What's A Hedge Fund?

A good explanation of Hedge Funds by Timothy P. Carney on Heckanomics:

"But what the heck is a hedge fund? Who owns them? Are they really unregulated? Are they really undertaxed?

The meaning of “hedge fund” is broad and fluid, and they don’t necessarily involve hedging. The two closest things to defining traits would probably be: (1) by law, they are not open to the general public; (2) the manager of the fund is compensated mostly by claiming a portion of the fund’s profits. Also, hedge funds typically multiply their gains by borrowing heavily (also known as leveraging). Another common trait is that they often employ short-selling (positioning the fund to benefit from a downturn in a stock, commodity, etc.) or creative investments that move in ways uncorrelated to the stock market."

Okay:
1) Not open to general public
2) Manager paid from profits
3) They borrow a lot ( Leveraging )
4) They short sell a lot ( Bet on stock, etc. going down )
5) Use assorted ways of not moving with the market

"Hedging is an investment practice whereby you protect yourself against risk, often by betting on both sides, so to speak. For example, if you’re a business that is vulnerable to increases in the price of gasoline — say, a trucking company — you might hedge your exposure to oil prices by investing in oil futures. If oil goes up and your costs increase, at least you can cover some of the cost with the increased value of your oil futures.

There are hundreds of ways to hedge an investment or hedge against a vulnerability. Hedging reduces both risk and potential reward — an unhedged trucking company might suffer more when oil prices climb, but they also are better off when oil prices drop. It’s kind of like an insurance policy: you pay to ward off uncertainty."

This is kind of like hedging your bets.

"The first hedge fund was all about hedging. Its creator, Alfred Winslow, called it a hedged fund. The fund took a long position on some stocks (betting on their going up), and a short position on others (betting on their going down). This strategy meant his fund lagged the market when the market was climbing, but it also meant his fund climbed when the market sagged. But by leveraging — investing mostly borrowed money — you can turn steady, but earthly growth into huge returns.

(If you invest $2 million of your own money, borrow $20 million and invest it all, earn 10%, and pay 5% interest, you just made more than a million dollars with only $2 million in seed money. A 50% return, by some measures.)"

The same thing. The details will vary, but you're investing on going up and going down at the same time. The trick is to make this counter investment make you money.

"Today, some people think of hedge funds not as being hedged, but as being a hedge against other investments. In other words, because they often get more creative in their investing, a hedge fund is a way to hedge against more traditional investments."

It's actually the same thing, you're trying to counter invest.

"But neither hedging or short-selling are not at the heart of hedge funds — those are investment strategies that one can engage in outside of a hedge fund. A hedge fund, at its heart, is a business model. It is a limited partnership in which the manager is rewarded proportional to the fund’s performance — a model crafted largely to avoid the regulations and taxes that constrain other forms of investment."

Main Objective: Manager paid for performance
To avoid regulations and taxes of other investments

This is why people invested in CDSs and CDOs in my opinion. In other words, to avoid capital requirements.

"Eager congressmen and much of the media describe the hedge fund industry as “unregulated.” This, of course, is an exaggeration, but at the heart of the “unregulated” claim is an important truth: hedge funds do not operate under the jurisdiction of the Securities and the Exchange Commission, they are not subject to Sarbanes-Oxley or the slew of reporting regulations the SEC imposes on publicly traded companies or mutual funds. Also — and this is key — they are not limited in how much they can leverage their position."

Now, I'm saying that CDOs and CDSs answer the same question: namely, how can we invest using less capital= increase our leverage. ( I should say that one can use them otherwise. One could simply keep more capital, and yet write a CDS. Whether it would be worth it is another question )

"Well, consider the purpose of SEC regulation of publicly traded companies and funds. It’s not as if the SEC polices these companies in order to make sure nobody’s getting too rich — or losing too much money. The SEC’s stated goal is to erect protections for investors, thus making Joe the Plumber believe he is less likely to be ripped off by whichever corporation, brokerage, or mutual fund is asking for his business.

But Joe the Plumber can’t invest in a hedge fund. If the hedge fund were to let Joe invest, they would therefore be subject to SEC regulation. And so, hedge funds evade most SEC regulation by making themselves open only to “accredited investors.”

Hedge Funds allow only Accredited Investors.

How does one become “accredited”? Basically, you have to be rich.

"A corporation or charity can be an accredited if it has more than $5 million in assets. An individual is “accredited” if he has net worth of more than $1 million, or has earned more than $200,000 each of the last two years (or if he and his wife combined for $300,000 each of the last two years).

The idea is, these people don’t need the protection of the SEC. If rich people want to blow their money on some dumb investment, or in some shady scheme, why should the taxpayers pay to protect them from their own errors?"

