In Defense of Hedge Funds

At the heart of this hysteria is a complete ignorance of what hedge funds really are, both among the regulators who oversee them and the financial media that have, in recent weeks, whipped up a panic about how hedge funds threaten to disrupt financial markets world-wide. So let's start by simply defining the term: A hedge fund is a pool of money pledged by "accredited" (read: rich) investors and managed by a general partner. While most people assume that hedge funds trade frequently and make big bets on financial esoterica, the truth is a hedge fund is a legal structure, not an investment technique.

So while the media routinely characterize hedge funds as "risky" or "highly leveraged," the reality is hedge fund strategies, just like mutual fund strategies, run the gamut from the ultra-conservative to the highly volatile. Some funds use high levels of leverage, others sit in cash for months at a time. Some employ complex spread trades, while others simply buy and sell stocks. Just knowing someone runs a hedge fund tells you absolutely nothing about how it's run. What matters are the strategies, positions and discipline that the manager uses to maximize the money.

Yet that reality hasn't stopped one of the more ignorant perspectives regarding hedge funds from spreading like wildfire. Thanks to the negative media coverage, there now exists the notion that hedge funds are ticking time bombs, recklessly leveraged and dangerously allocated portfolios just teetering on the verge of throwing international markets into a near meltdown.

It's a perspective that's fueled by a new breed of sloppy journalism that makes Newsweek magazine's Koran desecration story look like the Oxford English Dictionary. Business reporters now attribute just about any financial occurrence to those pesky and uncontrolled hedge funds. Oil prices high? Must be the hedge funds cornering crude. Tech stocks falling? Must be the hedge funds selling them short. They've become a convenient media scapegoat for every market move.

Most recently, it was the carnage in General Motors (GM) that was falsely attributed to hedge funds' influence. And while many funds certainly lost money trading GM's equity and debt, so did thousands of other investors, ranging from institutional pension accounts hedged with derivatives to Midwestern Ma and Pa Kettle's 100 shares of common stock. And despite the fact that the size of assets controlled by hedge funds is still dwarfed by those controlled by mutual funds and other investors, the press has become quite comfortable with attributing every market maelstrom to this woefully misrepresented group. Because hedge funds are required under Securities and Exchange Commission regulation to keep a low profile (more on that in a moment), they are never able to clearly respond and silence the rumor, innuendo and gossip that now passes for legitimate reporting.