Hedge funds have been in the news quite a bit lately with the now famous Gamestop short squeeze as well as the over-leveraged collapse of the Achegos fund. Both disasters have led investors to once again question whether such vulturous trading strategies should even be permitted. I felt much the same way until I travelled to Africa two years ago.
In Zimbabwe we had the opportunity to visit a vulture preserve. Given how most of us think about vultures, I wondered why anyone would want to preserve them. These ugly creatures circle, then devour other dying and dead animals. They are so disgusting that we refer to predatory humans as vultures. However, we learned during our visit of the critical role vultures play in the African ecosystem. Essentially, with their huge appetites they are natures’ cleanup crew, clearing the land of decaying animals and more importantly, disease. Dead animals carry many terrible diseases including anthrax, rabies and cholera. The acids in a vulture’s stomach make them immune to these diseases making them perfectly suited to their often-unappreciated role in nature.
Let’s return now to Wall Street’s version of the vulture, the hedge fund. Last week I wrote about how the markets are wisely designed to move capital to where it can be used most efficiently. It’s a wonderful system and has led to the strongest economy on earth because resources are constantly being moved to companies that produce the best results, and away from those who do not. But the system doesn’t always function properly. Sometimes inefficiencies, or even fraud creeps in causing prices in some stocks or sectors to be much higher or lower than they should be. Enter the hedge fund who may take a short position if a price is too high or buy on leverage if it is too low. In both cases the effect is to drive the price to a more efficient, or appropriate level. There are many, including myself, who have complained plenty about the practice of short selling, but it actually helps to keep markets healthy and properly priced.
Admittedly vultures act in their own self-interest as their only focus is satisfying their voracious appetites just as a hedge funds’ focus is on its own profits. But in the process, both play an important role. They provide balance to a system where an imbalance has occurred. Essentially a hedge fund helps clean up Wall Street where it has gotten out of balance.
Of course, being a vulture is not always a safe career. Hedge funds may take high risks to bet against the current trend and sometimes, as with the two cases mentioned above, they can pay a heavy price if the market fights back. I don’t recommend hedge funds for most investors given the risk level, but they do have their place in helping to maintain the efficiency of the markets which is so critical for the whole thing to keep working for the rest of us.
Hi, I'm Dan. I'm a CFP® Professional.
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