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Scam of Hedge Funds exposed

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    Posted: 23-May-2008 at 06:37
Hedge funds: Playing dice with the universe
By Julian Delasantellis

Speaking Freely is an Asia Times Online feature that allows guest writers to have their say. Please click here if you are interested in contributing.

In every decade, certain socio-cultural archetypes arise to become the avatars of their time. In the 1950s, there was the corporate "organization man" in his gray flannel suit; in the '60s, the tie-dyed flower-power hippie. In the '70s, there was the polyester-leisure-suited big-lapeled "est" sensitivity trainer, and in the '80s, it would have been the Hugo Boss-wearing avaricious corporate raider. In the '90s, we had the perpetually casual-Friday-looking 'Net entrepreneur.

And for this decade? It can be none other than the international

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hedge-fund manager, who "bestrides the world like a colossus" (as William Shakespeare's Cassius described Julius Caesar just before assassinating him), from offices looking out over Long Island Sound in Greenwich, Connecticut.

But has pride come before a very big fall? Recent events in the financial markets suggest that the answer could be yes.

On the real-estate pages of the New York Times, any story about the latest outrageous selling price of some co-op on the Upper West Side, or on the beach in St Barts, or the slopes of Vail is bound to have some reference to a hot hedge-fund manager as the purchaser. A new off-Broadway play, Burleigh Grime$, celebrates the wild ways of the title character, a hedge-fund manager who, in one of his more legitimate profit-making schemes, has dead fish dumped on the beaches of California to try to profit from an El Nino market panic.

Perhaps most cheeky of all, early last month, a manor estate just north of London became the venue for "Hedgestock", a psychedelic '60s-themed hedge-fund networking event, complete with groovily painted Volkswagen vans, and millionaire hedge-fund managers dressing as penniless tie-dyed hippies. In contrast to the original Woodstock (whose famous moniker of "three days of peace, love and music" was morphed into Hedgestock's "three days of peace, love and money"), where commerce was limited to trading in home-made jug wine and bad grass, the Financial Times reported that attendees at Hedgestock had to be satisfied with equally intoxicating Moet and Breitlings.

As plastic surgery makes the rich look younger to the world, maybe this is the next big thing: pompous fantasy charades that make the world look younger to the rich.

Starting with the tax cuts by US president Ronald Reagan of 1981, and especially after the near-worldwide evaporation of socialism in 1989, the regulatory, budgetary, and especially tax policies of the major capitalist democracies began unequivocally to favor the rich. This meant that greater and greater pools of free capital, once spread more or less evenly in smallish amounts among the broad middle classes, began to be concentrated in fewer and fewer hands of those at the very top of the income pyramid. This process barely slowed with the election of center/left-wing governments in the US in 1992, Australia in 1993, Britain in 1997, and Germany in 1998, and it continued after the US victory of George W Bush in 2000, and the passage and implementation of tax cuts heavily skewed to the rich by his administration in 2000-01.

This overabundance of capital presented a problem for the rich. What were they supposed to do with all the new money? Much of it went into mindless consumption of luxury goods, such as those offered by the Paris-based company LVHM. Created in 1987 by the agglomeration of luxury-goods purveyors Louis Vuitton, Moet and Hennessy, its stock rose almost sixfold from 1994 to the market top in 2000. Now having grown to encompass such further luxury brand names as Tag-Heuer, Donna Karan, Fendi, Givenchy and Guerlain, the company reported revenue of almost US$17 billion in 2005, rather impressive considering that amounts to 42% of world software leader Microsoft's $39 billion worldwide 2005 revenue.

But even the elite can only spend so much, and that left a lot of unused cash left over that had to be put to work, had to be invested. It was then that hedge funds came on the scene.

Just because the rich had earned or inherited the money didn't necessarily mean they had the investment skills to grow it. They wanted a surer thing than just buying and holding GM or some other common stock, and they also wanted something a lot more aggressive than the average tightly regulated mutual fund.

