How did your 401k do in May? Did you even look? If you did, you probably noticed a significant loss. OK, so it's short term, and what goes down can go back up again. But you probably want your retirement investments to be held in a relatively secure
investment, not some Wild West casino.
And that's where hedge funds come in.
Hedge funds are the SUVs of the investment world. Just as gas mileage loopholes for light trucks gave rise to the unregulated mileage of SUVs, so an exception for wealthy individuals to bypass mutual fund restrictions has given rise to the hedge fund industry. Read below to see why you should care.
To begin with as reported by
Money Magazine last Friday:
Hedge fund-related transactions now make up 30 percent of all trades in the nation's stock exchanges, and they can have a major impact on the markets. The funds control an estimated $1.2 trillion in assets.
So, remember May? Well, a lot of people think those heart-stopping declines in world markets were caused in large part by large numbers of hedge funds having to "unwind" positions (i.e., get out of an investment) all at the same time. In short, the value of your stock and bond funds in your 401k can be substantially affected by dangerously risky hedge fund behavior. And, as I diaried a couple of weeks ago, they inject "systemic risk" (the risk of an entire system meltdown) into the financial markets (remember Long Term Capital Management?)
And as for regulation?? We don't need no stinkin' regulation! As reported by the Hedge Fund Center, here are some of the differences between hedge funds and other funds of which you should be aware:
1. Hedge funds vs. mutual funds - structure: The primary difference is the legal and regulatory structure that a hedge fund operates under. A hedge fund is largely unregulated, whereas a mutual fund is very highly regulated. Given that, hedge funds are allowed to engage in activities that mutual funds can not, which would lead some to believe that hedge funds are more risky.
2. Hedge funds vs. mutual funds - marketing: Hedge funds marketed in the U.S. can only be sold to "accredited investors" as per the SEC. To be "accredited" an investor must have a net worth (assets - liabilities) in excess of $1,000,000 or have an income of at least $200,000 ($300,000 if married). Why is this? The SEC, as a securities regulator, is out there primarily to protect "the little guy." So, an investor that has a lot of money to invest, according to the SEC, should be expected to make more informed decisions and take on higher levels of risk.
3. Hedge funds vs. mutual funds - transparency: An investor can visit hundreds of web sites to get stock quotes and ratings on funds from Lipper and Morningstar. No such independent rating organization exists for hedge funds. Also the SEC restricts the online viewing of performance data to accredited investors.
4. What is leverage and the risks of leverage? Leverage involves borrowing money that you don't have and investing the borrowed funds. Examples include people who use margin accounts and mortgages. Numerical example: If you have a dollar and you borrow another dollar you have $2 to invest. If you invest and it pays off, your $2 may turn into $4. You can pay your $1 loan back and keep $3. You have just made 200% on your money, versus only 100% if you did not borrow (or leverage) with that dollar. The risk is that the markets turn against you and your $2 investment is worth, say, 50 cents. You then can cash out at 50 cents, but you still have to pay back your $1 loan.
5. Implications of leverage in hedge funds vs. mutual funds: Mutual funds are limited in the amount of leverage they can take on by the SEC.
You might think that a government that cares about its citizens might want to look at regulating such a large, risky industry. Well, before Bushco completely took over the Securities and Exchange Commission {SEC}, they took a stab at it. Unfortunately, on Friday the conservative District of Columbia Federal appeals court threw out their regulations:
The U.S. Court of Appeals in Washington, D.C., ruled Friday that new registration rules in effect since February are "arbitrary," tossing them out and forcing the SEC to consider whether to revise them.
....
But the ruling is surely a black eye to an agency that has increasingly tried to assert its authority over the blossoming hedge fund industry.
Hedge fund registration was a controversial rule, but one advocated by former SEC Chairman William Donaldson as a way to keep better tabs on the loosely regulated and secretive industry, which has exploded in popularity in recent years. More than 8,000 hedge funds manage assets totaling more than $1.4 trillion, increasingly from big pension and endowment funds.
Thousands of hedge funds registered under the new rules, except some very large ones, which lengthened investor lockup periods to get around registration. A few others didn't qualify under the rule.
The court's ruling was a surprise, says Terrence O'Malley, a partner at Fried Frank Harris Shriver & Jacobson and a former SEC enforcement attorney, because courts have typically been deferential to agencies when it comes to rule making. "This is going to sting," says O'Malley.
This morning was on CNBC an SEC Commissioner indicated that they were satisfied with the lack of regulation of hedge funds, citing their "sophisticated investors." Since that "sophisticated investor" might include your elderly mom and dad who have a net worth, including their house, in excess of $1 million, you ought to be very concerned about the SEC's new attitude. The CNBC reporter couldn't hold back his shock: "Sophisticated investors?!?!" he sputtered, noting that every single brokerage house has launched new hedge funds, targeting the more affluent members of the middle class.
More and more, it is clear that the Bushco plan for personal retirement includes exposing your hard-earned retirment cash to a market that has been turned into a Wild West casino -- unregulated and full of risk -- and no Sheriff to keep an eye on the bad guys.
That's why you should care about hedge funds.