Noront Resources

So, how many hedge funds are there? - last I heard, the estimate was about 9,000, and they are all looking for that competitive information edge which will allow them to out perform the market.

As one fund manager recently told me- we expect to be down about 35% this year, which should out perform the market for the 12th year in a row.

In case you didn't know, here's how a hedge fund works. One or two guys get together and they think they have enough experience and expertise to outperform the market in their particular field of speciality. They put together a document, put the first $5 million in themselves, and go out and raise another $95 million from institutional investors. They charge an annual management of 2% of the assets of the fund, and 20% of the profits. Then, they use the $100 million as collateral to borrow another $100 million plus for the fund.

Now you have $200 million under management, so you have $4 million in annual revenues to run the fund. Not bad so far. Then you get to keep 20% of the proftis generated as an incentive for achieving superior results. This is known as a "2-20" fund.

Now, here's the rub- you get paid 20% of the profits generated as long as your fund stays above the "high water mark". Each year, the fund needs to appreciate higher than last year in order to earn your bonus.

So, you cruise along for five years, generating 20% on your $200 million- the fund keeps growing and you get your bonuses. 20% on $200 million is $40 million, and 20% of $40 million in $8 million. If the fund gets bigger, so do the bonuses.

So- here's what's really happening out there. Some of these fund managers are placing the wrong bets and blowing up. Some of them have been absolutely killed- and it's not neccessarily in US equities. If you bet on oil, you got killed. If you continued to bet against the dollar, you are getting killed. You're pretty much getting killed in all classes of assets.

Let's take it one more step. Let's say the bank, which loaned you $100 million secured by your first $100 million, wants its money back. In fact, let's say that bank just seizes your fund, and is only concerned with getting whatever it can out of its $100 million back.

As the fund manager, you don't really care. Here's why. Let's say you simply close your fund with a 50% loss, and send back everyone's money on a pro rata basis. Why don't you care? Because, if you hung in there and tried to rebuild the fund, you would probably have to at least double the value of the fund before you ever made another bonus. Why bother?

Here's what you do. Liquidate- either forcibly or by choice, take your millions, and walk away. Wait six months for the mess to shake out, then come back and start another fund with a new high water mark.

Hundreds if not thousands of funds are closing down now under this exact scenario- why? It simply makes more economic sense for the fund managers to just walk away rather than try to rebuild. Hence- the big difference between hedge funds and mutual funds.

Forced liquidations are a major part of today's market climate, like it or not. Once you understand what's going on, you can better understand some of the whacky pricing we've been seeing.

I'm not saying its good or bad, I'm just explaining the scenario as is. It's great if you have cash. Let them implode, then pick up the pieces on bargain basement steals.

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