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The "Hedge Fund" Deception

By now you've heard how airlines "hedge" their fuel costs to protect themselves against adverse market prices.  The "hedge" comes at a cost by which the airlines buy futures contracts at a fixed price today so that rising prices are offset by their right to buy fuel in the future at today's price.  They pay big bucks for those contracts.  That price is their "insurance premium," so to speak.  So in such a purchase, the desire is NOT to make money on fuel, but to offset higher prices.  But their "offset" prices actually are increased by the cost of the "hedge." 

Hedging in the traditional sense produces a price-neutral guarantee of fuel price in the future in exchange for the contract cost.  A hedge, by necessity, increases their actual cost of doing business, but that cost is only a small portion of what "unhedged" fuel needs might cost if prices rise in the future,   Conversely, if fuel prices actually drop instead, the hedge becomes worthless and its cost is recouped as fuel prices drop.

In any endeavor, a "hedge" is designed to protect something, not to make it larger or smaller.

IN THE INVESTMENT WORLD, a hedge can be set up to protect the value of a stock portfolio by buying appropriate PUT OPTIONS.  In theory, if the market drops, the put options increase in value, offsetting the falling prices of the stock they are protecting.  Again, a hedge creates a market neutral result at a much smaller cost than would be realized if the stock fell in value without the hedge.  The cost of that kind of hedge is the "premium" paid for the PUTS.   If the stock portfolio rises in value, the PUT premium becomes "a cost of doing protection."  If the stock portfolio drops in value, it's true value will be reduced only by the PUT premiums and will stay relatively unchanged as long as the market falls.  Obviously, managing the buying and selling of the PUTS is tricky business, but in their finest hour, PUTS will only serve to keep the stock portfolio essentially unchanged in value in a falling market.  This "stock hedge" is used to protect existing value, not create new value.  It is a market-neutral strategy.

NOW you are ready to understand "The Hedge Fund Deception."  Speaking in general terms without reference to any specific hedge fund, they are available only to "accredited investors" (read, millionaires) who are buying one thing (in their own minds) but getting something else.  Remember, "hedging" is a protection strategy that even the "poorest" investor can effectively use.  You don't need to be a millionaire to qualify to protect your account.  So if "hedge funds" are for accredited investors, there must, by definition, be an element of HIGHER RISK, not neutral or lower.  But hedging does not, also by definition, increase risk.  To the extent that a millionaire invests in a hedge fund, he is NOT hedging anything.  He is in fact "diversifying" his market exposure into more complex areas of speculation, hoping that if his stock portfolio bombs, the hedge fund assets will not.  Hedge fund assets are NOT associated with traditional stock portfolios.  Only options or selling short could do that. THEREFORE, hedge fund portfolios contain no hedging investments at all.  Instead, they contain exotic investments that are not easily understood by the general public and are  specifically in search of unusual non-stock-related gains.

These funds attempt to "put the pedal to the metal" by investing in derivative contracts, futures, real estate, limited partnerships and selected high-yield opportunities, for example, wherever in the world they can be found.  During good times, hedge funds can by quite lucrative as ADDITIONS to normal stock portfolios.  Because they take on higher risks than normal, only "sophisticated," "experienced" or very wealthy people can participate.  In other words, they are available to people who can afford to lose their investment. 

And lose they do.  The falling markets of 2008-9 took everyone down, including the hedge funds.  BUT if the hedge funds had actually been "hedges," they would have had tons of money in "protective" places like PUT OPTIONS and SHORT SALES OF PUBLIC STOCK.  In negative market times, a true hedge fund would shine like a sparkling diamond or the sun itself.  That is what a "hedge" is supposed to do.

The deception is more of a disguise and a diversion than a straight-forward form of hedging.  Rather than actual protection, a hedge fund increases an investor's risk exposure by using non-mainstream vehicles, futures and currency contracts which include the use of leverage to go for outsized gains.  They are really "diversifying" away from the main stream of investment activities that are found in most everyone's stock portfolio.  Hedging requires a direct, 100% negative correlation to the primary portfolio content.  In fact, hedge funds simply do their own thing without regard to other conventional portfolio performance. 

If you dig into the historical performance of hedge funds, you will easily see that "Market-Neutral" hedging strategies are the LAST places they put their money.  The latest performance data (August 2009) contends:

As should be obvious, futures contracts in commodities and foreign currencies have been the TOP profitable choice of the Hedge Funds.  Note that there is nothing "market neutral" about futures contracts.  They are highly leveraged vehicles which can produce large losses as well as large profits.  Not only are 92% of the referenced hedge funds STILL in the tank, even after 32 months of fabulous trading opportunities, but none of them demonstrate any strategy other than "get maximum profits."  "Hedging" emphasizes "portfolio protection" and is not the least bit concerned about overall profits.  A "hedge" implies improved portfolio safety.  The actual investment behavior of hedge funds has little to do with safety.  In fact, the generic category should be re-named to "Rocket Funds" because that's what they attempt to be.

As a matter of fact, GCM does not engage in hedging activity.  GCM uses 6 futures contracts at all times for client money, but that strategy is not disguised by calling it "hedging."  A more accurate label for the strategy would be "Managed Speculation."