OK. Be honest. As soon as you hear the term “hedge funds” nowadays, you cringe. But, do you really understand what hedging is? It’s been in the news so much over the past three years, but few people really understand the concept.What is HedgingHedging, in its basic form, is simply insurance. Given the uncertainties of the marketplace, hedging is a means to insure that one does not lose his or her shirt, if the price of an item were to fall. At the same time, hedging also limits the potential gains, should the price skyrocket. One “hedges” the investment or event by making yet another investment to protect the gain and preclude some of the losses. Hedging has no effect on whether the price of the item rises or falls; it does not stop the negative event (the drop in price of the item) from occurring, it just mitigates the potential losses (while attenuating the potential profits) of such price changes. There is a cost to exercising the hedge (either the cost of buying a contract or the lost profits if one is on the losing side); this non-avoidable sum is the price paid to avoid the uncertainty and risk of the situation. Moreover, hedging is less precise than insurance. Insurance (less a deductible) provides compensation in full for one’s losses. Hedging may provide more or less compensation than the loss involved. The entity making the hedge hopes to protect against losses that result from price changes by transferring the pricing risk to a “speculator” who relies upon their skill to forecasting such price movements.Hedging, as a concept, has been practiced by astute farmers for years, as a means to protect themselves from terrible losses. The wheat farmer buys seed, fertilizer, and equipment, all with the hope to reap a great crop and make a profit. However, the price for the wheat is a function of supply and demand; there is no guaranteed price for the crop. If the price of the harvested wheat is high, the farmer makes a profit. If the price of wheat is low, the farmer may break even- or even worse, lose money. And, that’s before accounting for the labor put into growing this crop.Let’s put some numbers to these concepts. The farmer spends $ 1000 on supplies (seed, fertilizer, etc.) to grow 200 bushels of wheat in four months. The price of wheat right now is $7.50 per bushel, which means the farmer will make $ 500 to cover his labor and profit (assuming no other expenses). If the price of wheat rises to $ 9, the profit rises to $800. Should the price of wheat tumble to $ 6, there only will be $200 for profit and labor. (Taxes are assumed to be zero in all these scenarios.)As such, farmers purchase wheat “futures” to cover the size of the crop they planted. (A “future” is a contract to buy or sell an asset [commodity or product] at a guaranteed price for some date in the future; hence the term “future”. ) This transaction is governed by a clearing house. (We will discuss this concept more fully below.) This contract guarantees the farmer a set price for the crop in the future. Buying futures for $8 means the farmer is assured to sell his 200 bushels of wheat for $1600, but the futures contract itself costs $ 100, yielding $ 500 for labor and profit. If the price of wheat were to rise to $ 9, the farmer would lose out on that extra $ 200; but had the price fallen to $6, the farmer still be paid the $8 (his “futures” price), thereby guaranteeing a higher return overall, given the price decline.This example describes one kind of hedging (“commodity risk” hedging). Another place where commodity price hedging has been crucial has been within the aviation industry. The price of aviation (jet) fuel is one of the biggest headaches for the airlines. The industry sells tickets for travel in the future, without knowing what the price of fuel will be on that day in the future. With fuel being such a large component of their costs, airlines have been buying oil futures for a while. Should the price of fuel go up, the airlines will pay more for their fuel, but make money on their futures, thereby mitigating their higher costs. Should the price of fuel drop, the airlines save money on their fuel (lowering their costs), but lose money on the oil future contracts they bought. For years, this was one of the methods by which Southwest Airlines was able to maintain a high degree of profitability. Prior to 2008, their ability make a profit was legendary. But, in 2009, the price of future contracts they purchased cost them more than their ability to maximize profits from operations. As such, this instance of hedging cost Southwest Airlines significant profits, where before this time, it was a significant revenue enhancer.The same hedging concept also applies to the buying and selling of stocks. Generally, stocks do very well when the annual inflation rate ranges from 2 to 5%. When inflation is much greater than 5%, stock performance is not as great. Hedging against risks in such inflationary environments is not beneficial because the interest rates are spiked by the inflation rate.Other kids of risks that can be protected by hedging include interest rate risks (the price of a bond or loan will worse as interest rates rise), equity risks (protection against stock market price rises and falls) currency (or Foreign Exchange) risks (protecting against the rise and fall of currency values when selling products to a foreign country at a set price). For example, firms selling medical products abroad when the value of the dollar is plummeting against other currencies often purchase currency futures to protect against losses in the exchange rate, since they have already signed set price contracts to provide their products over 24 months.Types of Derivative ProductsHedging involves the sales of derivatives, a financial product whose value is a function of other variables. Oftentimes, these variables can be the price of the underlying asset (the price of an object- but NOT the object itself), interest rates or indices. The most common derivative products are futures, options, and swaps.As we said earlier, a “future” is a contract to buy or sell an asset [commodity or product] at a guaranteed price for some date in the future; hence the term “future”. When a hedge is made selling futures, the process is called making a “short” hedge. On the other hand, buying futures is called making a “long” hedge. As opposed to “futures”, a “forward”, while also an arrangement to buy