What is the deal with hedge funds?

John W. Schoen • Profile • E-mail

The financial storm that swept through the credit markets in the past two weeks involved a cast of characters that included a somewhat mysterious entity known as a hedge fund. Though the markets seems to have calmed down a bit, and the dust may be settling, many readers are still wondering: what exactly is a hedge fund?

What is a hedge fund?
— Paul Stanwood, Washington

Hedge funds aren’t what they used to be — and not just because some of them have just lost boatloads of their investors money.

The original ancestors of what we now call hedge funds were a specialized form of investing that placed a very specific kind of bet — looking for opportunities to “hedge” one investment with another. Unlike a mutual fund, which buy stocks and holds onto them hoping they go up, hedge funds also sell stocks short, buy futures contracts to offset risks and use an increasingly complex set of derivatives — a specialized breed of financial instrument, many of which were invented to help investors hedge the basic risks of owning a stock or bond outright.

For example, if you’re holding a lot of stocks that are included in the S&P 500 index, you might take a short position in an S&P 500 futures contract. (Short sellers sell something they’ve borrowed hoping to buy at a lower price when they have to give it back — or “cover their position.”)  If the index goes up, you win on your stock bet. If it goes down, you win on the short sale of the futures contract. Since many of these bets rely on relatively small price moves, some hedge fund managers soup up their returns with borrowed money.

Along the way, these funds developed a number of different strategies. Today, the phrase hedge funds refers to one of thousands of funds that are unregulated (they don’t report their holdings) and generally restrict their list of investors to wealthy individuals or other big investors like insurance companies or pension funds that, presumably, understand the risks and can afford to lose money.

The expansion of hedge fund strategies also brought on an ever-expanding basket of financial instruments — some of which don’t actually change hands very often. Subprime mortgage-backed securities are one example. By pooling otherwise risky mortgages into different classes of bonds — with strict rules on which of those bond investors get paid first — the theory was that, even if some of these borrowers went bust, at least some would keep paying, so the investors who were guaranteed a place in the front of the line were a lot safer than those at the end.

But since these mortgage-backed bonds mostly sat idly in hedge funds and other accounts once they were sold — and didn’t trade in the open market like stocks or bonds — no one really knew what they were worth. So computer models set the price. Instead of letting the market assess risk and “price” these bonds, buyers relied on a complex chain of analysis. Credit agencies assigned three-digit FICO scores to mortgage borrowers; bond rating agencies reviewed the documents setting out which classes of bonds got paid what and graded them for risk; fund managers ran their risk scenarios that were supposed to show what would happen if the bottom fell out of the market.

All went well for years. In fact, things went a little too well. Before long, the buyers of these bonds felt the risks were so well-managed they bought them with almost the same level of confidence they gave to the safest bonds like U.S. Treasuries. Riskier bonds are supposed to pay higher interest rates to make up for the risk that you’ll lose your money. But as of a few months ago, these mortgage-back bonds were paying only a small “premium” to Treasuries.

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