Are hedge funds suitable for retail investors?

¶ … hedge funds suitable for retail investors?

Hedging is profitable in trading with bigger lots and the retailer is not the entity expected to trade with big lots. That being one of the considerations of profitability in the type of investment, authors are at loss to explain what exactly is hedging. In simple terms some commodity or stock is purchased at a future determined price as against the current price depending on perception of future rise or fall in the price of the lot. The definition of a hedge fund is vague. The hedge funds can be analyzed in terms of the legal operation methods followed, and also based on the principles of hedging and strategies they pursue. 'Hedge fund' was a term used in 1949 to describe a business that Alfred Winslow Jones created. The business operation consisted mainly of reducing future risk by buying currently undervalued stocks and 'simultaneously short selling' overvalued stocks, and because of the possible future differences of the prices of either equity the profit could be made. (Brouwer, 2001, p. 9)

To meet the short selling criteria thus the seller 'borrows' from the market with a promise to repay at a future time and this along with the use of what was called the gearing or leverage led to the creation of more and more hedge funds. It is difficult to exactly define what a hedge fund is because there are funds that do hedge but do not fit in with the rules of hedging. A hedge fund thus can be described as "A hedge fund is a regulated instrument -- created by a firm or company that may charge incentive fees for generating returns in diversified portfolios not correlated with the returns from the stocks or bonds that is used for investment." (McCrary, 2004, p. 26) Retail investing refers to the public at large participating in the hedging of financial stocks with little capital. The basic requirements may be high, but still the public buys and sells the hedged funds on a small -- lot or retail basis. The question then is retail investing in such funds proper? In fact retail hedging is done by financial entities today.

Retail Investing and the Type of Funds

The retail hedging today is a function of banks. They are bound to provide information to the customer on the basic amount, interest rate, entry load and maturity. The major issue is the ability to come up with the funds at the appropriate time. Considering the precarious nature of banking, this is an issue and hedging business is not for every bank. To provide the hedging services the bank has to have a very big capital structure with some cushion investments as a fall back when the monetary pressure gets high. (Khambata, Dara. 1996, p. 205)

There is a possibility that bank may have to buy the securities or give bridge financing to the hedge operations to avoid collapse. Hedging provided by banks is a service to customers including that of investment banking. Banks that operate in these sectors have to look out for steady income based on high-volume, specialized business. Hedge funds are similar to mutual funds in the sense that they are also investment vehicles that is pooled by a lot of retail or small investors, and are operated using the publicly traded securities. The hedge fund and a mutual fund are different in the sense that while the mutual fund investing has to follow a rigid investment pattern the investors of the hedge funds allow the fund managers to follow what they may see as the absolute return strategies. (Harper, 2009)

Thus though the mutual funds also use hedging principles they are relatively safer for the small investor. The difference can be seen that while the mutual funds seek relative returns with a completely predefined operation strategy and the returns are tied to some index or benchmark, the hedging funds are based on seeking the absolute returns and this without any consideration of either performances of indices or benchmarks. Hedge funds have more inherent risks with short selling, trading in derivative instruments and is suited more to the bear markets. "In a bull market, hedge funds may not perform as well as mutual funds, but in a bear market - taken as a group or asset class - they should do better than mutual funds because they hold short positions and hedges." (Harper, 2009)

Financial debacles in hedging -- especially concerned with the operation banks arises when there are mismatches between maturity dates and rate sensitivities of all assets and liabilities on the balance sheet. Normally there must not be a disparity between the maturity dates and interest. Banks offset their financial pressure by establishing a futures position to contain the rate fluctuations. But the financial markets are highly volatile and the international banking activities are very risky with the high volume of operations and low profit. The problem with the retail uncertainty relates to the financial institutions with the growth of the spreads, and the huge amount of speculative transactions has made banks fragile. That is why banks as financial facilitators to hedging are themselves using the concept of hedging to protect the banks from future risks. (Khambata, 1996, p. 223) the hedging by banks as a retail participant does not eliminate the risk to other participants. Retail participants could be the household investor, speculators and those who deal in the commodities or investments that could be hedged. Is retailing a better solution? The hedging operation in the market has a lot of issues that must first be seen.

