T A B L E__T A L K Too much stuff! Are you suffering from "affluenza"? Share your thoughts on overconsumption in Table Talk's Business and Personal Finance section R E C E N T L Y Rooting for the crash By Dwight Garner Retirement fund be damned, this market watcher is looking forward to the end of the Wall Street boom (10/02/98) The grueling world of work By Heather Chaplin Bagels on Fridays, teammates and jovial bosses can hide the ugly truth (09/25/98) Move over, Susan B. Anthony By Lance Gould Sacajawea and a new tribe of currencies are on the loose (09/18/98) Gluttons for a crash By Heather Chaplin Why so many investors are riding high on the new market lows (09/11/98) Separate checkbooks By Hank Hyena and Carol Lloyd Married but not sharing (09/04/98) - - - - - - - - - - - - - - - - Browse the Reluctant Capitalist archives - - - - - - - - - - - - - - - - Salon Columnists S A L O N E M P O R I U M FREE! 12-ounce bag of Salon Blend with a purchase of $30 or more. While supplies last.		[ T H E_.R E L U C T A N T_.C A P I T A L I S T ]________ While the world's mega-players bail out a wrecked hedge fund, one befuddled reporter tries to figure out just what these arcane vehicles actually are. __________- - - - - - - - - - - - - - - - BY HEATHER CHAPLIN The story of the hedge fund that borrowed too much, gambled too freely and considered the consequences too little has been spinning its ugly tale across the front pages of newspapers for two weeks now. As with any good debacle, the Long-Term Capital Management disaster has left the public bewildered and shocked, the pundits outraged and thrilled and industry insiders both furious and scared. Politicians have called for reform, celebrity commentators like James Cramer of theStreet.com have called for punishment and reporters have speculated on the future of the industry. Amid all the intrigue and the unfolding of unsavory facts, I have found myself asking one question again and again: What the hell is a hedge fund? If anybody knows and can explain it clearly, please call me. Although I'm rumored to be a business reporter, I have only a scant notion of how those mysterious entities known as hedge funds work. That I have even a scant notion is actually a new development, thanks only to the Long-Term Capital story, which made me sick in the way only news stories about rich people screwing up and being rescued by their buddies can, but also curious about the mechanics of their moneymaking schemes. I received some encouraging words from a friend who's been a business reporter since before I was born. Hands clenched like claws above my keyboard, aching to type something that made sense, I begged her to help me. She said, and I paraphrase: Give it up. Nobody understands this stuff. She told me she'd tried -- once -- to write a story on derivatives, an important concept in understanding hedge funds, and spent a full month on it before realizing the futility of the project. So now I resent the guys at Long-Term Capital even more. Not only do they appear to be a bunch of gambling-addicted sleazeballs, they also forced me to embark on a learning journey that's left me with a headache the size of Long-Term Capital's bail-out package. Hedge funds are difficult to understand because they are slippery by nature -- loosely defined, largely unregulated and not for the likes of you and me. The fact is, hedge funds are bound together by only three characteristics: members are rich, managers are compensated with a thick slice of the profits -- usually about 20 percent -- and government oversight is minimal. Unlike mutual funds, which are public offerings and must follow guidelines set down by the Securities and Exchange Commission, hedge funds are private partnerships between fund managers and clients. As such they can slip beneath -- or rise above, depending on how you look at it -- many of the safeguards the government has developed over years of market turbulence for other investment vehicles. Freedom from regulation allows hedge fund managers to follow investment strategies that would otherwise be forbidden them, such as leveraging (borrowing money to increase the profitability of bets) or short selling (borrowing stocks expected to take a downturn, selling them at the high and then returning stocks purchased at a lower rate). Contrary to public opinion, however, hedge funds are not all risk-crazed, currency-smashing Goliaths. Just as mutual funds specialize in different kinds of investment strategies, so too do hedge funds take a wide variety of shapes and sizes. They can specialize in areas as mundane as stocks or real estate, and they can specialize in strategies as risky as investing in the equity or debt of emerging markets. The funds that get all the press tend to be of the riskier variety. For example, George Soros' Quantum, probably the most famous hedge fund in the world, has been called nasty names by global leaders, accused of demolishing the Malaysian ringgit and bringing down the value of the British