From the domain of the wealthy privileged few in the early 1990s to a retail mass market, the hedge fund industry has witnessed remarkable growth over the last five to seven years. Anecdotal evidence would even suggest that it has achieved the highest growth among all sectors of the financial services industry since the advent of the derivatives markets.
Indeed there are other very lucrative areas in the financial services. Prime broking, one of the more profitable areas of modern investment banking, encompassing the processing and administering of hedge fund trades, as well as the funding of the hedge funds` trading positions, in itself one of the biggest growth areas in the financial services industry today.
However, as the hedge fund industry has expanded, an increasing number of traders have moved into this area, many of whom are mediocre traders at best. This has been most notable over the course of the last two to three years when the industry has seen its most aggressive growth. Hedge funds previously were select institutions run by seasoned professional traders, indeed some of the most legendary traders in the financial markets. Nowadays traders with just a few years experience have in many cases sought to move into a hedge fund trading role, or have even set up their own hedge funds. The resultant dangers are all too obvious.
Hedge funds seek to make money whether markets are falling or rising; they do not have a mandate to be along any asset, unlike most other types of investment funds, hence they can remain on the sidelines if things start looking in any way unappealing. Indeed, their strategies are so flexible they can even profit from falling markets. With the lack of performance of traditional markets, most notably equities, this has driven investors to look elsewhere, and the fact that hedge funds have been able to show reasonable returns over the course of the last few years while more traditional funds are barely keeping their heads above water.
As with most innovations, it has taken a while for this offering to percolate through the system to the mass market; however, with increasing demand from their client base most financial institutions now offer hedge fund products for their average customer, not just the super rich.
One of the main advantages of hedge funds, apart from the fact that they are not mandated to be invested in any one particular sector or product, is the fact that they can borrow money to fund their trades; this is known as "leverage" and is very similar in principle to the way a bond works when purchasing a house. The dangers of hedge funds and their use of leverage is, of course, well known thanks to the debacle of long-term capital, whereby for every dollar they put down as a deposit on an investment, they could borrow as much as $1 000 to invest in the same product. Where I perceive the danger is with too many hedge funds chasing too much of the same thing; long-term capital was a situation whereby one fund had massive positions in very similar products due to the fact that they were offered practically limitless borrowing facilities; this should never again happen. A sample of this problem was seen recently when the credit ratings of two of the big US car manufacturers were downgraded. Many hedge funds had placed trades against this, and subsequently lost substantial money due to this downgrade.
So where does that leave us? Any one of these potential issues highlighted above on their own is not cause enough for serious concern. Does this mean, however, that it is an industry that needs to be regulated? Well, there are obvious advantages to having the industry regulated to avoid unscrupulous hedge funds taking advantage of na"ive or inexperienced investors; however, to totally regulate the industry is not possible. In the case of the hedge fund industry, the best solution is that of education; the public needs to be made aware of exactly what and how the industry or particular hedge fund operates; and the hedge funds must be able to provide this information to the interested investor when requested.
Specifically how does this apply to our domestic market? The hedge fund industry in SA is still an embryonic industry which has yet to permeate down to the retail investor; furthermore with the relatively strong performance of the local equity and property markets people have not been seeking extra returns elsewhere. Remember by investing in a hedge fund you are essentially hiring the hedge fund manager to invest your money, before you invest aggressively, educate yourself. And as with all hires, you must make sure you hire the right candidate.
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