The Badger Herald: Opinion: Funds open to exploitation

Opinion

Funds open to exploitation

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Also by Mike Skelly:

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Funds open to exploitation (October 3, 2006)
Debate stifled by entrance of politics (September 26, 2005)

Tuesday, October 3, 2006 12:00 a.m.

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A few weeks ago, Amaranth Advisors LLC had a meltdown for the ages. Reminiscent of the collapse of Long-Term Capital Management in the late 1990s, Amaranth found itself on the wrong side of the futures market, losing nearly 65 percent of its total $9 billion in assets during the month of September. Trying quickly to salvage what was left of the fund, the company's officers looked for several strategic partners who could potentially buy out their positions, but as of now it looks as if the fund will have to liquidate its assets.

Amaranth's collapse came as a shock not merely due to the size of their losses, but also in part because of its prior performance. The Connecticut-based hedge fund had been one of the top performers in the world for the first half of 2006, making an astonishing $2 billion on natural gas futures. This result, coupled with the fund's performance from the previous year, had made the company's wunderkind energy trader, Brian Hunter, a Wall Street star.

Yet, in the midst of the success, it seems as if the company became too confident in its own strategy, taking far bigger risks in order to match the returns it had seen in the previous periods. Evidence of this comes from the revelation that the New York Mercantile Exchange held a meeting with the fund in August to warn them that they had created too large of an exposure to natural gas and that they would have to reduce the amount of contracts they had outstanding.

While the full repercussions of Amaranth's collapse will not be fully known for some time, it has certainly brought additional scrutiny to the subject of hedge fund regulation. After the announcement of Amaranth's losses, Connecticut Attorney General Richard Blumenthal said he was reviewing the case and cited the event as impetus for increased oversight of hedge funds. This comes in addition to a call from Congressman Mike Castle for an investigation into the risk posed by hedge funds to the national economy.

Even though cases such as Amaranth do highlight the risk of investing in complex investment vehicles, they do not necessarily signal a need for the increased regulation from the government over hedge funds. The purpose of a hedge fund is to allow sophisticated investors to use the gamut of financial products in order to create a higher return than those offered by more conventional entities such as mutual funds. While in the past, the sophisticated investors who used hedge funds were largely comprised of wealthy individuals who were assumed to be able to afford the inherent risk of the funds, increasingly there has been a large influx of capital from large institutional investors such as pension funds.

This poses a concern for the beneficiaries of pension funds, since they have little control over how their pensions are invested and count on those funds being available to them after retirement. Yet, even though this may be a problem for pensioners, this does not necessarily constitute a dilemma for the hedge fund industry itself. When representing a constituency such as a pension fund, the fiduciary responsibility lies with the pension fund itself, as opposed to the hedge fund in which it invests. Hedge fund managers should be correct to assume that their investors understand the corresponding risks of investing in hedge funds. If anything, this should signal to pensioners that there should be additional oversight of pension funds as opposed to additional oversight of hedge funds in order to ensure that pension managers are not taking excessive risks with someone's retirement fund.

Jim Cramer, host of Mad Money, wrote in an article appearing in New York Magazine that "the only governmental regulation we need is a prophylactic one: If you aren't rich or your clients aren't rich, you shouldn't be in hedge funds." While this might be an oversimplified answer to a fairly complex question, it does have a solid logical basis. Hedge fund investors should be comprised of those who can understand how the fund makes its returns, and with that knowledge, come to a rational decision of whether the returns outweigh the risks. With that in mind, the government should be mindful of additional regulations, if any, that they might make.

Mike Skelly (meskelly@wisc.edu) is a senior majoring in finance and political science.

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