"Hedge fund" is simply a fancy name for a high-initial-investment limited partnership. In contrast to mutual funds, where an account can be opened with as little as $500, starting investments in hedge funds are frequently in the $1-million-to-$10 million range; thus their status as investment vehicles to the very upper classes (when pressed to defend their social utility as institutions that make the very rich even richer, the funds say that university endowments or public pension funds are also their customers, although these are but a small minority of the industry's customer base).

Also very much in contrast to mutual funds, hedge funds are for the most part unregulated as to the investment or, more accurately, speculation choices they can make. Mutual-fund managers are usually highly constrained as to their possible investment options. The mutual fund may be restricted by charter to invest only in large capitalization stocks, Treasury bills, or corporate bonds, but the hedge-fund manager has unlimited license to invest in stocks, bonds, countries, commodities, parcels of real estate, or anything else. The hedge-fund manager also has unlimited license either to buy the investment, in hopes that he/she will be able to sell it later at a higher price, or "short" the investment, hoping to profit from a decline in price.

In today's financial world, hedge funds are all the rage. Although there are no real statistics (a big appeal of hedge funds is their reticence; although most operate out of such places as Greenwich, almost all are registered offshore, about half in tax-friendly havens such as the Cayman Islands) detailing the actual or aggregate size or the world's hedge funds, Institutional Investor magazine estimates the worldwide total of hedge-fund assets under management (AUM) at more than $1 trillion.

To illustrate the magnitude of the industry, if hedge funds were a country and the AUM represented a nation's gross domestic product (GDP), it would rank eighth in the world, according to the World Bank, just behind Italy and ahead of Spain. Since most hedge-fund strategies involve substantial borrowing, using AUM as, say, 5% collateral for positions up to 20 times the actual cash on hand, multiplying the AUM times 20 gives you a potential hedge-fund-market impact just about the same size as the United States' GDP.

Hedge-fund managers, mostly recruited from concerns such as brokerages and investment banks, are far and away the most generously paid players in the money-management game. This is because, on top of the standard base "salary" hedge-fund mangers earn, usually comprising up to 5% of total AUM (meaning that on the day the hedge-fund investor hands his money over, he starts 5% in the hole), the hedge-fund charters usually include managers taking home substantial portions, usually around 20-50%, of the yearly total profits the manager earns for the clients. Thus, since successful hedge-fund strategies almost always include substantial borrowing to produce huge returns, it is not surprising that Institutional Investor reported in 2005 that the average salary for top hedge-fund managers was $363 million; the reputed top earner, James Simons, of Renaissance Technologies Corp, is reported to have taken home $1.5 billion in 2005.

So hedge-fund managers get the compensation, and the accompanying world stature bordering on adulation, of modern-day Uebermenschen. Do they deserve it? Are their investment strategies and techniques so breathtakingly advanced that they deserve to be worshipped as the new century's reigning deities?

Maybe. Maybe not.

At first, back in the late 1980s and early '90s, hedge-fund managers did have a few new tricks up their sleeves. Chief among them was a tactic that was not really all that new, for there are records of it being done as far back as the rice-futures markets of ancient China.

That tactic was arbitrage, the simultaneous buying of an asset cheap in one place, and selling it higher for a profit someplace else. If, say, your computer is saying that gold is trading for $400 an ounce in New York and $400.25 in London, you put two simultaneous orders in; one to buy an ounce in New York, and another to sell in London.

Excluding commissions, and the fact that you almost never get the price for a trade that the computer monitor says you will, you will earn 25 whole cents on this trade. However, if you can borrow, say, $1 billion for this effort, your take for a minute or two of this work could be up to $250,000. Do this two or three times an hour, for 250 trading days a year, and it adds up to real money.

But if your computer is tempting you with this profit, others are doing the same for other hedge-fund managers. If everybody's buying in New York and selling in London, eventually the price will rise in New York and fall in London, erasing the profit potential. Somehow, a new hedge-fund strategy had to be found.

