Hedgefunds agree that more transparency is required

Hedge funds, often portrayed as murky operations managing billions upon billions and working offshore with managers earning €100,000,000 a year. The truth is a little different, like in any industry the very top people make exceptional livings doing what they do, the average hedge fund is based around people working hard, and trying to ‘hedge’ their bets, or the bets of their clients.

However, this week at a hearing on the Hill, while being grilled by Congress they agreed that they “see the benefits greater transparency can bring to maintaining stable economies and a healthy global financial system”. It is probably worth talking about hedgefunds and what they do.

The concept is relatively simple, you buy long and short positions. ‘Long’ means that you buy it because its a good stock, or it has good dividend or it is undervalued etc. it is based on the same traditional reason you would buy any stock. ‘Short’ is the reverse, you can buy and sell shares, you can also sell and then buy, the seceond description describes ‘short selling’. So if you sold a share at €10 and then bought at €8 then you make a profit of €2. That’s a simple way of describing the process but its adequate.

You can also short sell using derivatives, this became more popular in the last decade, sometimes it would be using things like Credit Default Swaps (CDS) or Contracts For Difference (CFD’s), often these amount to no more than an insurance policy, however the growth in that market was exponential since the turn of the millennium.

How is a CFD an insurance policy? Well, a CFD normally has a buyer and seller side (when you hear about ‘counterparty risk‘ it is the danger that one side of the party doesn’t have the money to complete the deal- often firms try to hedge this risk too). Normally the seller will pay the buyer the difference in a certain price at the time the contract matures. If the difference is negative the Buyer pays the Seller. A quick example will help: you and me go into a CFD (and these are a tradable transaction) I am the seller and you are the buyer, the agreement is that the contract price is €4.00 (we won’t get into margin examples – i.e.: where you borrow money to magnify loss/gain).

If the price goes to €4.20 then the seller has to pay 20 cent on each share, if it went to €3.80 then the buyer has to pay the seller 20 cent on each share. So basically you are buying a set point in the price scale and betting on the movement of the stock. This is a form of insurance because I might do something like this: I buy StockX in the belief it is good, but just in case I also enter a CFD for the downside, I become the seller, that way if the stock does go down I make money and that is called ‘hedging‘.

Traditionally hedging was done by short selling, nowadays it tends to take place more and more in the derivative market, the actual CFD’s themselves can also be traded. Imagine if you bought an insurance policy for property (for this example its not for a certain address just ‘property’ in general) and then suddenly there was a fire coming towards the area you lived in, the value of that insurance policy would go up. Again, this is not the actual working methods of derivatives, more so its a way of explaining them that hopefully won’t send you to sleep!

Hedge funds are not murky or dodgy, and the claim that they were out to destroy banks by short selling is laughable, they only capitalised on weakened banks because of the position banks put themselves into. You can’t successfully short sell a strong company, banks take opportunities all of the time in their investment sides to short sell, it just becomes unpalatable when it happens to them! Short sellers are not the devil, they are a vital part of the market and they merely trade on a move in a different direction.

If we were betting on trains there are people who might favour northbound trains, others might prefer those heading south, one is not better than the other, they operate on the same number line but prosper on opposing movements.

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