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What Do Hedge Funds Do?

Why are "Unregulated" Hedge Funds "Secretive" and Why Are Their Managers "Reclusive"?

Regulations

Legislation called the American Jobs Act was recently signed into law that broadens what the hedge fund community can disclose to the outside world. While a lot of people in our area work for them or invest their money with them, they have historically operated under severe restrictions about what they can say about their work. This has led to the habitual descriptions of "secretive" or "reclusive". Such villanous-sounding folks were typically also "unregulated", despite the detailed regulations preventing their activities' disclosure. So, now that they can spill the beans, what do they do?

Research

Hedge funds are primarily research operations. The research that hedge funds produce is primarily based on original sources. In this regard, it is a bit of investigative journalism or detective work. It involves an enormous amount of reading.

Researching What?

Prices, and more specifically, mispricing. In other words, they are in the business of finding flaws in markets and fixing them for a profit. Here is where hedge funds really are completely different than traditional money managers, even though the basic description sounds similar. Conventional money managers pay a given price for stocks or bonds in order to expose their investors to that risk. Hedge funds are doing something that looks similar but is completely different. They are researching all types of markets in order to wait for a flaw in the price system. Markets can operate smoothly, rationally, and efficiently most of the time. But sometimes they don't. Why might prices fail? Essentially price has to do too many things at once. It has to sort out differences between views on what something is worth - value - but also sort out differences in terms of how much someone wants their money back - liquidity. Occasionally the job that a single price has to do leaves it out of whack. That is when hedge funds swoop in.

Partnerships

Finally, hedge funds are partnerships, but in structure and in substance in ways that few other industries still are. Fund managers usually have much of their wealth in the funds that they offer to investors. For better or for worse, they are on the same team. In the 1800s, private partnerships dominated the financial services industry, but they died out throughout the 20th century. And in this century, when we went through the greatest financial crisis since the Great Depression, the epicenter of the crisis was our government and public corporations. With so much of their own money at stake, most private partnerships behaved much as they have for centuries. There were few hedge fund failures and none that threatened the stability of our economy or required a bailout. They were researching, waiting, watching, and finding price failures.

Hedge Funds Regulate Markets

Unregulated? The short answer is that it is simply untrue. Hedge funds have regulators. However, the longer answer is that hedge funds are market regulators. Average investors have little by way of resources to bear on any one investment, that they cannot be faulted for research that tends to be light by hedge fund standards. It is normal for hedge funds to spend hundreds if not thousands of man hours on a given investment, with research into every conceivable aspect of a potential investment. Due to the intense pressure for fund managers to operate on a timely basis, this work is typically done months or sometimes years before a government regulator has looked into a market. What do fund managers find? Many of the accounting frauds of the past few decades where discovered by hedge fund research well before the government or auditors. Hedge fund research first drew attention to structural flaws within housing finance, bond insurance, and sovereign debt. Hedge funds have the motive, alignment, and resources to uncover and begin to fix market flaws in a way that is swifter and surer than any government. Unregulated? Hedge funds are the regulators.

Further Reading

For further reading on what hedge fund managers do, you might consider Hedge Fund Market Wizards: How Winning Traders Win.