A look inside hedge funds | Marketplace Whiteboard

hi my name is patty Hersh I'm a senior editor at marketplace today I want to talk about hedge funds the reason being because firstly hedge funds have been responsible in some cases for a lot of the volatility that we've seen in many of the markets recently and secondly because it's clear from a number of conversations and postings that people have made to the website that people don't really understand exactly what a hedge fund is so that's a go at explaining that all right the name is obviously very helpful we have hedge funds the name tells you that it's a fund the startings that involves it gets involved in hedging so what is hedging well hedging just judging by the expression to hedge your bets it means it's a way of offsetting risk in a any trade or investment that you make so let's take our hedger his name is Dennis Dennis this is an adventurous investor and dennis has got a number of means at his disposal in order to hedge his bets if he invests in debt for example he might take out insurance in the form of a credit default swap CD s if he involves in if he buys bonds or debt or of some kind or stock he could short that stock short selling he might get involved in arbitrage he might get involved in options put some calls that can help him deal with air or help him to to to offset his risk by making investments I'm not going to go into all of these things a number of them we've actually explained another whiteboard explainers that you can find on the website but say that Dennis decides after a short career in investment banking to start his own hedge fund well the first thing he does is he goes to see his Uncle Sam well is the older Uncle Sam here a bit of a stern chap and uncle sam says so what is it you're going to be buying and Dennis says well I want to I want to buy everything I'll buy stocks and one of my bonds I want to buy loans I want to buy credit default swaps based on the government debt from Boutin I want to buy racehorses in Ireland everything well uncle sam says well in that case you're going to be a hedge fund and if you're going to be a hedge fund there are some rules okay Dennis so what are the rules well the first thing says Uncle Sam is 65 percent of your investors have to be a credit it's 65% accredited accredited investors and what does that mean says says Dennis well Sam says it means that they have to be rich and buy rich I mean they have to have more than a million dollars in assets or last year they have to have made more than 200 thousand and next year they have an expectation of running the same or if it's a man and his wife a man in a spice they have to earn more than three hundred thousand a year last year and be expected to earn the same in the coming year now of course Dennis knows that there are church mice in New York who weren't two hundred thousand dollars a year and after they paid their mortgage they can barely affair - oh but afford to shop at the Hope at the farmers market so he's quite happy with that arrangement all right any other rules he asks and number sensors we'll know that's the only book okay first Dennis so he decides to take 10 percent or so something of the bonus that he got paid when he left Wall Street which is about four million dollars and invested in his own hedge fund and he's going to call that hedge funds Buccaneer a capital it sounds like a very sexy name that he thinks should get a lot of attention in the press and by the way there was a hedge fund called pirate capital which this has nothing to do with there but you can read all about the adventures of pirate capital if you go to the website and check on some of the links that we have they're fascinating reading anyway Dennis goes out and he decides to form Buccaneer capital and there's only one rule that the the Uncle Sam has given him which is about these accredited investors so he decides to make up a few his own rules the first thing he decides to do is to invest a large personal stake okay his stake is of course four million dollars and the reason he decides that is because he really thinks that if he has a large personal stake then more people will have incentive to join his fund the second thing he decides to do is to have high minimum investments okay a high minimum level of investment why does he want that well he knows that the more people that invest the more fees he gets but at the same time large amounts are a lot easier to deal with in smaller money so he decides to say okay so you're the minimum investment is going to be a million dollars right so that's his that's his high minimum so he goes right to a bunch of people and he says investors invest your money with me I've invested 4 million I'm looking for 10 million you know I love invest your money and make you 15 20 percent over the next three years and people invest for various reasons one might say wow you know buccaneer capital that's a cool name I'll give you two million dollars somebody else might say wow you know you're putting up four million dollars of your own money you must really know what you're doing I'll give you 2 million dollars and then you know he goes to another person you know maybe is auntie and she says oh you've always been one of my favorite nephews I'll give you two million dollars so people invest for all sorts of different reasons in these hedge funds but eventually he ends up with the 10 million that he's after 10 million in total but what he says to these investors is thanks very much for 2 million dollars but you know I'm going to be doing some fairly crazy investments that can make a lot of money but one of my new rules is that I am going to lock you in for a year so first year lock-in you can't get your money back for a year and when that first year is over I'm going to limit your redemption capacity to so I'm going to have infrequent redemptions maybe once every - once or twice every year or maybe once a quarter so we have infrequent redemptions as they're called can only get your money out a couple of times a year or maybe four times a year so he then goes out and he looks for his investments and they can be whatever he wants he can invest as I say he confessed in race courses in Ireland he can invest in CDs you know backed by the