or sell an asset at some price in the future, involves a contract is written by the two parties involved in the exchange directly, and has no third party involvement or guarantee.An option (another type of derivative) is simply a contract between two parties that provide the right, but not the obligation, to buy (a “call” option) or sell (a “put” option) an asset. The agreed-to-valuation is known as the strike price, and it is fixed at a specific date and time that the parties determined by their contract. American options afford the owner of the option the right to require the sale at any time up until the maturity date. European options, on the other hand, provide the owner the right to effect the sale or buy on (but not prior to) the maturity date.There can be combinations of the option strategies, as well. Combining a buy and sell at set prices (the “call” and “put” option can straddle a desired price range (“collar” the goal). These collars provide protection from steep price declines, while they reduce the potential profits should the prices rise. However, these collar hedges afford protection against either or both potentialities.The third derivative is an agreement to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets. These are called “swaps” and are used to protect against the risk that a customer demands more or less of an asset than expected. However, one must recognize that swaps are the riskiest of the derivatives- one party wins and the other loses- in a swap.Derivative MarketplacesThere are two basic types of derivative contract markets – over the counter (OTC) and exchange traded derivatives (ETD). OTC contracts are negotiated and traded directly between two parties. Often these trades occur in private between “sophisticated” parties (entities that are used to dealing with large sums of money and risk). Without a central authority, each of the two parties is relying upon its counterpart to perform.Exchange-traded derivatives (ETD) involve similar contracts, but are sold via third party intermediaries, which take a margin (a fee) from both parties and insure the trade as part of its efforts. Typically, these ETD are traded on the Eurex (European markets), the CME (the Chicago Mercantile Exchange, which incorporated the Chicago Board of Trade and the New York Mercantile Exchange), and the Korea Exchange. These public exchanges provide access to the risk/reward hedges.Hedge FundsNow that we understand hedging as a concept, let’s examine how hedge funds themselves operate. Over the course of their 60+ year history, hedge funds were similar to mutual funds in that investors “gang up” or pool their money, with the common goal of making a profit. However, the hedge funds differ from mutual funds in that there was no Securities Exchange Commission (SEC) registration or regulation required for these asset pools. Hedge funds were considered private offerings, only available to “qualified investors” (also known as “accredited” or “sophisticated” investors), to institutions, or to pension funds. To be considered as an accredited investor, one needs an income exceeding $ 200,000 or joint income exceeding $ 300,00 for the previous two years, have a net worth exceeding $ 1 million (solely or jointly with spouse), or be an officer, director, or partner of the entity issuing the security. Obviously, institutions and pension funds were considered to be sophisticated investors and had no means testing involved in their qualification.Many of the hedge funds operated using a “2 and 20” structure. This meant that the hedge fund managers received management fees from the investors equal to 2% of the value of their positions, plus the funds retained 20% of the gains (performance fees), in addition to their basic management feesBecause of the long nature of their investments, hedge funds also required investors to agree to “lock-up” periods. A lock up period is the duration of time that investors are unable to withdraw funds after making their investments, since the investments being made on their behalf were considered to be “long-term”. The investor’s funds were used to purchase assets that were involved with futures of forward contracts. The lock-up periods ranged in length from a single month, to a quarter, or to a semi-annual waiting period; the longer lock-up periods were associated with those funds that imposed lower fees (1.75% management and 17.5% of profits). This lock-up problem became acute during the 2008 stock market failure, when investors demanded the ability to liquidate the value of their hedge funds. (There were some $ 782 billion in redemptions demanded; the hedge fund industry was unable, due to the “long” nature of their investments, to process these redemptions in a timely fashion.)Hedge Fund ProfitabilityUp until 2008, the hedge funds were universally touted as “absolute return” vehicles, because of their ability to seemingly generate profits, regardless of the stock market cycle. The managers of said funds were hailed as the “Masters of the Universe”. (Some of them even believed the moniker). It was thought that hedge funds could consistently generate positive returns and were virtually immune to problems. However, while the industry’s problems actually began to be noticed in 2006, these were considered to be aberrations, until the overall stock market collapse in 2008.What is often forgotten by many who examine this massive hedge fund market failure, is that the hedge funds, as a class, actually did not fall as much as the rest of the stock market- and, except for this short time span, have generally outperformed the market. In the bear market of 2000-2, hedge funds still managed to earn profits, compared to the rest of the market. In 2009, after the fall, with the stock market barely performing, the hedge funds also outperformed the market.The failure in 2008-9 was that manage hedge fund managers had bought assets (debt vehicles) that were totally bogus, in their desire for growth and fee income. The desperation of hedge fund managers to amass more assets with upon they could asses management fees let them skim over their need to perform due diligence and insure they were making good decisions.One of the prime examples of this situation (as well as an example of insider information trading) was the case of Marc Drier, who headed a 250 person law firm, Drier LLP. Drier’s firm sold promissory notes that were