Friday, January 15, 2010

1. One commenter on my blog does not think the hedge funds are doing anything wrong. That depends on what one considers to be wrong.

2. Hedge funds works on borrowed money. That is quite normal and acceptable. But they borrow anything up to thirty times the funds held by them. Ordinary investors cannot do this.

3. Investors therefore have to invest in hedge funds in order to take advantage of the borrowing capacity of the funds.

4. If an investor invests 1 million dollars, the hedge fund can borrow 30 million dollars. With this 30 million the hedge funds can invest in a variety of shares etc.

5. Obviously when the shares yield returns they will be 30 times the return on the 1 million invested with the funds.

6. After paying interest on the loans and subtracting the commission due to the managers of the funds there would still be a lot of profits left to pay to the original 1 million dollar investor. Paying this investor a 20% – 30% return on his 1 million investments would be well within the amount earned from the 30 million investments.

7. I am simplifying the example a little but essentially this is what happens. The savvy fund managers, very knowledgeable about the market can also guarantee the return on the 30 million and certainly the high return on the 1 million.

8. But supposing the investments by the fund result in a loss, the amount lost would also be 30 times more than the losses to be sustained by 1 million investment.

9. Assuming that the loss is 5%. On 30 million it would amount to 1.5 million. The loss cannot be met by the original 1 million investment. If the interest and other charges on the 30 million is added, there is no way for the hedge fund managers to cover the losses. That is when the 1 million investment would be lost. Orange County in California was bankrupted in this way by the investment in the hedge funds.

10. The operation by this hedge fund is legitimate. It can result in huge returns for the investors. It can also result in the investor becoming bankrupt. In America it has contributed to the financial crisis plaguing it today.

11. Whether we consider the investment through the hedge fund is good or bad depends on us. If we don’t mind the collapse of the financial institutions then it is good. But most people regard the current financial meltdown as bad.
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