Chinese government Chinese government bonds whatever he wants to do invest in absolutely anything and he can use all of these hedging techniques so he has a use of use of hedging techniques and he has a variety of investments all right and some some hedge funds you know just go they decide to just invest in a certain number of things maybe they'll only invest in in bonds or only invest in bank debt or only invest in stock and some of them will only use one or two techniques means there are classic types of hedge fund calls long short hedge funds which will only invest in stock or bonds and they'll go long on one side and short on the other to balance themselves out the next rule he has is he says you know what you guys investors money great I'm going to have to look after myself of course I'm going to be guaranteeing you say 15-20 percent a year what I'm going to do is I'm going to take my 220 that's called two percent of the you of the initial investment and then 20 percent of any gains down the road so that's his two twenty M's for him that's his income all right so that's his structure he's only got ten million dollars and he goes out and he sees a lot of his compatriots in you know servers capital or whatever you know these large hedge funds that are making all sorts of money and he gets a little bit jealous so what he then does is he goes to his bank goes to Google Chase Manhattan Bank as was and he says guys you know I've got I've got ten million dollars here got some great ideas resources in Ireland I can make loads of money high by two giving me some more money how about levering me up I say okay well I'll tell you what we'll lend you 50 million dollars so give you a 60 million dollar fund so these guys give him 50 50 million he's got 10 million which means he is now 5 to 1 levered or levered 5 times ok so the last thing that this guy's got in his fund is leverage so here's a list of all the things that hedge funds there's the characteristics of the hedge fund firstly is the hard and fast rule the accreditation secondly most of them have large pope put in large personal stakes they have a high minimum investment often between 250 thousand to a million dollars of the minimum investment usually the first year is locked in and you can't get your money back there are infrequent redemptions thereafter these guys use all sorts of hedging techniques that world is pretty much open to them and they have a variety of investments that they can invest it pretty much anything they want most of them use this structure where they had they gain they earn 2% on the initial investment and then 20% on any air any earnings in the fund and the mass the majority of them in the past have used leverage although this is less common these days also the fee structure is coming down as well so those are the main characteristics of the hedge fund the thing that we're worried about these days and the one reason that hedge funds are in the news so much is because of the infrequent redemptions and the leverage ok what's happened is say you have a hedge fund that only has redemptions four times a year while the hedge fund calls up its investors and said okay redemption times coming up you need to let us know if you want your money back and of course because the markets in the state that it is and so many investors want to be in cash and don't want to be involved in the market because it's sinking like a stone they say we want our money back and they're doing it by their hundreds of thousands and as a result hedge funds are finding that there's a run on hedge funds essentially and hedge funds are finding that in order to make this money back they have to sell almost everything that they have in the fund and of course because they're leveraged up really really high as soon as they start selling hard it means that they're in real danger of losing their principal but they don't really have a choice because they're they're committed to giving these redemptions well when I say committed there's a course one other rule which is that there really are no rules apart from this one so a hedge fund can always turn around to its investors and say you know what we're going to lock you in and we're going to say to you you can't get your money back at all we're going to hold on to the fund going to allow no money to come out of the fund until such time as the market has risen back up again and we feel that we can sell our assets at a reasonable price firstly not drive the market down and secondly get a fair price for the asset so that we can actually pay you back when you won't root your redemptions so they're locking people ends until the edge of the market settles down this is necessary because if they don't lock in then they're going to have to make these sales because of the leverage in the accounts and the fact that people want their money back they're having to sell things very very quickly this is one of the reasons that we're seeing so much volatility in the market now because the hedge funders realize that it has to give its money back it's got to sell everything in its portfolio the price of which has already gone down so once it starts to sell and sell hard it's driving the prices of things down further and further and further and that's leaving everybody in the market both hedge funds and investors badly needing a drink

Channel: Marketplace APM

Views: 1,046,099

Keywords: Marketplace, business, money, hedge funds, financial crisis, economy, collapse, NPR, stock market, Paddy Hirsch, personal finance, kai ryssdal, marketplace apm, hedge funds 101, hedge funds vs mutual funds, hedge funds vs private equity, hedge funds vs investment banking, explainer video, economics 101, Demand, Big banks, Exchange, Recession, Financial crisis, Trade, Work, Commerce, Financial affairs, Money, Economy, private equity, investment banking, mutual fund, hedging, beer

Id: ksLySMWRwLs

Length: 10min 51sec (651 seconds)

Published: Mon Dec 15 2008

Reddit Comments

[u/Calamity58]

Too interested to relax. Damn my vaguely inquisitive mind.

[u/Destillat]

I love me some Paddy Hirsch, I didn't realize he was doing full on videos for Marketplace. Thank you for posting!

[u/DrThom]

yep that worked

[u/desipride1991]

i don't think he likes hedge funds