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Hedge Funds Riskier Than Ever

States, Feds May Ramp Up New Regulation

By Fred Yager
ConsumerAffairs.com

October 10, 2006

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Have you ever thought of investing in a hedge fund?

Do you even know what a hedge fund is? No, it's not money you set aside for landscaping. Hedge Funds are an estimated $1.5 trillion dollar industry that puts money into what are considered speculative or risky investments.

Only a handful of people actually know how where that money is and they're not saying.

What's really scary is that the biggest investors in hedge funds are the same people who are in charge of billions of dollars set aside for retirement in the form of pension funds. Some of the country's largest city and state pension funds use hedge funds as a way to increase returns since on average they tend to perform better than the stock market.

Or at least until things go terribly wrong ... such as what happened with Amaranth Advisors, a Greenwich, Connecticut-based hedge fund that lost $6 billion of its $10 billion in a single week by betting too much on natural gas.

The San Diego County Employees Retirement Association reportedly invested $175 million of its $7 billion pension fund in Amaranth and lost an estimated $45 million.

Now you might say $45 million from a $7 billion fund is a small percentage. But $45 million here, another $45 million there and pretty soon you're talking big money. And in this case, it's money those San Diego County employees were counting on for retirement. Keep in mind, that's just one pension fund's investment in one hedge fund.

Amaranth is just the latest in a long line of hedge fund collapses.

Since last year, more than 1,000 of a total of 9,000 hedge funds have been liquidated. That means more than 10 percent of all the hedge funds in the world went out business in the last year and a half.

Unlike the securities or mutual fund industries, hedge funds have no regulatory body such as the SEC looking over their shoulder to make sure everything is on the up and up.

That could change however.

Recently, Connecticut's department of banking created a hedge fund oversight unit to investigate such matters as potential fraud. Some say it's a start until a more formalized federal body is formed while others claim it will be ineffective without any new laws to regulate hedge funds.

Meanwhile, the SEC is also looking into raising the investor net-worth requirements for hedge funds after a record number of them went belly up.

In the beginning hedge funds were supposed to reduce risk by "hedging" or investing in both sides of a potential move in the price of a security such as a stock or a bond. Some of the money was bet on whether the security would go up, while some was invested in whether the security would go down, thus hedging or reducing any potential loss.

It was kind of like roulette, where you cover a number of options in an effort to "hedge" your bet. These, days however, most hedge funds don't actually hedge their risk. It's become more like "Russian Roulette," where the wrong bet can kill an entire fund.

And now, according to an article in Forbes, another potential disaster is brewing on the horizon, over something called "credit default swaps" and hedge funds reportedly account for 58 percent of all trading in these derivatives.

A credit swap is sort of an insurance policy on a bond, often a junk bond. If the bond defaults, the seller of the credit default swap has to pay up.

According to Forbes the total amount of bonds, loans and other debt covered by credit default swaps is $26 trillion or twice the annual economic output of the U.S. which means if the economy goes into a recession, the hedge fund industry will be in trouble ... and so will its investors.

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