Benefits of Hedge Funds

The two primary benefits hedge funds provide (externally of the fund itself that extends to financial markets) is they give necessary liquidity to markets that are otherwise illiquid by investing in rarely-traded instruments and secondly, they provide risk diversification that is not possible with more traditional stock and bond investments. A hedge fund’s diversification leaves only systemic risks (market risks). This risk cannot be diversified away. Other benefits of hedge funds are helping mitigate excessive price swings by taking small gains or losses and consequently, reduce the bid/ask spreads and market volatility.

Internally (within the fund itself), it is the potential to reduce portfolio risks by investing in non-financial commodities (oil, grains, futures, interest rate swaps, stock options, indexes, credit risk swaps, mortgages, currencies, etc.). This flexibility to invest in other vehicles gives hedge funds the potential to produce returns in up or down markets. This flexibility when combined with the specific skills-based strategy of the fund manager gives hedge funds their everlasting allure to investors. This is the compelling argument for hedge funds. A prime example of this is the Thames River Fund (a fund that invests in other hedge funds) managed by Mr. Ken Kinsey-Quick. It had sold short the sub-prime mortgage sector since last year and this year reversed itself by buying the same cheap sub-prime assets.

Hedge funds have recently found themselves a new role – that of instigators of management change. Because funds always maximize the returns on their investments, they now take an “activist” role in the management of the firms they had invested in. They do this in many different ways but primarily, they demand that either management adopt their suggestions of improving company performance (and hence returns) or they will gather proxy votes during stockholders’ meetings to vote out the current management officers whom they view as not performing up to par. Managers of hedge funds are generally against so-called “managerial capitalism”, a situation that was also denounced by economist Adam Smith back in 1776. It is an agency problem that arises whenever one person allows another to act in his behalf as agent. This situation is true where shareholders allowed senior management (as their agents or proxies) to supposedly act in their best interests which sometimes do not happen. A glaring example of management not acting in the best interest or exercising “anxious vigilance” is when managers vote for themselves high salaries despite mediocre performance to the detriment of the shareholders. This activist style or role has engendered some positive changes and boosted performance.

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