Accredited Investor= A wealthy investor who can afford to lose money and not be indigent

"A hedge fund, then, is a limited partnership, in which every partner must be an accredited investor. Most partners in hedge funds are investment banks or non-profit institutions such as foundations or pension plans. A minority are wealthy individuals.

When Alfred Winslow Jones wanted to launch his hedged fund, he didn’t want limits on how much he could leverage himself, and he didn’t want to run his every move past the SEC. So, he couldn’t just launch a mutual fund. He had to make a limited partnership, and that was the first half of making the modern hedge fund.'

This is financial innovation.

"If you have heard complaints about how filthy-rich fund managers are under-taxed, well, that’s kind of the point.

Before we get to the taxation of hedge fund managers, it’s important to explain the business model of hedge funds. The manager of a fund gets most of his compensation based on the performance of the fund. That gives investors bit more faith in the fund manager — both of them have their wealth riding on the fund’s growing. But just how the fund’s growth translates into the manager’s wealth is at the heart of the current debates over hedge-fund manager-taxation.

You may know that the top tax rate on capital gains is 15%, while the top income tax rate is 25%. That means the money you make when you sell your stocks for a profit is taxed less than the paycheck you bring home. You can imagine why a trader, possibly earning millions each year, would try to find a way to replace all his “income” with “capital gains.”

This is the other essential aspect of a hedge fund. The fund manager may receive some compensation in the form of straight-up fees, but the managers are compensated mostly through what’s called “carried interest.”

“Carried interest” is not interest like the interest you pay on your mortgage or collect on your savings account. It’s an interest in the fund — as in, a stake in the fund. In the business, they call it the carry.

As the fund increases in value, the manager, who very well may not have invested a single dime, gains an interest in the fund. If the fund stays stagnant or shrinks, the manager gets paid only the nominal fees. Sometimes there is an agreed-upon rate of return (for example, inflation, or the gains in the stock market) before which the manager gets no carried interest. Once that threshold is crossed, though, 20% of all gains are credited to the manager."

The manager gets paid with part ownership of the fund.

So, if all the investors combined put in $50 million, the manager might collect $500,000 in fees (much of which goes to expenses), and then he will gain a 20% interest in all earnings over 2% per year. If, after one year, the fund is worth $75 million, $4.8 million of that money is the manager’s stake, while the rest is divided among the partners proportional to their investment."

Fine. He can sell the interest or proceedings at a lower tax rate.

"Hedge funds, then, are the fancier versions of the mutual funds or investment schemes you and I get to play with. Because their managers have the opportunity to make huge gains, hedge funds attract much of the best talent. Because they are not regulated as tightly as stocks and mutual funds, they have opportunities to correlate their profits to things other than the stock market.

From one way of looking at it, it’s odd that Congress should want to impose SEC-style regulation on hedge funds. Why should our government pay to protect rich people from losing money? Shouldn’t folks with millions of dollars to invest be left to their own as far as deciding who is a worthy trustee of their wealth?"

Good question.

"One factor advancing hedge fund regulation: existing hedge funds will benefit from any regulations that make it harder to enter the business."

Raising the entry fee. If they're lucky, they'll become a cartel like Ratings Agencies.

"Another: all this talk by politicians of regulating and increasing taxes on hedge funds has driven a huge a boom in hedge funds’ contributing to these politicians’ campaigns — and hiring the politicians up as lobbyists."

They're citizens just like everybody else. Why shouldn't they.

To be honest, I think that they should pay regular tax rates on carried interest. To the extent that certain investments are regulated, the Hedge Funds should play by those rules. But the basic lesson to be learned out of all this is that financial innovation means taking or adding risk by avoiding laws and regulations.

If you want to keep track of this, you're going to have to have broad principles that can funnel all risky investments, say ones that extend leverage, or involve third parties, or magnify risk, to an agency that can look them over. Whether or not to regulate should be secondary to making sure that they're following basic sound rules of investing.

"who represent competing strains of Democratic economic thought": I'm A Sort Of Non-Competative Strand

Yesterday Free Exchange commented on the post by Robert Rubin and Jared Bernstein about interest and debt, and how they are viewed in the Democratic Party. My party. Now, you might well ask where I fit in, but I've about 600 posts now trying to answer that, so let's move on:

"ROBERT RUBIN and Jared Bernstein are two left-leaning economists (both of which have advised Barack Obama) who represent competing strains of Democratic economic thought. Mr Rubin, Treasury secretary under Bill Clinton, was known as an economic centrist—pushing free trade and fiscal responsibility. Mr Bernstein is a more progressive economist, who has emphasised international labour standards and a robust social safety net.

Today, the New York Times published an opinion column co-written by Mr Rubin and Mr Bernstein. It lays out the broad areas of agreement between the two men which, one assumes, hints at what might emerge from an Obama administration. It's not particularly scary stuff—short-term stimulus, infrastructure investment, long-term fiscal discipline, sympathetic labour policies, and a trade policy that seeks to protect workers but not jobs or industries. A change in direction, to be sure, and one that deserves vigilant oversight, but not a new social democratic state."