Hedging Markets and its Issues

Hedge funds are dynamic and volatile operations that are based on market fluctuations and premises based on the future. Many researchers have studied the behavior of hedge funds and have provided some interesting insights. For example using a number of commercial databases for the analysis of aggregate hedge fund-index returns for 7,924 individual hedge funds from 1977 to 2007 it was found that the hedge fund returns have a serial correlation. This appeared to show that the fund manager's returns are predictable, but this must not have been because the properly anticipated prices fluctuate randomly. This could have also been the result of many illiquid securities in the fund, like a security that is rarely traded and such securities may actually make the analysis bad. (Lo, 2010, p. 64)

One of the problems that the retail investor may face is the problem of identifying the ideal fund to invest. There is a popularity of hedge funds but the performance of the funds in the long run. The reason may be because of volatility, and errors by portfolio managers, and the change in the absolute returns. The mutual fund industry grew because of the theory of portfolios which promised absolute returns with investments being diversified minimize risks. The retail markets grew with the perceptions of the benefits of diversification. This also had the development of many new investment strategies going for the new financial market because of its dynamic and predictive nature, the investment strategies could not be static and many index of active investment like the portfolio-return and benchmark-return and the use of predictive analysis to foresee certain market trends well in advance was the edge to the investment manager. (Lo, 2010, p. 168)

It has to be noted that there are dangers in this type of investment and this can be noted in the financial crisis of 2007 -- 2008 that nearly wiped out the hedge fund sector. The investments may either become frozen, non-existent or illiquid that may cause the loss that is extreme, and for this the managers of funds have what is called the gate option that allows the managers to unwind positions such that value is preserved for all investors. Thus the gated investors will be at the receiving end of risks that are not appropriate. Some suggestions to overcome these problems are to include a futures-overlay strategy where the investor's gated assets are hedged out or shaped to satisfy specific constraints from the moment an investor submits his redemption notice to the day when his assets are fully paid out.' (Lo, 2010, p. 303)

But these strategies do not take away the probable and highly possible loss and great risk in the hedging of funds for the investors. The alternate solution is to see that the financial service provider or the hedge fund manager is made to invest only in those investments that are highly volatile and have a chance of remaining liquid under any circumstance. These may include most liquid stocks, stock index, bonds, interest rate hedges and currencies. In modern markets the commodities and currency forward contracts are the most liquid futures available. The optimal choice in this argument thus is currency and currency futures, because these are the most liquid and most volatile in the market. (Sparkes, 2002, p. 117)

Today the society expects that the investors also invest in social capital. The investors have responsibility to invest based on the social needs. The retail investor, can for example is thus a person who buys socially responsible unit trusts or mutual funds. Actually the investment that is being touted as responsible investment is the work of socially beneficial institution like pension funds, and some charitable foundations. Normally the institutional investors do not enter the socially responsible investment scenario. Of late however the new approaches to fund investment by the institutions have bordered on social concerns. The issues of institutional investment are more complicated and diverse than the retail funds. (Sparkes, 2002, p. 117)

There are many other investment opportunities available to the retail investor without incurring the risk but at the same time gaining efficiency in value without hedging. The retail investors thus are better off in those segments and hedging must not be opened to them. There are ample other investment portfolios that offer similar returns without so much risk. The cost of operation, entry cost and exit costs are also less.

The Arguments

The hedger stands to gain if the assumption made was correct and shall sustain loss if the assumption was wrong. The question is if retail trading in this is good? The answer can be found if it is explored who could be the retail investor. Setting aside the fact that institutional investments and individual investments are different and considering them as the same entity, the only difference we can see is the risk bearing capacity. The institutional investment has capital back up and the reverses can be sustained. On the other hand the individuals and groups of individuals who buy small lots and speculate with greater margins will end up in penury at a small change in the volatile market overnight. For investors in the retail segment therefore there must be the enforcement of the regulation regarding the net worth guidelines, where the investor cannot trade without an asset that is shown as a backup to a prefixed amount. (Barnes, 2007)

Regarding regulation, the Securities Exchange Commission -- SEC in 2007 was of the opinion that hedge funds will generate better diversification benefits. The retail hedge is put under severe restrictions to protect the investor and these funds managers are expected to apprise the investors about the risks on a daily basis. They are also to be audited by securities regulators. While the Global Investment Performance Standards -- GIPS exist as guidelines for mutual funds, there is yet to become a proper standard for hedging. So far only institutional investors have used the hedge fund investments because they can benefit from the diversification of funds from the underlying fixed assets. (Barnes, 2007) to retail such a risky thing to an unprotected investor who cannot appreciate the nuances of the risk and the dangers inherent is bad policy.

Conclusion

Therefore taking into consideration that hedge funds have more inherent risks with short selling, trading in derivative instruments and is suited more to the bear markets, the determination of which is a very specialized affair, and the investment is a risk based on market fluctuations and premises based on the future, the retail investment is not advantageous. The retail investor has other instruments that avoid incurring the risk but at the same time these portfolios that offer similar returns. Hedging is beneficial to the institutional investors on account of diversification of funds from the underlying fixed assets. They have less chance of instability with market reversals. It is opposite in the case of the retail investor. Hence retain investing in hedge funds is not advisable.