The dictionary definition of the word hedging says that it is a way to minimize or protect against loss by counterbalancing one transaction against another. This suggests that it would be logical to assume that a hedge fund would be a relatively safe medium. History, however, suggests that some hedge fund managers use a different dictionary than the rest of us.
Historically, some hedge funds have been exactly the opposite of conservative. Security regulations acknowledge the practicality of hedge fund activity through stringent controls that include suitability requirements limiting participation to investors with substantial assets.
Despite the connotation of the word hedge, hedge funds have been in the middle of several financial storms, including the most recent credit problems.
In 1998, Long Term Capital Management (LTCM) was the kingpin of the hedge fund world. Starting in 1996 with slightly more than a billion dollars, two years later the fund had leveraged its operation to more than $124 billion. At its demise, the fund ended with a nearly $5 billion net loss but not before creating sufficient financial turmoil that the Federal Reserve with a major helping hand from major bank had to step in to calm the entire U.S. credit market.
The LTCM problem and others like it have given hedging a bad name. However, hedging done correctly does not have the negative connotation some hedge fund activity implies.
Financial hedges come in many forms. Businesses find that some of them are critical. Importers or exporters want to make most of their money on the production and sale of their products. Currency fluctuations, however, complicate the process. To get the currency factor out of their profit equation, the companies often buy or sell foreign currency futures contracts that precisely match the time their products are exposed to potential currency risks. Correctly done, these hedges can assure a profitable transaction that is not adversely offset by a currency change.
In securities, theoretically a perfectly structured hedge in which one side of the transaction exactly offsets the other removes all the risk in a transaction, but it also eliminates all the profit potential.
There is a happy medium, however.
Homeowners hedge against a major decline in the value of home through the purchase of insurance. No one really wants to have to collect on a major insurance claim, but if a fire, storm or other unexpected event occurs, a comprehensive insurance contract can completely offset a potential loss.
Oddly, few investors consider using a form of insurance on individual stocks or a portfolio -- yet unforeseen circumstances can have as much adverse effect on their value as a sudden severe storm or other calamity can have on the value of a home.
Part of the resistance to financial insurance probably stems from the need to spend additional money on top of the cost of an individual stock purchase. Oddly, however, most people think nothing of spending additional cash on home insurance.
Put options, which allow the holder to sell a stock at a fixed price through a specified period of time, are a simple form of insurance. Like any insurance, this protection device needs to be renewed periodically. Premiums also vary depending on the perceived likelihood that the holder will exercise his rights under the contract, but this is no different than homeowners insurance that can cost more or less depending on the likelihood of a claim.
A somewhat recently developed series of Exchange Traded Funds (ETF) offer the potential to hedge entire portfolios. Dubbed inverse funds, these ETFs are designed to move in exactly the opposite direction of a specific market index or average.
It always is important to read the terms and conditions of any insurance contract. Likewise, it is important to understand thoroughly how financial hedging vehicles work, including some of their tax consequences.
No one normally wants a perfect financial hedge that removes all profit potential, but understanding and successfully applying financial hedges might help you rest easier during periods of excessive market turmoil.
