Hedge Funds or Hedge Hogs?

Quote of the day:
"There's nothing remarkable about [making music]. All one has to do is hit the right keys at the right time and the instrument plays itself."
--Johann Sebastian Bach

Today’s high temperature in Baghdad: 102
Today’s high temperature in Phoenix: 112

Financial news headline of the day:
“Two Bear Stearns hedge funds essentially worthless.”
--Yahoo

What is a “hedge fund”? In effect, it’s a mostly-unregulated mutual fund for rich people. The minimum investment is typically $500,000.

Because they don’t have the restrictions of mutual funds, hedge funds can invest in just about anything. And they do--whole companies, new issues, Chinese bonds, copper futures, real estate and more.

The reason they are called “hedge” funds is that, initially, they were created to provide a very sophisticated way for investors to hedge their bets--that is, protect themselves from major market fluctuations. The funds were sold on the premise they could do this while making a substantial return.

Due to the level of skill needed to accomplish this, hedge funds carry an extraordinarily high cost. Most charge an annual 2% fee plus 20% of any investment return. Some are 3% plus 30%.

Because they are so larcenously lucrative, hundreds of hedge funds have been created in the last several years. Taking costs into account, most of them underperform market indexes. In fact, I don’t know of a single hedge fund that has consistently beaten the market for five years.

With such huge fees, managers of these funds must take significant risks to make the kind of returns that attract investors. More often than is reported, they lose lots of money,

Occasionally, as in the Bear Stearns case yesterday, they go bust.

And, occasionally, a few do incredibly well for a year or two. Then money pours in from investors who tell themselves the costs are worth it.

What happens after that is anyone’s speculation. But the odds are that these investors will lose money.