Hedge Hog "Hogwash" — Part III: How funds do it

Chris Clair's on-going answer to my questions about the "worth"of hedge funds (Do they actually contribute to society?) and their exorbitantly paid managers (How much is enough? How much is simply obscene?) continues.

I've decided to extend Chris' response to four parts. Part III appears here. Part IV, a summation, will come later in the week.

For a review of my original post, which inspired Chris, go here. The first two parts of his response are here and here.

As noted previously, Chris, a friend and former student, writes for Hedge World, an industry newsletter.

Part III — How the funds make their money

For the most part hedge fund managers trade securities, just like mutual fund managers. The key difference is that hedge funds can bet on falling securities prices as well as rising prices through a process known as “shorting.” In a short sale, the hedge fund manager borrows securities – let's say stock in a company the manager believes is overvalued by the market – and sells them. When it comes time to repay the borrowed securities, the manager hopes the price has fallen so they can be repurchased at a lower price. The manager pockets the difference, and the brokerage pockets the borrowing fee.

Hedge funds also bet on what are known as "spreads" or the difference in price between securities. Sophisticated pricing models can be employed to estimate securities prices. If the manager sees a too-large or too-small discrepancy between the prices of two securities, the manager can bet on the spread to either narrow or widen.

Those are just two examples of many different strategies managers follow.

Often hedge funds are engaged in what Roger Lowenstein called “vacuuming up pennies” in his book When Genius Failed, about the failure of the hedge fund Long-Term Capital Management. As he explains, "vacuuming up pennies" involves leveraging loans 100 or more times over.

LTCM was using that kind of leverage, which worked fine as long as the models were correct. However when Russia defaulted on its debt, bond spread characteristics changed beyond the model's ability to handle the calculations. Because LTCM worked with so much borrowed money – hundreds of millions of dollars – when its bets appeared to go wrong, the banks called for more collateral. To them LTCM was a counterparty, and to a certain extent its losses became the banks' losses, at least as far as balance sheets were concerned. This was why the government had to step in and back LTCM, so that the hedge fund's counterparties wouldn't be dragged down by its problems.

Today, similar problems have been exacerbated because the financial world is even more intertwined now and securitization is more prevalent.

Hedge funds also were players in the securitized credit markets that resulted from packaging and repackaging loans (many of which had highly risky contents). Now some funds are hurting. Even many of those that earned positive returns last year are losing assets, as investors pull out what money they can find to cover losses elsewhere, or to live on.