pound. Quantum is what's known as a "macro hedge fund." Macro hedge funds try to profit from changes in global economies. Often they take positions on a country's currency based on their analysis of the country's economic fundamentals. If they think a country can't sustain its exchange rate, for example, they'll bet on the currency's devaluation, usually by selling it short, or using complicated derivatives, which serve as the functional equivalent of short selling. Not all hedge funds indulge in this arcane stuff. Some are more conservative than your average mutual fund and do no short selling or leveraging; the key is they have the option to. The name "hedge fund" actually comes from the idea of "hedging" your bet, i.e., reducing your risk. The idea behind hedge funds, which started in the 1960s, was to work with alternative investment strategies in order to cover your bases in the event of a market downturn. For example, hedge fund managers would short certain stocks to protect against a downturn and simultaneously borrow money to buy undervalued stocks in case of an upturn. This way they were covered no matter where the market went. Too complicated? Here's something easy: Hedge funds, on average, have outperformed mutual funds for the last nine and a half years, according to Van Hedge Fund Advisors International, a Nashville, Tenn., investment advisor. As of June 1997, hedge funds averaged annual returns of 17.6 percent, vs. 14.5 percent from equity mutual funds. All right, sign me up, you say. So what if some emerging nation's population is plunged into poverty because my manager drove its currency into the ground -- how do I get on board? There's the catch. Part of the justification for these funds' lack of regulation is the fact that, in the parlance of the industry, only "sophisticated" investors are allowed to participate. This does not mean your hedge fund manager will require proof that you know the difference between a salad fork and a dinner fork. "Sophisticated" is a not-so-subtle euphemism for "rich." Most hedge funds require you to be worth at least $1 million and willing to invest at least $250,000 upfront. Many require you to be far richer. Long-Term Capital required investors to ante up a minimum of $10 million. Not surprisingly, a lot of hedge fund money comes from large institutional investors. Which is not to say there aren't enough millionaires out there to have pushed the industry's capital up sixfold since 1990 to $300 billion at the end of last year, according to a recent report from Cerulli Associates, a Boston consulting and research firm. In addition, the number of hedge funds has more than doubled in that time to roughly 4,500; a quarter of these funds have assets of less than $10 million and only 5 percent have assets of more than $500 million. So how did Long-Term Capital get into so much trouble? It started about four years ago, when John Meriwether, former star bond trader with Salomon Brothers, opened the fund in Greenwich, Conn. With the help of two Nobel laureates, several billion dollars in capital and billions more in borrowed funds, Meriwether began betting on everything from Danish mortgages to British interest rates to Russian bonds to American stocks. In a nutshell, he lost too many bets. The general consensus seems to be the fund was risking too much money in areas in which it didn't have enough expertise. It got hit by the emerging market meltdown, Russian troubles, the U.S. stock market decline and a merger it was betting heavily on that didn't pan out. Before it could crumble, though -- no one seems sure of the fund's liabilities, but suffice it to say it was a whole lot -- a group of its investors, lenders and trading partners put their heads together. Shepherded by the Federal Reserve Bank of New York, 14 firms, including monster players like Goldman, Sachs & Co., Merrill Lynch, UBS of Switzerland and J.P. Morgan, each agreed to pay between $100 million and $350 million to infuse Long-Term Capital with cash. The total bailout -- all from private sources -- has been estimated at $3.7 billion. Why the life preserver? Supposedly the fund's collapse would have ignited a brush fire capable of spreading around the world and scorching the earth's financial markets in its wake. For many, this was an unpleasant scenario, requiring some interference. Those people say we should be grateful for the rescue, thankful it was accomplished without public funds and cognizant that it was our collective butts snatched from the flames of burning financial markets. I have my doubts. It may just be me, but I think there's something sketchy about a private enterprise whose sole purpose is to make the rich richer wielding that kind of power over all the rest of us. Of course, nobody knows exactly what would have happened if Long-Term Capital had been allowed to fail -- except a lot of very rich people would have lost a lot of money. And I guess that's an even bigger no-no than meddling with our beloved free market. SALON | Oct. 9, 1998