Why You'll Feel Hedge Funds' Pain

In the early part of this decade, amid a raging bear market, a handful of major corporations -- led by General Motors(GM Quote), ironically enough -- grew concerned that their pension funds would never meet their investment goals if they continued to focus strictly on long-only stock-and-bond strategies. So they directed their pension managers to put billions of dollars on behalf of their retired blue-collar workers into "alternative investments," which is a term of art for hedge funds.

Broadly speaking, pension funds try to maintain a balanced allocation of 60% stocks and 40% bonds. The idea of that split is that they'll get more bang for their buck out of stocks -- and yet if equities are soft, returns will be cushioned by nice, safe bond yields. The problem has been that the Federal Reserve's expansive money policy of the past few years created a financial regime in which bond yields were extremely low -- and yet stock returns haven't been too hot, either.

Bundling Up Bonds

So what's a pension manager to do? Well, in pursuit of returns of 8% to 10% in a negative or flat market, many sought out bond hedge funds that promised to use new mathematical modeling techniques to seemingly manufacture money out of thin air.

When you hear the word "bond," you probably think of a U.S. government or corporate debt instrument that pays holders an annual interest payment whose size is related to risk and duration. Short-term U.S. Treasury bills backed by the government's taxing power pay the smallest amount of interest, while the long-dated obligations of iffy companies with poor credit -- known as "junk" bonds -- pay the most.

But between those two extremes is a wide range of debt products. To make it simpler to buy and sell them, investment banks came up with the idea to "securitize," or bundle up, a lot of different types of bonds into instruments called "collateralized debt obligations," or CDOs. These are in turn sliced up by banks into smaller pieces, generally categorized by risk, that are known by the French word "tranches."

Something like 90% of all corporate bonds are securitized and resold in this way -- spreading out the risk in a way that helps issuers get financed and grow.

New Financial Models

Now enter the hedge funds seeking to provide dependable returns to pension managers. A new breed of math geniuses entered the scene not too long ago with financial models that they believe help them understand when certain tranches are undervalued relative to other tranches. The big idea is that if you can figure out which ones are overpriced and likely to lose value, and which ones are underpriced and likely to gain in value, you can short one and buy the other and make a few bucks as their prices converge.