Ask Money

Hedge funds 101

Scott Jagow May 31, 2007
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Ask Money

Hedge funds 101

Scott Jagow May 31, 2007
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TEXT OF INTERVIEWSCOTT JAGOW: For most investors, hedge funds have been off limits. You need a million bucks to get in. Well, not anymore. For the first time, a hedge fund will offer shares on the New York Stock Exchange. The Man Group says anyone with $2,000 can buy shares. Of course, you should read the fine print about hedge funds. Our economics correspondent Chris Farrell has more on that.

CHRIS FARRELL: The typical structure is hedge fund manager gets 2 percent of assets alright? That’s their fee. And then they get 20 percent of the profit. So you’re really smart, this guy he really knows how to run a hedge fund, so you get more and more money. All of a sudden, your business changes. It’s no longer about being smart in the market, it’s about getting as many assets under management as you can. If you get a billion dollars, and you get 2 percent of a billion dollars, you’re doing OK.

JAGOW: Yeah that’s not bad.

FARRELL: You get $5 billion, you’re bidding for Van Goghs. And then this 20 percent, what’s the incentive? Why not take some big risks? Because if I win I get 20 percent, if I lose I still get my 2 percent of $5 billion. And you know my investors . . .

JAGOW: Well they get, pardon me, screwed don’t they?

FARRELL: Exactly. They do. It’s reminiscent, it’s not an exact parallel to the savings and loan debacle.

JAGOW: You’re gonna have to explain that one.

FARRELL: Alright. We deregulated the thrift industry, the savings and load, so they could take a lot of risks. And some very smart operators — hmmm, sounds familiar doesn’t it? — smart operators realized that you could run a savings and loan and take big risks. If you invested in junk bonds or takeovers or all kinds of risky operations and the investments did well, you pocketed a lot of money. Did poorly? You turn it over to the government and the taxpayer. So it was, in a way, heads I win . . . tails you lose, right?

JAGOW: But in this case the government isn’t backstopping this.

FARRELL: Now with hedge funds that’s the big difference, the government isn’t backstopping but it is the teachers, the pension funds, the institutional investors and that is the “who loses.”

JAGOW: But they know that going in, they know how risky it is, so why are they doing it?

FARRELL: There are two things going on here. One is the time-honored greater fool theory. Everybody believes they’re smart enough to get out of the game, pass it on to the greater fool before it all comes to an end. And the other one, which I actually think is the more powerful theory, is herdlike instinct. ‘Everybody’s going into hedge funds.’ And John Maynard Keynes, the great economist, as he said: It’s better to fail with everybody else than to be right and go against the grain.

JAGOW: Alright Chris thanks a lot.

FARRELL: Thank you.

JAGOW: Our economics correspondent Chris Farrell. In Los Angeles, I’m Scott Jagow, thanks for listening.

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