Bear Stearns Hedge Fund Investigation |
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One of the most widely discussed, but least understood, investment trends to date are hedge funds. Exacerbating the confusion are recent hedge fund collapses including funds managed by major Wall Street brokerages such as Bear Stearns and Goldman Sachs.
Hedge funds pool investors' money and, by using complex financial instruments, aim to achieve higher rates of return than traditional investments such as mutual funds. Historically, hedge funds tried to hedge against the risk associated with a bear market by entering into a short position. Although hedging is the practice of attempting to minimize risk, today, hedge fund managers largely make speculative investments thereby exposing themselves to more risk than the overall market.
Hedge fund investment techniques include:
- Investing in equities, bonds (including mortgage backed securities), options, futures, commodities and illiquid investments;
- Hedging by buying a security to offset a potential loss on an investment;
- Investing in distressed or bankrupt companies;
- Concentrating positions in securities of a single issuer or market;
- Investing in derivatives, such as options and futures contracts;
- Short selling (sale of a security you do not own);
- Investing in volatile international markets;
- Arbitrage (simultaneous buying and selling of a security in different markets to profit from the difference between the prices);
- Investing in privately issued securities.
Hedge funds aren't limited to any particular financial market and often leverage assets (borrowing money for investment purposes) to maximize profits, with the potential for returns to be significantly higher. This technique greatly increases risk and is the reason many funds are collapsing.
Hedge funds are lightly regulated and currently managers are not required to register with the Securities and Exchange Commission (SEC). Hedge funds are allowed to operate behind closed doors because they are considered private offerings under the Securities Act of 1933. Additionally, these funds aren't required to submit periodic reports.
Historically, hedge funds have only permitted high net worth and institutional investors to contribute money. Funds of hedge funds have changed this dynamic by allowing significantly lower minimum investments, sometimes as low as a $25,000. Funds of hedge funds are an investment company that invests in multiple hedge funds, balancing out risk and rewards among them.
Hedge Fund Facts:
Due to leveraged assets and volatile strategies failure may be more likely than with other investment vehicles. Problems can arise when a hedge fund experiences cash flow problems following a period of poor returns on investment. Excessive leverage can precipitate sudden capital depletion when investing in volatile financial instruments or commodities. Furthermore it is possible that a hedge fund can be forced to liquefy assets at a steep discount if a lender makes a margin call.
Some high profile hedge funds recently collapsed including:
- Amaranth Advisors LLC - $9 billion fund that lost $6 billion in one week and was accused of market manipulation soon afterwards.
- Bear Stearns - The High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Strategies Enhanced Leverage Fund lost $1.6 billion when the subprime mortgage market collapsed.
- Dillon Read Capital Management - The UBS backed hedge fund accumulated losses of $124 million in a single quarter forcing its closure.
- Sowood Capital - $3 billion fund run by a former Harvard-educated money manager used leveraged to invest an estimated $12 to $15 billion. The fund lost more than half its value in the credit market and was forced to sell its remaining portfolio.
Of greater concern to investors is a hedge fund's failure resulting from fraud. Despite no requirement to register with the SEC, hedge funds are still subject to the same prohibitions against fraud as other market participants, and managers have the same fiduciary duties as other investment advisers.
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