Hedge funds impact -- Protect yourself from volatility

June 6, 2007

Hedge funds currently have over $1 trillion in global assets, and are growing significantly. Since hedge funds are not required to register with the SEC, and so are less regulated than mutual funds, bonds and savings accounts, nobody really knows where this large amount of money is invested

What hedge funds impact means:
Hedge funds are private partnerships that offer above market returns with higher risk. Unlike mutual fund managers, hedge fund managers receive a percent of any return, and receive nothing if there is a loss.

Hedge funds use complicated trading techniques, including commodity options, currency futures and short selling. They are often guided by sophisticated computer programs that automatically generate buy or sell orders when the market triggers certain parameters. The amount of leverage these funds use greatly magnifies any market corrections.

Their focus on leveraged derivatives also means that when the market changes direction, these funds must make huge shifts in their investments to cover their positions. This increases the swings in the market, and ultimately the volatility in your portfolio.

Long-Term Capital Management was a hedge fund that nearly collapsed in the summer and fall of 1998. Since so many banks and pension funds were invested in LTCM, its problems led to the global market decline that year. Without the swift intervention of Fed Chair Alan Greenspan, the entire financial system threatened with a collapse. There is growing concern that the large role of hedge funds in today’s markets could cause a repeat of that panic.

Action Steps:
Like the private equity funds I wrote about last week, hedge funds increase market volatility. This explains some of the dramatic declines the market incurred in February. Remember the old adage, "It's not how much you make, it's how much you keep." Now is a good time to review your portfolio and perhaps shift some of your holdings into safer funds, such as commodities or bonds, and out of riskier ones, such as small cap.

Source:

Hedge Funds, Leverage and the Lessons of Long Term Capital Management by The President’s Working Group on Financial Markets, 1999.

Remarks by Chairman Ben S. Bernanke At the Federal Reserve Bank of Atlanta’s 2006 Financial Markets Conference, Sea Island, Georgia, May 16, 2006

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