Tuesday, August 02, 2005

Hedge funds

Aug. 2, 2005
Hedge fund investing –

Here is my personal view about hedge funds. After learning about what it is and mulling over the long term implications of hedge fund investing, my conclusion is that it is not a good idea and does not contribute to the good of capitalistic society.

To understand where I’m coming from, I first have to explain what investing is in general.
To me, investing in stocks and bonds and mutual funds is an integral part of the capitalistic system. In order for things to be build and progress made, we need capital. These companies take risks and raise the capital they need to expand their business. The people invest in these companies also assume the risk. If the company is successful, then we have a win-win situation. The company profits, the individual investor profits and society reap the benefits. Of course, if the company does not do well, it can suffer losses
and eventual bankruptcy. In this case, the company close shop, the investors lost his savings. The difference is that society does not necessarily loose anything. The reason is the power of free enterprise and open competition. When a company looses because of poorer products and miss management, the system penalizes it as a manner of normal process. This way, free competition shapes the activities of all players for maximum profit and efficiency. A company that cannot compete should go out of business.

Therefore, the idea of allowing people to short stocks and buy options of puts and calls is a distortion of this basic investing principle. In my mind, this changes the whole process of investing from technical analysis to a form of gambling. Instead of playing by the rules, working hard, doing the homework and make money the hard way. Some ingenious people on Wall Street have invented a scheme whereby someone can make a fortune by betting against a company or in some cases against a country when dealing with currency trading. What it comes down to is this – a company’s fortunes is taken out of his own control but may be manipulated by a few for their own material gains. Under this scenario, for example, a company who is doing well or just average may be subject to external attacks that can cost both the company and their investors havoc. The winners in this case may be a few that has a lot of money at hand and the losers are the company, their employees, their investors and society as a whole. This is contrary to any sense of justice and fair play. I believe in the basic tenet of capitalism but I do believe there should be some limited amount of government regulation. A good example is laws that prevent monopoly from taking hold. This stifles competition and is not good for all.
In this case, I do believe some amount of regulation should be instituted to take the gambling element out of the equation. Think about it, a company can be destroyed by the basis of a rumor, spread by some individual, causing the stock to tank and the individual profit from shorting that stock. All this happening without any real facts or basis. Is this right? Another basic tenet of capitalism is that it can only survive if the people involved operate under some basic sense of morality and fair play. No among of laws and enforcement can legislate basic morality. If no such rules of behavior exist, then capitalism will fail. The end will justify the means and survival of the fittest and meanest will rule.

Suppose on Sept. 10, 2001, you would acquire some knowledge about the terrorist plot.
You do not have the power or detail to stop it or prevent it from happening.
Would you profit from this information by shorting the stock of the Airlines?
It is a moral dilemma isn’t it? You can rationalize that it was going to happen anyway, and why not make a killing? You can go even further by rationalizing that you can use some of the profits to help the victim’s family. Does that make it OK?
If society does not allow shorting of stocks, then it removes the temptation for some to act in a selfish way. This is the best argument against these types of investments.

On the other hand, if hedge fund was intended to reduce volatility of the stock market, and help stabilize a panic public, then it could be a good thing. For example, in the post 9/11 scenario, if some hedge funds were to buy some companies that were in free fall due to the temporary panic, then it would have made money for their investors and at the same time help stabilize the market. If a company is basically sound and has great balance sheet, there is no reason why a terrorist act should disturb the long term profitability of that company.

In my perfect conservative world of investing, I would not allow shorting of stocks, options trading and trading on margin. I would also aggressively go after inside traders and financial advisors that pump and dump stocks. Day trading should be discouraged. All of these are detrimental to the small investor. I believe in a level playing field. If someone is willing to pay a fee for a fund manager to actively trade in some stocks, that is fine by me. The perspective should clearly state their investment goals and the risks and all fees should be explained up front. It is almost criminal for some funds to charge a fee for getting out of the fund (back loaded funds).

A responsible government should not allow greed to destroy our financial institution and turn investing into a gambling game as it exist today.

-Jack Lee