Basically (Part 3)......
Hedge funds are periodically in the news, so let’s shine a light into that corner of the market beginning with a definition. When used as a verb, hedge means to limit or qualify (something) by conditions or exceptions. Since we know that a fund is a pooled investment strategy, we can see that a hedge fund is a pooled investment used to limit risk. Although incorrectly used hedge funds regularly receive bad press, they have perfectly appropriate uses. In fact, investment hedges are one of the strategies we use in trying to provide protection for our clients.
It’s obvious that stock prices go up and down but it may be less obvious that a profit can be made either way. Making a profit when a stock’s price falls is called short selling. Imagine that you’re hiking out in the dessert with a group of people. Everyone would appreciate a cold drink but only one person thought to bring a cooler. Her drinks have a much higher value out there than they would back in town. If she was willing to loan you a can, you might drink it or you might choose to sell it at the heat-related premium. Once the group returns to civilization, you could repay her by purchasing a replacement can at a lower cost. The difference between the high price for which the borrowed can was sold and the discount store replacement cost is your profit on the transaction.
Similarly, an investor can borrow shares of a stock which he feels are currently overpriced and sell them. Later, he hopes to purchase replacement shares at a lower price. Since markets allow for short selling, it’s possible to hedge an investment portfolio against a range of risks. In the case of a stock portfolio that’s gone up in value, a hedge can be put in place to offer protection if markets fall. A hedge fund typically includes both the up and down sides of the transaction in one place. Originally intended for the largest and most sophisticated investors, most brokers now offer them to their customers. We rarely recommend this approach due to the high fees involved but I think their frequent appearance in the press makes them worth discussing.
Since stock investing is inherently complex, there have been attempts to provide shorthand approaches for well over a hundred years. Back in 1884, journalist Charles Dow and statistician Edward Jones published a daily summary of railroad-related market activity using what is now called the Dow Jones Transportation Index. This index, or average, took the daily price of fourteen stocks and presented them as a single number. That number made it possible for investors to tell at a glance how that sector of the market was doing. Although there have been changes to it over the years, the index now known as the Dow Transports or simply the Transports, continues to be published today. In 1896, Dow and Jones offered a new index, one they hoped might better represent the country’s burgeoning manufacturing base. The Dow Jones Industrial Index (now known as the Dow Jones Industrial Average or simply the DJIA) is also still published. It’s often in the headlines, even though the daily returns of its 30 component stocks may or may not be the best available shorthand for overall market performance.
Financial writer Henry V. Poor began publishing his own reports on the status of US railroads even earlier, in the late 1860’s. His son, Henry W. Poor, merged their business with the Standard Statistics Bureau in 1906 in order to broaden the range of reports they could offer. Of course, competition is basic to the American way of life, so Standard & Poors began publishing its own index, the Composite, in 1923. Sometimes still called that, the S&P 500 is probably the best known of all indexes. It certainly presents a broader picture of market activities than does the more narrowly focused Dow and is often what’s being referred to when someone says the market. Although the DJIA and S&P 500 are among the best known, there are now thousands of indexes compiled by hundreds of publishers. One problem with the index as shorthand concept, then, is that there are many to choose from and each reflects only a portion of a much larger picture.
Although both indexes and mutual funds had been around for more than 100 years, it wasn't until the 1970’s that they were successfully combined by John Bogle of Vanguard. Although Vanguard’s S&P 500 index fund is now one of the largest mutual funds in the world, it got off to a slow start. Being the first at anything is rarely easy but perhaps the most significant strike against it was that it paid no sales commissions at a time when virtually all funds were sold through stock brokers.
There’s no rule saying only one mutual fund can attempt to track a particular index, so it’s not surprising that many of the popular indexes have more than one fund tracking them. In fact, the research firm Morningstar lists nearly 1300 US-based index funds in their database.
Although mutual fund sponsors have attempted to offer something for everyone, it’s possible that they’ve gone too far. According to contemporary American fashion designer Thom Browne: “When people have too many choices, they make bad choices”. Beyond bad choices, I’ve encountered many people over the past twenty-six years who simply can’t seem to make a choice. Don’t allow yourself to become overwhelmed by investment paralysis. A Google search for “free financial planning” returned 37,600,000 results. Even if you don’t have a personal financial planner, there is help available.