TORONTO (ResourceInvestor.com) -- The largely unregulated hedge fund industry has become the subject of great controversy in recent months as the number of funds continues to increase.
There are roughly 7,000 to 8,000 hedge funds today, controlling nearly $1 trillion in assets - a lot of weight to throw around. It is estimated that their assets have doubled over the last five years and are up from about $40 billion 10 years ago. Investors in hedge funds usually need a minimum of $250,000 and in many cases $1 million just to get in the door.
Unlike mutual funds, hedge funds entail much greater risk as they use leverage and shorting strategies, which magnify gains and losses alike. Derivatives are a risky business at the best of times and the idea that there are 7000 real experts in the field is a little hard to swallow.
Clearly the rewards for managers are well worth the risk, as most funds take a standard management fee and 20% of all their gains in any given year. Multi-millionaire and centi-millionaire managers are popping up all the time. One of the most successful managers made a billion dollars personally last year! Is this a bubble?
Chairman of the U.S. Federal Reserve, Alan Greenspan, recently weighed in on the issue, addressing a conference of bankers in Beijing.
According to Greenspan, "After its recent very rapid advance, the hedge fund industry could temporarily shrink, and many wealthy fund managers and investors could become less wealthy."
That wouldn't be nearly as scary as the suggestion of many analysts that there could be a blowup the likes of Long Term Capital Management (LTMC). LTMC was leveraged about 30 to 1 to their client's capital (roughly $5 billion) and was bailed out by the Federal Reserve when the collapse of the ruble caused a flight to liquidity in 1998. The Nobel-prize winning roster of experts on the board of LTMC were using only ten years worth of data in the so-called revolutionary computer system they had devised to create profitable trades.
Greenspan, however, does not paint such a horrific picture and believes that, "so long as banks and other lenders to these ventures are managing their credit risks effectively, this necessary adjustment should not pose a threat to financial stability." Further, with so many hedge funds out there now, one major failure is less likely to bring down the house of cards.
The chairman believes that hedge funds have picked the "low-hanging fruit" as a result of cheap credit, and may not enjoy similar success going forward. The numbers would appear to bear out his prediction as heavy redemptions in the second quarter and flat returns for the year are causing some investors to think twice.
Furthermore, with so many managers now in the game, the opportunity to capitalize on market inefficiencies is disappearing quickly. As a result, "significant numbers of trading strategies are already destined to prove disappointing," according to Greenspan.
Investors in the resource sector should note that while key commodities like copper have doubled in the last few years, many hedge funds have made no real money on the move, despite all of their complex trading strategies (or perhaps in spite of them). There may be something to the old logic that "the trend is your friend", rather than constantly attempting to accurately predict every little wiggle in the market.
Only time is going to prove whether the financial system is equipped to protect itself from a massive failure as a result of a sudden spike or collapse in currency or interest rates. Some believe that as long as bets are not all stacked on the same side, losses and gains should cancel each other out to some extent.
Given their inherent high-risk due to leverage, and propensity going forward for more average returns, the industry of managers trading for the same arbitrage quarter point grows increasingly saturated. Investors need to examine their own financial needs and goals in order to determine whether or not hedge funds are really the best way to make a buck.
