The Danger with Hedge Funds - Coursework Example

Introduction

The high risk associated with hedge funds is one of the reasons that they usually receive negative media expression coupled with the huge number of investors that have become victims of this form of investment. In essence, the reason many investors become victims is because they focus on the huge returns that they are likely to earn and thereby invest more and more money on the funds that are high-performing; these investors fail to give regard on ways through which the performance is being carried out and whether it can be replicated in the future in order to guarantee continued returns. Good examples of hedge funds in which investors continued to add more money without concern of how the performance was being obtained are those by Bear Stearns, an investment bank that owned the High-Grade Structured Credit Fund and the High-Grade Structured Credit Enhanced Leverage Fund; they rekindled the discussion concerning hedge funds after they were announced to be worthless (Detzer 2007). These funds were invested in the mortgages market that made it easy for debtors to access loans including those that had low or medium credit worthiness; the result was the sub-prime lending crisis that contributed to the 2007-2008 global financial crises. Nonetheless, a number of hedge funds are quality investments that can be a part of the integral process for investors seeking a well-diversified portfolio. In this regard, this paper seeks to conduct an evaluation of the dangers of hedge funds, in which the direct and indirect negative effects of hedge funds will be presented.

What are Hedge Funds?

Prior to discussing the dangers of hedge funds, it is crucial to understand what hedge funds are and whether they have positive effects to the investors and the economy. According to Sauert (2007) hedge funds are loosely unregulated funds that are not supervised or restricted by the federal financial supervisory agency or any other part; as such, they are privately-owned firms that create a pool of investors and invest or reinvest their money in diverse financial instruments, with the prime goal being to perform better than the market. On the other hand, the Financial Industry Regulatory Authority (FINRA) (2008) defines hedge funds as pools of private investment for financially and wealthy sophisticated investors that seek positive performance by targeting to generate stipulated returns without regard to the underlying trends or transformations taking place in the stock market; this feature differentiates hedge funds from mutual funds, whose success is dictated by the performance of the stock index; for instance, the Dow Jones Industrial Average. Some of the strategies adopted by hedge fund managers, which do not align with stock market expectations include; arbitrage whereby the buy and sell securities in diverse markets and generate profits from the difference in the prices; hedging or the purchasing of securities with the aim of offsetting the potential loss attached to the investment; leveraging, which involves the borrowing of funds in order to engage in investment activities such as distressed and companies that are at the verge of bankruptcy.

Positive Side of Hedge Funds

Investors that opt for hedge funds accrue a number of benefits from this form of investment; for instance in a situation where a fund of funds diversifies amid different investment options and utilizes varying strategies, the hedge fund managers are in a position to control risk, which is not the case in other fund investment such as the mutual fund. This positive results of hedge fund can be demonstrated by the fact that in 2014 there were approximately 8,000 hedge funds, which controlled $2.8 trillion and this was a triple of the amount that was managed in 2004 (Williams, 2015). Inherently, this demonstrated that hedge funds had outperformed the stock market, although since 2009, following the global financial crisis, they have been underperforming as they were greatly affected. Although most of the returns obtained in 2014 belonged to super-large funds, small funds also earned quality returns that would encourage them to continue investing in the fund (Williams, 2015). The other benefit associated with hedge fund is the fact that they are not regulated or restricted as is the case with the stock market and therefore, they are in a position to invest in high return although speculative financial investments. In addition, the use of sophisticated derivatives to invest allows the hedge fund managers to continue making profits even when the stock market is failing or is underperforming; this emanates from their ability to leverage and time the right moment to outsize the stipulated returns; because they can predict when the market will fall and when it will rise (Williams, 2015). Moreover, the hedge fund managers are rewarded on a percentage basis of the earned returns; for this reason, hedge funds are in a position to attract many but mostly frustrated investors whose investments in other funds, such as mutual funds have been underperforming and they are required to pay fees, regardless of whether the fund performs or fails.

Direct Negative Side of Hedge Funds

One of the negative sides of hedge funds is that regardless of the new dynamism they present in the market as they are very aggressive and have strong grounds in the movement of money; their performance is never revealed. As such, although it is crucial for the investor to understand how his funds or investment is performing, hedge fund does not reveal this information, a situation that increases the frustration and disappointment of investors who continuously invest more and more money with the aim of generating high returns, only for their investments to fail or underperform (Mills, 2003). The other direct negative side of hedge funds is the fact that they are not regulated; unlike other investments, hedge funds are not subject to the registration by the United States Securities and Exchange Commission (SEC) as well as disclosure requirements. Without the registration, investors lack the protection that is accorded to those holding other forms of funds, such as the mutual funds and this makes it easy for the hedge fund manager that is unscrupulous to engage in investments that do not guarantee the investor any returns as well as fraud. Additionally, since the investors of hedge funds are part owners of the Limited Liability Companies, they easily lose their investment when the firm goes bankrupt as the same happens to the hedge fund (Mills, 2003).

