IE 11 is not supported. For an optimal experience visit our site on another browser.

What is the deal with hedge funds?

The financial storm that swept through the credit markets in the past two weeks involved a cast of characters that included a somewhat mysterious entity known as a hedge fund. Which left many readers wondering: What exactly a hedge fund? Answer Desk, by's John W. Schoen.

The financial storm that swept through the credit markets in the past two weeks involved a cast of characters that included a somewhat mysterious entity known as a hedge fund. Though the markets seems to have calmed down a bit, and the dust may be settling, many readers are still wondering: what exactly is a hedge fund?

What is a hedge fund?
Paul Stanwood, Washington

Hedge funds aren’t what they used to be — and not just because some of them have just lost boatloads of their investors money.

The original ancestors of what we now call hedge funds were a specialized form of investing that placed a very specific kind of bet — looking for opportunities to “hedge” one investment with another. Unlike a mutual fund, which buy stocks and holds onto them hoping they go up, hedge funds also sell stocks short, buy futures contracts to offset risks and use an increasingly complex set of derivatives — a specialized breed of financial instrument, many of which were invented to help investors hedge the basic risks of owning a stock or bond outright.

For example, if you’re holding a lot of stocks that are included in the S&P 500 index, you might take a short position in an S&P 500 futures contract. (Short sellers sell something they’ve borrowed hoping to buy at a lower price when they have to give it back — or “cover their position.”)  If the index goes up, you win on your stock bet. If it goes down, you win on the short sale of the futures contract. Since many of these bets rely on relatively small price moves, some hedge fund managers soup up their returns with borrowed money.

Along the way, these funds developed a number of different strategies. Today, the phrase hedge funds refers to one of thousands of funds that are unregulated (they don’t report their holdings) and generally restrict their list of investors to wealthy individuals or other big investors like insurance companies or pension funds that, presumably, understand the risks and can afford to lose money.

The expansion of hedge fund strategies also brought on an ever-expanding basket of financial instruments — some of which don’t actually change hands very often. Subprime mortgage-backed securities are one example. By pooling otherwise risky mortgages into different classes of bonds — with strict rules on which of those bond investors get paid first — the theory was that, even if some of these borrowers went bust, at least some would keep paying, so the investors who were guaranteed a place in the front of the line were a lot safer than those at the end.

But since these mortgage-backed bonds mostly sat idly in hedge funds and other accounts once they were sold — and didn’t trade in the open market like stocks or bonds — no one really knew what they were worth. So computer models set the price. Instead of letting the market assess risk and “price” these bonds, buyers relied on a complex chain of analysis. Credit agencies assigned three-digit FICO scores to mortgage borrowers; bond rating agencies reviewed the documents setting out which classes of bonds got paid what and graded them for risk; fund managers ran their risk scenarios that were supposed to show what would happen if the bottom fell out of the market.

All went well for years. In fact, things went a little too well. Before long, the buyers of these bonds felt the risks were so well-managed they bought them with almost the same level of confidence they gave to the safest bonds like U.S. Treasuries. Riskier bonds are supposed to pay higher interest rates to make up for the risk that you’ll lose your money. But as of a few months ago, these mortgage-back bonds were paying only a small “premium” to Treasuries.

All it took was a few high-profile losses from funds that invested in these subprime bonds for hedge fund managers and other holders to rethink how much their mortgage bonds were worth. And since many of these bonds were bought with borrowed money, lenders began asking for more cash to cover potential losses. Nervous hedge fund investors started asking for their money back. But as the market for these mortgage bonds dried up, fund managers had to sell stocks or other assets to raise money. That’s one reason the stock market saw such a sharp selloff this month.

But as the dust begins to settle, investors are still not sure if the storm has passed. Because hedge funds don’t have to report their holdings, it’s not entirely clear that the reports of big losses are over. Another big implosion could send the markets into another downward spiral.

It also won’t be known how badly banks that lent money to these hedge funds and pension funds and insurance companies that invested them have been hurt. The next round of quarterly earnings reports for big financial services companies aren’t due for another two months.

I am thinking of taking advantage of this downturn in the housing market and purchasing an investment property. I plan on renting out the property for several years until the market recovers, and then selling it for a nice profit. Is this a sound financial plan?
Ron G., Stafford, Va.

It’s not a bad idea generally, but the Devil’s in the details. And it's not as easy as those guys on late-night TV infomercials say it is.

Investors call this "bottom fishing" — and it can be a great way to pick up bargains. The hard part is figuring out when to buy. It’s not at all clear that prices have hit bottom — or when that will happen. Some home builders and analysts say it could take at least another year for the market to recover. If you buy too soon, you’ll risk seeing the value of your investment fall soon after you buy it.

You’ll also need to finance this purchase. Lately, the mortgage markets have gotten very tight — especially for so-called “jumbo” mortgages (over $417K). So your financing costs could turn out to be high enough that you can’t cover your monthly mortgage payment with rent. If you wind up with “negative cash flow” (mortgage and other costs are more then rental income), it’s going to be hard to make money.

A lot depends on how much you put down. Most lenders these days are looking for a substantial down payment, especially for investment properties. The more you put down, the more likely you'll cover your mortgage payment with rent. But then you’re losing the return you could make on that down payment by investing it elsewhere.

Your plan also relies on the market “recovering” in such a way that you make a nice profit on the rising value of the property. There’s no way to know, but there are also no guarantees that the housing market will return to the rapid appreciation we all grew accustomed to earlier in the decade. Many of those now getting washed out of the market got hurt because they were relying on ever-rising prices.

Finally, no matter what trends you see in mortgage costs or housing prices, real estate really isn’t one big market: It’s a collection of very small markets that move in different directions at different times. In any market, there are always some properties being bought and sold at prices that will allow you to make money. But most sellers these days are still holding out and waiting for prices to continue to rise. So it may be very difficult for you to buy a rental property at a price that can make you money.

Real estate can be a good investment in any market, but in times like these you really need to do your homework. There may be money to be made, but there's also still a lot to lose.