What is a hedge fund?
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M$2 Answers
The first hedge funds traded stocks by going long strong companies in a sector and selling short weak companies. This was in contrast to mutual funds that are only allowed trade long stocks. This is where the name hedge fund came from.
The hedge fund has evolved into an investment fund with few restrictions on what and how it can trade. A hedge fund can trade stocks, bonds, futures, options, currencies, OTC forwards, swaps, leaps, art, and really anything else they want. They can do this by buying and going long or selling to go short and use leverage in search of higher returns.
The reason so many hedge funds trade derivatives is the leverage. Being able to control a large amount of product with very little cash. For example a hedge fund can go long a $100,000 of 10 year treasury notes using a futures contract by only putting up $2k in margin. To buy the physical t-note they would have to put up the full face value.
Hedge funds work with a number of other parties depending on the strategy and the products they are trading. Funds that trade stocks work with a prime broker who are large investment banks (companies like Goldman Sachs) to trade. Funds that trade currencies trade with the big banks. Funds that trade futures work with Futures Commission Merchants (FCM).
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M$
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M$
"trade strategies and markets that are not appropriate for average investors." Your way over my head here. How do you trade a market (you mean like a derivative connected to a market?) How do you trade a strategy?
Do all hedge funds trade derivatives, clarify that?
Why is a combinations of shorts and longs called "hedging"? or how does an entity that does that get to be called a "hedge" fund?
Your going to have to help me with the concept of leverage.
How do I, average man, get in the Hedge fund game? I know Bernie Madoff was a hedge fund manager and he had all sorts of clients who were not professional investment entities.
How on earth can you buy a 100,000 T-Bill contract with just 2,000?
Did excessive leveraging have anything to do with the financial meltdown?
I remember after heard that their is about 600 Trillion of worth in derivatives and only 30 trillion in monetary cash, I thought to myself, "no way is that sustainable, it doesn't take a genius to see the instability involved in that" and couple years later were in this and they say it has to do with insufficiently funded insurance contracts in the finance industry. So was I right?
I will do my best to answer your questions from the top down.
The powers that be congress, securities & exchange commission, commodity futures trading commission and the federal reserve make rules on what average people can invest in. Rich people or in the industry known as accredited investors or qualified eligible participants are people with incomes over $250k and/or net worths over $1m are allowed to invest in things that ordinary people can not. The reason for the restrictions is most of the restricted investments are extremely high risk or you can lose more than the initial investment.
Trading is buying and selling things. A trading a strategy is the traders plan of how to make decisions about buying and selling.
Not all hedge funds trade derivatives but most do because derivatives have very few restrictions on what trading strategies can be used and the ability to control a lot of something with a little bit of money (I'll explain this below).
Hedging is making opposing bets in the belief that if you are losing on one bet you are winning more on the other. The stock example where traders buy the strong companies in a sector and sell the weak companies should work because if it is a bull market the strong companies will go up faster than the weak companies. The net result is they make more on the longs than they lose on the shorts. EX) Buy ABC @ $100 and sell XYZ @ $50. The market is bullish and ABC goes up to $125 and XYZ goes up to $60. The trader makes $25 on ABC and loses $10 in XYZ for a net profit of $15.
If there is a bear market and stocks fall the weak companies stock prices will fall faster than the strong companies and they will make more on the winning short bets than the losing long bets. EX) Buy ABC @ $100 and sell XYZ @ $50. The market is bearish and ABC goes down to $85 and XYZ goes down to $25. The trader loses $15 on ABC and makes $25 in XYZ for a net profit of $10.
How does an average person get into a hedge fund? If you are in a large pension fund then you probably are invested in several hedge funds. If you are not an accredited investor to go out on your own and invest in a hedge fund is difficult because of the restrictions that go along with the rules than exempt hedge funds from most regulation. There are some publicly available Commodity Pools where you can invest for as little as $5,000. They are hard to find again because of regulations on how they can market to the general public.
Bernie Madoff had a lot of investors that were not investment professionals but they were either rich that made them eligible to invest or were invested through a pension fund.
The trick with the 100,000 t-bill for 2,000 is that you are not buying it you are controlling it. In a futures contract you are required to put up margin. Margin is a performance deposit. If the price goes against you money gets taken out of the margin and if it gets below a point the exchange requires you to deposit more money for margin or get out of the trade.
Most of the derivatives that they talk about in the news are glorified insurance policies. The difference is that instead of being written against a car or a house they are written against some sort of financial product. When you buy car insurance you are getting tens of thousands of dollars in coverage for a few hundred dollars. The same thing with these derivatives the buyer only putts up a few cents on the dollar of potential coverage. It gets more complicated because what happens next is there are derivatives created against the performance of the first derivative and this goes out a number of times resulting in on one product there could be a half dozen or more different parties with some degree of exposure to the performance of the initial product. This is how they come up with a derivatives with a face value of more that 20 times all the money in the world.
Yes the excessive leverage was a major factor in the economic crisis. Bear Stearns was brought down by the excessive use of leverage. The historic rate of default on mortgages is 2.5%, BS was leveraged roughly 40 to 1 on the mortgage backed securities and corresponding derivatives. 40 x 2.5 = 100% loss. This basically guaranteed that they were going out of business.
One bank going down is not a problem. The problem with the derivates having so many layers is the banks and investment houses were so intertwined that when a banks fell it could not pay their obligations to less exposed banks making them unable to pay their obligations and the house of cards started to fall.
There were a number of other factors that compounded to create the problem. The most notable are extremely low interest rates, changes in financial regulations that rolled back rules that restricted the way banks could invest deposits that were put in place during the great depression and the loss of faith in the stock market after the dot com era.