The new strategy wasn't all that new. It was speculation, the simple buying of a commodity or asset in the hope its value will rise. For average investors, this can be a rather risky strategy. More than 30 years ago, economists Burton Malkiel and Eugene Fama put together what came to be known as the Efficient Markets Theory, which stated that individual investors cannot outperform market averages for any extended period of time.

But if you're speculating with $500 million instead of $5,000, you get advantages that the average guy sitting at the kitchen table with a desk calculator and the stock tables of the Wall Street Journal will never have.

Through painful experience, armies know that you can't march soldiers across a bridge in formation, for the force of all those feet striking the bridge deck simultaneously can reinforce the natural vibrations of the bridge with each step, causing the bridge to collapse. It's the same with investing. Get a lot of players all doing the same thing, putting in huge orders to buy or sell the same instrument at about the same time, and you can move the price of that instrument tremendously in a short time. Those fat bonuses rise along with the inflated asset paper values, and as long as there are always new buyers, as long as nobody sells, everybody's happy.

Then May 11 of this year came along. People started selling.

During the first days of heavy market decline, Fox News attributed the selling to what it called "traitors" who leaked the news of the National Security Agency's latest phone-surveillance scheme to the media. Those who still had some connection to the reality-based community had another explanation.

With hedge funds needing to borrow huge amounts of money to finance their trades, the hedge-fund managers discovered a neat trick. Why borrow in US dollars and pay high US rates (the current US prime rate is 8%), when you can borrow in Japanese yen and convert the proceeds to dollars, or any currency you want? Ever since 1999 yen interest rates have hovered around 0%, as the Bank of Japan desperately tried to pull the economy out of a seemingly unending recession that started with the crash of the Japanese stock market in 1989.

This maneuver, called the "carry trade", works great - unless either Japanese interest rates or the yen rise in value, for that would eat up the trades' profits for the hedge funds. When the yen did rise to 110 to the US dollar, and fears of rising Japanese interest rates spread through the market, hedge funds acted to protect their profits by selling massive amounts of gold, oil, steel, and developing-country equities - all the stuff that had risen so strongly before as they purchased it.

On June 1 the European Central Bank (ECB) warned of the risks to market stability from what it called the "correlation of hedge-fund returns". If all the hedge funds are doing the same thing - such as placing huge leveraged bets on the Indian stock market, a major casualty of the post-May 11 global selloff - then all their returns will be "correlated" or, in non-economist terms, similar. ECB vice president Lucas Papademos stated: "The increasingly similar positioning of individual hedge funds ... is another major risk for financial stability."

It has happened before. In September 1998, one of the top hedge funds in the world was Long Term Capital Management (LTCM), which had on its board Nobel Prize for Economics winners Robert Merton and Myron Scholes. Unfortunately, the shining stature of Merton and Scholes apparently blinded the funds' investors to the risks LTCM was actually taking. When the firm realized that the massive bets it had made in the global bond markets were going horribly against it, the fund was looking at $4.6 billion in losses, many times its capital base. The New York Federal Reserve, fearing that an LTCM bankruptcy could initiate a cascading series of bankruptcies among the big banks that comprised LTCM's creditors, then the creditors' creditors, etc, stepped in to arrange an emergency bailout of LTCM.

In the eight years since the LTCM crisis, with the proportion of income in the developed capitalist democracies remaining heavily skewed toward the upper classes, the concomitant amount of global wealth controlled by hedge funds has grown tremendously. With all of them investing similarly, the risks of the market turning against their positions, resulting in a tremendous destruction of global capital liquidity, have also grown apace.

The result? We are all like hapless ancients, trembling before the gods playing dice on Mount Olympus, knowing that we are powerless to affect the results that will so greatly affect our lives and destinies. As they might have said at Hedgestock:"Bummer!"

Julian Delasantellis
is a management consultant, private investor and professor of international business in the US state of Washington. He can be reached at

(Copyright 2006 Julian Delasantellis.)
The beginning of a revolution is in reality the end of a belief - Le Bon
Destroy first and construction will look after itself - Mao
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