Now, I didn't respond to this column because I also didn't see it as particularly scary or even interesting. It dealt at the level of nostrums. I'm more on Rubin's side, but I actually am concerned about Bernstein's concerns.

"What's most interesting to me are the areas where the two authors are forced to concede disagreement. One of these issues—the effect of long-run deficits on interest rates and economic growth—is one of the most contentious areas of debate for lefty economists. The authors write:

One of us (Mr. Rubin) views long-term fiscal deficits — in combination with a low national savings rate, large current account deficits and foreign portfolios that are heavily over-weighted in dollar-dominated assets — as a serious threat to long-term interest rates and our currency and, therefore, to our economic future. The other views these economic relationships as much weaker.

This is the view that shaped Clintonian deficit reduction. It also angered many Democrats, who would have preferred that increased revenues be used for a health insurance solution or public investments. Mr Rubin's position strikes me as fairly orthodox. The thing is, I'm not sure that it makes sense in light of recent events. A lot of people expected a dollar run to precipitate crisis. Instead, crisis precipitated a dollar boom."

Again, here I'm on Rubin's side. But I see the problem.

"And now, Calculated Risk is arguing that declining American deficits might result in higher long-term interest rates. Why? A reduction in the current account deficit would trim growth in foreign central bank investment in dollar-denominated assets, pushing up interest rates. In short, so long as Bretton Woods 2 held up, American deficits meant low interest rates. Only when that financial system comes apart can we expect Mr Rubin's conditions to obtain.

Mr Rubin was right about interest rates given that he was in a certain financial equilibrium, but he was wrong about which equilibrium he found himself in. Given Bretton Woods 2, and the resulting ability to borrow cheap, America should have borrowed heavily and ploughed Chinese capital into long-term domestic investments. By instead running a surplus, Mr Rubin simply made easy credit available to the private sector which, understandably, poured that credit into heavy consumption and investment in non-tradable sectors (like housing!) which weren't rendered comparatively unattractive by Chinese currency policies."

I saw the Calculated Risk post as well, and it bothered me. ( but see Setser here )

"So which should America choose moving forward? For the moment, the risk of a dollar collapse seems low, and the need for deficit spending appears high. Beyond that, we must see whether China will continue to finance American borrowing, or if China will allow domestic spending to flourish by letting the RMB appreciate. Increasingly America is learning that neither its monetary policy or its fiscal policy is as independent of international forces as it believed."

So, this really is food for thought. I agree with:

1) Risk of dollar collapse is low ( I also agree with 'seems' )

2) That's why I accept some deficit spending in the short term and a stimulus plan.

Where to go from here. Let me utter some nostrums:

1) A banking system based on Bagehot's Principles

2) Reducing government spending

3) Lower debt

4) A slight budget surplus or debt in normal times

5) Lower taxes, and fairer and more efficient taxes

I fear:

1) Inflation

But I have to admit, all these gyrations are making things hellishly complicated.

However, this post by Bob McTeer seems to echo more or less the same view, although I would disagree with him on some specifics:

"The most important near-term thing you could do to reassure financial markets and quell the turmoil is to announce early that you don't intend to eliminate President Bush's marginal tax-rate cuts. If you can't go that far, keep the adjustments as small as possible and announce your intentions to be moderate early. A little bad news early is better than great uncertainty and expecting the worse. ( I'm fine with small adjustments )

You have an education job to do. You must be able to articulate clearly how high tax rates on capital (capital gains, dividends, corporate taxes, the death tax, etc.) diminishes the demand for labor and keeps wages from rising. ( I agree )

While tax-rate increases are bad anytime, they are particularly bad in a recession. The timing couldn't be worse for a tax increase. ( I tend to agree, but the debt bothers me more )

Energy limitations must be attacked on all fronts: drill, drill, drill, nuclear, clean coal, wind, solar, and so forth. Don't push for energy independence; push for less energy dependence. ( I sort of agree, but have more environmental concerns )

Everyone knows that exports create jobs, but few focus on imports, which represent the gains from trade. Help educate people on the benefits of low prices via imports. ( I agree, basically )

Don't overdo the regulatory reaction to the current financial crisis. Another Sarbanes-Oxley is the last thing we need." ( I agree )

In other words, while things are in flux, let's stick to our general principles, while confronting reality and bending them where necessary. But like Becker and McTeer, I agree that we don't want to kill the goose that laid the golden egg.

As to Rubin and Bernstein, I'm not that bothered by either of them. I see them as sensible people. I've no fear of some massive economic shift. There will be tinkering, but tinkering can often be wise.