedgefunds now use derivitives and leverage to amplify risk rather than hedge against it. The name has just stuck.

Personally I think "giant bucket on money" is better description.

[notesdev]

2. Hedge funds are fine

It's not the hedge funds which are the problem, it's the fraud. Hedge funds have a legitimate place in the financial system, as insurance for big institutional investors like public pensions, they help to limit losses when things don't go as one might expect (which is the purpose of a "hedge").

[taught_me_patience]

4. Hedge funds are ok

The original intent was to "hedge" and limit losses. Of course, most hedge funds use their "hedge" to speculate. Nothing wrong with that for qualified investors that wish to take that risk.

[RaleighNCDUer]

5. You set aside $20/month for a year or so, and then you go to

Lowe's Garden Center and buy some hedges.

That's all I know about hedge funds.

[Statistical]

6. What you described is what Paulson did but it doesn't describe a hedge fun.

Just like if I drive my car to CA and speed the whole way it wouldn't be accurate to describe a car as "a device that transports all people to California at 100mph".

A hedge fund is essentially just a pool of money under professional management. There are bond hedge funds, currency hedge funds, there are even "green" hedge funds.

They are similar to mutual funds that everyone is familiar with. You contribute $X get shares in the fund and then a fund manager invests that money according to the plan of the fund.

The differences between hedge funds and mutual funds are in the structure
1) generally involves large amounts of money. Minimum investment is often in millions.
2) Requires the investor be "sophisticated". IRS has rules on who can participate.
3) The compensation for manager is "pay per performance" where mutual funds tend to be flat rate.
4) They have lockups. You can't "get out" when you want but rather when plan lets you. Often they have "windows" that you can get in/out.
5) Lot more secrecy
6) The funds have huge power because they have a very concentrated amount of wealth, lockups let them control length of a strategy, and hedge fund manager has a lot of control.

So hedge fund is simply a "bucket of money" just like a mutual fund, or pension funds, or personal IRA it just happens to be on a lot larger scale with different rules.

This won't make you a hedge fund expert but will give you an overview:
http://en.wikipedia.org/wiki/Hedge_fund

[anigbrowl]

13. minor correction

rules on participation are set by the SEC, mainly in schedule D, rather than by the IRS. This info just to avoid possible confusion, overall your description is great.

[HopeHoops]

8. You put your money in a mason jar and bury it under a shrub in the front yard.

It will be worth more that way than if you "invest" it with one of the Wall St. pirates.

[cbdo2007]

11. The media just uses these terms like "Hedge Fund" because they need someone

to blame and they don't understand how they work either, therefore they must be bad and we must make everyone think "hedge funds" caused this mess.

Same thing with "Ponzi Scheme" - I just read something on another site where someone referred to Health Care Reform as a "Ponzi Scheme". Really there is nothing "Ponzi Scheme" about it, they just know a Ponzi Scheme is bad and scary so they want everyone to think it is. Same thing with Hedge Fund. People don't understand it so it must be scary and bad.

Wall Street isn't bad. Hedge Funds aren't bad. Investment Banks who sell products designed to fail and then bet against those same products - they're bad.

[kentuck]

12. Now that you have noted the distinction...?

>>>Do you think they should be prosecuted? Is it fraud to pay (bribe) rating agencies to rate almost worthless stocks with a AAA rating? Then put them in a basket with other worthless stocks and deceptively sell them? Is that fraud or just a bit of unethical actions??

[cbdo2007]

14. Yes definitely. I don't know enough about it to know

how far prosecution and then future regulation should go in regards to all of this, but definitely GS committed fraud here and should pay some major consequences. More than just a fine - they've got more money than God!

Also, regulation of the entire market is necessary. Not enough to stop the average guy from making some money but these investment banks literally control artificial price movements and profit on BOTH the ups and downs of the market at the same time. How is it possible??? I don't know but they do it. Look at last Friday when GS lost 13% in their stock price. I'd bet you anything that GS was short selling their own stock that day and profiting from themselves losing money. That shouldn't happen.

Most of the market works correctly. I pay close attention and am invested in a bunch of great stocks. I look for good companies with good management and the stock price rises. That's the way it's supposed to work. It benefits me and it benefits the company. Everybody's happy. This other stuff, as you can see, is done by a small amount of people with too much money and too much power and it has dire consequences for all of us.

[kentuck]

16. Excellent post!

"Look at last Friday when GS lost 13% in their stock price. I'd bet you anything that GS was short selling their own stock that day and profiting from themselves losing money. That shouldn't happen."

What's the solution? Force them to keep their stocks for longer times before selling? Taxing each trade at a higher rate? Those are the types of tough regulation that Wall Street would understand.

[cbdo2007]

17. Wow, thanks!

Like I said, I don't know enough of the specifics and stuff to know for sure what a good solution would be but you're on the right track. One major problem here is that the people making the rules and decisions are in bed with the Investment bankers. It's nearly impossible to even get small amounts of regulation passed against them, taxes or rules, to make a difference. Hopefully *crosses fingers* Obama will do the right thing and really push for this without them bullying him around.

It's true that maybe each trade should be taxed? Hmmm. See, one problem is that GS can do like last Friday and let's say they made $1 Billion shorting their own stock. Ok, it's legal and stuff, but Yes they should be taxed on that $1 Billion. Instead, they probably had their Brazil office short it for them so that they won't owe any U.S. taxes on it. Then at the end of the year they've got all these gains in Brazil with a super low tax rate, and take all their losses in the U.S. so they end up getting a refund of $$Billion$$.

Really, it's more complex than you or I will ever understand. It is all a huge slight-of-hand, convoluted mess so we just have to hope someone out there puts an end to it.

[anigbrowl]

15. What you describe is certainly fraudulent

but those activities are not confined to or characteristic of hedge funds in general.

[BlooInBloo]

18. There should be a law that people utterly ignorant of maths should stfu about maths.

[deaniac21]

19. You put money in and a shrubber is assigned to do your

landscaping.