Hedge funds are a risky investment owing to their lack of liquidity and the restrictions that hinder their resale or transfer. The idea is that unlike the mutual funds, which have specific regulations and rules concerning their pricing process, hedge funds lack specific rules that expound on the pricing process and therefore, it becomes difficult for the investors to redeem their investment (Sauert, 2007). In other words, hedge funds are illiquid investments because there is not secondary market in which their sale can take place and the investor is likely to loss his money in a situation where he wishes to switch to another form of investment.

Another direct negative side of hedge funds is that they engage in speculative investment activities and adopt sophisticated derivative techniques to trade. As such, in a situation where unpredicted events occur in the economy, there is a high possibility that the investor will loss his entire investment; this is because hedge fund managers wait for the appropriate moment in which they can sell or buy securities and things do not always go their way (Hall, 2008). The high risk of losing one’s investment emanates from the limited understanding of the techniques that the hedge fund manager adopt when deciding where to invest as well as the fact that they do not report the performance of the funds to the investor. For this reason, it is advisable that investors that cannot afford to lose their entire investment to perhaps opt for other investments even though their return will be lower than that of the hedge funds. A good example is in 2003, where numerous hedge funds were included in the market-timing scandal, which later rocked in Wall Street; a few years later, SEC disclosed the involvement of Pequot Capital Management in insider trading business, although it is one of the renowned firms in the nation owing to its prominent funds (Hall, 2008). Further, hedge funds have adverse tax outcomes that emanate from the complexity of their tax structure registration. As a result, the investor is required to request for extension prior to filing for his income tax return; the danger with this is that the calculation of tax becomes more complicated and the investor may not be in a position to manage it. As such, it is likely for the investor to be charged on allegations of tax evasion, a situation that would affect his investment as he would not be in a position to continue investing more and more money in the hedge fund.

Indirect Negative Side of Hedge Fund

The prime indirect negative side of hedge funds is the effect they have in the entire financial market as was seen during the global financial crisis in 2007-2008, which was contributed by the lack of restrictions and regulation of this investment. The housing prices decline started in 2006 and resulted to the underlying mortgage default by those who has borrowed loans and had minimal credit worthiness (Detzer, 2007). Although the hedge fund managers believed that they were protected from the foreseen effects of the default by the credit default swaps, the immense number of defaults on mortgage exceeded he issuers of the credit default swaps and they sought for the intervention of the federal government so that they would remain in business. The same case happened to the banks that they attempted to increase their investment through hedge funds such as the Lehman Brothers, which went bankrupt in September 2008 following the refusal of the federal government to bail it out; the result was the plummet in the global stock prices (Hall, 2008). Nevertheless, the economy has since recovered from the financial crisis and it is expected that hedge funds will start gaining high returns. Conversely, in order to protect the nation from a similar occurrence, SEC adopted regulatory measures for a number of hedge fund aspects by requiring that those over $150 million to be registered. This regulation is being enforced through the Dodd-Frank Wall Street Reform Act of 2010 (Williams, 2015). A Financial Stability Oversight Council has also been established to ensure that large hedge funds are regulated.

Conclusion

In conclusion, this paper sought to conduct an analysis of the dangers of hedge funds, which is one of the risky investments but has high returns compared to other funds such as the mutual funds. The paper started by expounding the meaning of hedge funds in order to clarify what it was discussion; this was followed by the examination of the positive side of hedge funds, even though most articles have presented them as dangerous investments that investors should at all costs avoid or risk losing their entire investment. The direct and indirect negative sides of hedge funds were later discussed; the paper culminated with the acknowledgement of the measures that have been adopted by SEC to regulate the performance and operations of hedge funds.

Reference List

Detzer, D. 2007. Characteristics, Strategies and Aspects of Hedge Funds. Munich: GRIN, Verlag.

Financial Industry Regulatory Authority, (FINRA), 2008. Funds of Hedge Funds-Higher Costs and Risks for Higher Potential Returns. Retrieved from < https://www.finra.org/investors/alerts/funds-hedge-funds-higher-costs-and-risks-higher-potential-returns>.

Hall, D. G., 2008. The Elephant in the Room: Dangers of Hedge Funds in our Financial Market. The Florida Law Review, 60(1).

Mills, D. Q. 2003. The Problem with Hedge Funds. Harvard Business School. Retrieved from < http://hbswk.hbs.edu/item/the-problem-with-hedge-funds>.

Sauert, D. 2007. Hedge Funds. Principles, Chances and Risks. Munich: GRIN, Verlag.

Williams, J. 2015. Hedge Funds & Derivatives Risk 2015. Retrieved from < http://www.hedgeweek.com/sites/default/files/HW_Risk_15.pdf>.