forgeries, backed by financial statements that were bogus and bolstered by falsified audit opinions. Since there was no central authority involved to arbitrate and insure the veracity of the transactions, one had to rely upon the other party to perform as promised. In these cases, one of the parties has already perpetrated fraud; as such, the transaction was doomed. This situation also prevailed in the Bernie Madoff Ponzi scheme (where investors receive funds that are not related to actual profits earned by the organization; instead they are derived from their own money or money paid into the fund by subsequent investors). At one time, it was thought that Madoff’s firm was managing some $ 17 billion in assets (and, in actuality, had virtually no assets under management).But, back in 2008, these were the problems that were first being recognized. The hedge funds private arrangements and their lock-up periods (restricting withdrawals for a set time period) created ill will as the investors began to panic at the size of their potential or actual losses. Then, it became clear that the derivatives at the basis of the hedge fund were not based upon true hedging (“insurance”)- but the concept of speculating (or “bets”). The fund managers were banking on the price of a stock to plummet or credit to rise, so they sold futures based upon very low prices for the stock or high prices for the credit vehicle. Risk managers were not being responsible; they were not buying corresponding futures to protect the other side of the equation. This left the funds and their investors exposed to potentially unlimited losses. By not including both sides of the equation (sharing the gains while protecting against terrible losses), it became obvious to investors and the public that the funds were no longer operating as a true hedge, but simply as a bet.This is how the hedge fund mortgage fiasco resulted, as well.. The mortgages had been combined together in large pools. Many risk managers felt this protected the pool; they could not believe that large numbers of the mortgagees would simply default. No downside futures were included in the investment equation, which would have made this an example of “credit risk” hedging, covering the risk that the borrower may not pay its obligations (which the prudent investor employs to insure against said risk). As the underlying mortgage investments were losing value, the funds for new mortgages (due to the failing economy) was also drying up (which might have afforded the possible refinancing of the problem mortgages) and the process of mortgage failure escalated.Hedge Fund Firm FailuresOne of the first big failures among the hedge fund industry giants was Bear Stearns, which was eventually bailed out by JP Morgan Chase (as opposed to terminating its operations in bankruptcy, as happened to Lehman Brothers). Many of Bear Stearns’ sub-prime mortgage investments were based upon fraud, coupled with misstatements of income and document forgeries. There were inflated appraisals for the mortgaged properties, many of which also were not the homeowners’ primary residences. (It is generally believed that payers are more likely to default in times of trouble when the mortgage is not protecting their primary residence.) As further investigation into the situation was effected, it was found that many of the sub-prime mortgages were provided to people with less than ideal credit and at “teaser” interest rates that skyrocketed after a few years, rendering the mortgage repayment virtually impossible. Coupling such situations with the fact that many hedge funds were desperately seeking deals and failed to perform due diligence on their investments is exactly what led to the massive failure of the mortgage funds.By December of 2008, the world was reeling from the failures of hedge funds. With the failure of Lehman Brothers, and the knowledge that from 2004 through 2007, these funds had leveraged their assets by 20 to 30 times (meaning that the value of the assets underlying their cash positions was between 3 and 5%), it is not surprising that the stock market manifested its worst failure since the 1929 crash. The hedge funds had some $2.1 trillion under management at its peak in 2007 (it is now down to $ 1 trillion) and suffered losses that were approaching 60% of their cash values (also meaning there were no assets to back up these cash losses).Hedge funds no longer appeal to the high net-worth investors; these investors crave liquidity ever since the credit crisis. As such, institutional and pension funds comprise the bulk of the investors in hedge funds now.Future RegulationBecause of the 2008 failures, new laws were imposed to try to regulate against similar devastating failures in the future. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Public Law 111-203, previously HR Bill 4173, enacted in 2010) was written to insure that hedge funds provide more information to their investors and provide controls on the operations of these funds. In addition, leverage ratios will be kept more modestly, closer to 1 (meaning the cash values in the funds will match those of the underlying assets).One should not consider that this period marked the end of the hedge funds. At least one firm routinely advertises about the ease by which one can start a fund- in one’s basement (Eze Castle Integration, which has been around 15 years, even posts a PowerPoint presentation providing instructions and links so this can be done). Moreover, not all hedge funds are criminal or are tainted. It’s just that the ability or potential for abuse is great and the regulations can be skirted (even Dodd-Frank). There needs to be additional restrictions and prosecutions of insider trading (directors of the fund obtain non-public knowledge not available to other investors), front-running trades (the ability to employ supercomputers, with or without illegal machinations, and effect transactions prior to the ability of the rest of the market to accomplish same), late trading (when transactions are booked after the market is closed, when announcements that move the market have been made), and Ponzi schemes.Regardless of the future of the hedge funds themselves, the process of hedging will continue. It is part of the critical business considerations necessary to mitigate risk when planning and operating in environments where the future is unknown- in other words, at all times.