Betting the House In Hedge-Fund Nation

“Don’t gamble: take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.”

—Will Rogers

Yogi Berra couldn’t have said it better. This viewpoint is in accord with today’s thinking, which is to take your savings, spend money on a financial advisor, pick some stocks—preferably when they’re selling at a price they will never attain again—and then hold on for dear life as the college money for the kid evaporates or the retirement funds turn into steam and disappear into the thinnest of air.

We may soon have a new way of executing the Will Rogers personal-finance technique. According to The New York Times, which seldom errs, Fortress Investment Group is moving toward going public. If it does so, it will be the first hedge fund to sell stock in itself to anyone with a 401(k) and a hankering to live dangerously.

A hedge fund is a mutual fund on steroids. Hedge funds have been known to borrow money to buy stocks that the funds’ managers think are going to shoot up in price, something your ordinary, hokey-pokey mutual fund doesn’t do. More broadly, hedge funds take what seem to outsiders to be big risks. But the theology of Wall Street has it that hedge-fund managers are the smartest people around, endowed with mathematical talents of such Einsteinian dimensions, and able to develop formulae of such uncanny power, as to anticipate future price movements and so take the risk out of risk.

Or so, at any rate, we are led to believe. We small ones do not and cannot know much about what goes on with hedge funds, since—unlike mutual funds and other kinds of securities—these are not registered with the Securities and Exchange Commission, nor are they required to file much of anything in the way of reports. Hedge funds are none-of-your-damn-business private.

Hence, going public—as Fortress is considering—would be a 180-degree departure from past practice in the hedge-fund world. If Fortress were to go ahead, it would have to comply with a host of laws and regulations that it need not concern itself with now. In return for giving up its privacy and its protections against prying eyes, it would stand to make seven or eight billion dollars—which, even for a hedge fund, is not in the chump-change category.

Until now, the money for hedge funds has come from the very rich, who are the only individuals that fund managers have wanted to bother with, and sources such as pension funds and universities. Both government regulations and the managers’ preference have made it next to impossible for small investors—that is, people with a mere couple of million—to get in the door. Not that the funds appear to have needed the wee people’s contributions: Without them, hedge funds manage almost a trillion and a quarter dollars.

That’s enough money to move the world, but, in addition to the moneys given the funds to manage, they have borrowed who knows how much more money. It could be a couple of trillion more—or enough, if things go awry, to bring the financial cosmos down on all our heads. Eight years ago, a hedge fund named Long-Term Capital Management came close to doing that all by itself—but, like one of those meteors which almost hit Earth, the disaster was avoided at the last minute, although not without much pain in various places around the globe.

A few weeks ago, a hedge-fund operation called Amaranth Advisors succeeded in losing about $6 billion in six days by making what turned out to be ill-advised bets on the future price of natural gas. Various pension funds have taken it on the chin as a result of these losses, which constitute about two-thirds of Amaranth’s total worth.

You would think that people responsible for running pension funds would know how to avoid huge loses, but they often don’t because, as The Wall Street Journal explained, “pension managers—especially at public pensions—lack the resources, expertise and time to keep a close eye on the people managing the money. In some states, pension funds are run by underpaid civil servants who rely on consultants to allocate money. Others rely on advisory firms that invest in many hedge funds, promising diversification and charging additional fees.” This being the case for large investors, guess what fate lies in store for small individual investors looking to generate the money necessary to get little Sally through college.

In the past, even after the gigantic fees their managers charge, these funds have deposited super-sized gains for their investors. Those days, however, are apparently no more. Way back when hedge funds were a new idea and there weren’t so many of them, a 20 or 30 percent annual return on your investment, if you were lucky enough to have been allowed in, was to be expected. Of late, hedge-fund earnings to their investors are averaging less than half that number.

Since there are almost 9,000 hedge funds, it stands to reason that their performance, on average, would drop. Even on Wall Street, where fortunes are conjured up out of little more than guile and a tunnel-visioned talent for playing with numbers, that many winners is impossible. For the managers of these funds, however, new billions may be ready for the taking if they change course and start selling shares to the masses of small investors, who—doubtless inflamed by stories of hedge-fund riches—will buy them as fast as they appear on the market … for a while, until disillusionment and loss sets in.

Long before the idea of selling shares in hedge funds to the unwashed and unwary was bruited about, some people had been calling for government regulation of hedge funds—and, in the last few years, the Securities and Exchange Commission has made them cough up a certain amount of information about themselves.

Any regulation would involve prohibiting the funds from taking daring chances, but hedge funds came into existence to take chances that other closely regulated operations are forbidden to do. The rationale for leaving hedge funds alone is that only the big guys, who should know what they are doing, are allowed to invest in them—although, as cited above, sometimes the big guys don’t know either.

If protecting ordinary worker bees, driven into the financial markets to make up for the loss of pensions, etc., is what we’re after, prohibiting hedge funds from going public is easier than regulating them. Not that hedge funds are not crying for some looking into.

Beyond their propensity to borrow money to buy stocks—an inherently risky proposition—they are deep into the derivatives game. A derivative is a financial instrument based on nothing more than the movement of the price of something else over a stated period of time. It is a bet that something will or will not happen, backed up by nothing of value whatsoever. Derivatives are classified on Wall Street and in departments of economics not as gambling, but as “risk management.”

It is estimated, tra-la, tra-la, that there are over $200 trillion (that is “T” for trillion) worth of derivative bets floating around. When all goes well—which means when all goes according to the computer models—these bets more or less wash out, and we move on to buying and selling new derivatives. But sometimes things do not go as planned—especially in the business of managing risk, whether it’s financial or any other kind—and then there may be hell to pay: We may very well see a chain reaction of defaults that brings the heavens down upon us.

Something else to worry about; something else to plan for, if you can. It’s all just a bigger version of what Will Rogers told us to do anyway.