Think of a hedge fund as a private club of investments in anything the hedge fund manager wants to invest. Hedge funds have limitless investment options. One feature unites hedge funds today: performance fees in the range of 20 percent of the funds profits plus management fees of about 2 percent of principal. That makes hedge funds far pricier than mutual funds, which charge no performance fees at all. Index funds, like Vanguard's fund based on the S&P 500, charge as little as one tenth of one percent (0.10%).
Roger Lowenstein describes hedge funds in his excellent book about the largest hedge fund collapse to date, When Genius Failed: The Rise and Fall of Long-Term Capital Management:
"As far as securities law is concerned, there is no such thing as a hedge fund. In practice, the term refers to a limited partnership, at least a small number of which have operated since the 1920s. . . . Unlike mutual funds, their more common cousins, these partnerships operate in Wall Street's shadows; they are private and largely unregulated investment pools for the rich. . . . For the most part, they keep the contents of their portfolios hidden. They can borrow as much as they choose (or as much as their bankers will lend them - which often amounts to the same thing). . . . [H]edge funds are free to sample any or all of the more exotic species of investment flora, such as options, derivatives, short sales, extremely high leverage, and so forth."
Lowenstein, When Genius Failed, at 24 (2000) (emphasis in original).
The phrase “hedge fund” mischaracterizes most of the hedge funds in the news. The term "hedge" ordinarily refers to hedging one's bets. Trial lawyers do this when they enter high-low settlement agreements before a jury trial in which a defendant promises to pay the plaintiff no less than $500,000 but no more than $2,000,000, regardless of whether the jury awards $1.00 or $10 million.
Some hedge funds operate this way, but not the ones in the business pages. To the contrary, as Lowenstein points out in When Genius Failed, many hedge funds have investments that not only lack any real hedges, but contain large amounts of leverage. These leveraged funds present substantial risks of gain and loss to their investors.
For that reason, Warren Buffett refuses to use that label when referring to the funds making all the news today. As Buffett wryly observes, the funds retain one important hedge: the hedge fund manager's compensation. His 2006 letter to shareholders describes the hedge-fund trend in classic Buffett style:
"[Imagine the] allegorical Gotrocks family – a clan that owned all of America’s businesses [that] counterproductively attempt[s] to increase its investment returns by paying ever-greater commissions and fees to ‘helpers.’ [That is, high-profile hedge-fund managers.]
. . . .
"[The hedge-fund managers,] Wall Street’s Pied Pipers of Performance[,] have encouraged the futile hopes of the family. The hapless Gotrocks will be assured that they all can achieve above-average investment performance – but only by paying ever-higher fees. A flood of money [has gone] from institutional investors to the 2-and-20 crowd. For those innocent of this arrangement, let me explain: It’s a lopsided system whereby 2% of your principal is paid each year to the manager even if he is accomplishing nothing – or for the matter, loses you a bundle – and, additionally, 20% of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. . . .
"The inexorable math of this grotesque arrangement is certain to make the Gotrocks family poorer over time than it would have had it never heard of these ‘hyper-helpers.’ Even so, the 2-and-20 action spreads. Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the money.”
See Warren Buffett, Berkshire Hathaway 2006 Annual Report, at 21-22 (emphasis in original).
Bear Stearns faces litigation on several fronts. Investor advocate Jake Zamansky has initiated at least one arbitration claim before the former National Association of Securities Dealers, now known as the Financial Industry Regulatory Authority, or FINRA, as reported on CNBC. At least one institutional investor has initiated legal action against Bear Stearns for losses arising out of its hedge funds.