Topic :

The Role of Hedge Funds in Financial Markets

Overview

A hedge fund is an investment fund which is a limited to high net worth investors. It undertakes a wider range of investment and trading activities compared to other investment funds and pays a performance fee to its investment manager. Management fee paid annually is usually 1%-2% of the asset. Performance fee is also paid which will be 20% of the return the manager makes from the asset (Hedge Fund Studies 2006)

Each fund has its own strategy which determines the type of investments and the methods of investment it undertakes. (Hedge Fund 2009). It can be invested in equities, futures, currencies, commodities, bonds, real estate, even in Weather Derivatives (betting on weather conditions) or seed capital for start-up companies like private equity / venture capital funds. Unlike mutual funds, hedge funds have no restrictions on where they could invest or in what they could invest in.( Hedge Fund Studies 2006)

Many hedge fund companies manage assets worth billions of dollars, excluding leverage. These companies dominate certain specialty markets such as trading within derivatives with high-yield ratings and distressed debt. (Hedge Fund 2009) Their number has also grown rapidly in the past few years to more than 10,000 funds all around the world and total assets of more than a trillion dollars. Due to the large amounts involved in the transactions, it is believed to have influence on the prices and returns of commodities, equities, and securities around the world (Hedge Fund Studies 2006)

Investment Strategies

The 3 main types of hedge funds can be identified as macro funds, global funds and relative value funds, although within these broad categories, there are further sub- categories. (Eichengreen & Mathieson, 1999)

Macro funds take “large directional (unhedged) positions in national markets based on top-down analysis of macroeconomic and financial conditions, including the current account, the inflation rate, and the real exchange rate”; (Eichengreen & Mathieson, 1999)

Macro events are global economic changes that are caused by shifts in government policy which impact interest rates. These in turn, affect all financial instruments, including currency, stock, and bond markets. Macro investors anticipate the results of these policies by investing in financial instruments whose prices are most directly influenced by these macroeconomic trends. Accordingly, they participate in all major markets (equities, bonds, currencies, and commodities), though not always simultaneously. Leverage and derivatives are often used to with the intention of greater gains on their market moves. (Friedland 2009)

A notable example of macro investing is the highly leveraged, high stakes investments of macro hedge fund managers such as George Soros, Julian Robertson, and, formerly, Michael Steinhardt. Most notable is when Soros bet $10 billion, a large portion of which was borrowed, on the proposition that the British pound would be devalued. The move resulted to a $2 billion profit for his investors. Some believe his shorting of the Sterling caused its drop and the subsequent pullout of the European Monetary Union. The hedge fund managers however do not always profit in their transactions. In 1994 for instance, some placed huge, unhedged bets that European interest rates would decrease, causing bonds to rise. Instead, the Fed increased US interest rates which also caused European interest rates to rise and investors who bet that European interest rates would go down to lose money. (Friedland 2009)

Global funds also take “positions worldwide, but employ bottom-up analysis, picking stocks on the basis of individual companies’ prospects”; (Eichengreen & Mathieson, 1999).

Below are market data from Bloomberg (as of April 13 2009) between HSBC and CITIGROUP to illustrate the global fund strategy that hedge fund managers could employ.

HSBC FUNDAMENTALS

HSBC COMPARATIVE RETURNS (vs. INDUSTRY)

CITIGROUP FUNDAMENTALS

CITIGROUP COMPARATIVE RETURNS (VS. INDUSTRY)

(Bloomberg.com:Personal Finance 2009)

HSBC has better fundamentals than Citigroup and has better than industry average returns compared to Citigroup’s lower than industry average returns. Hedge fund managers might see this as an opportunity to take the short position on Citigrop. It could leverage on Citigroup stock resell it at the current price with the outlook that prices would go down and profit in the process. If the data provides them a more positive outlook for HSBC then they could take the long-term view buy its stocks and hold on to it for a longer period with the expectation that price will increase (Green 2007)

Relative value funds take “bets on the relative prices of closely related securities (treasury bills and bonds, for example)”. (Eichengreen & Mathieson, 1999)

The investment strategy of relative value funds could be illustrated from the Wall Street Journal data below on the treasury yield and Libor rates.

(Wall Street Journal: Market Data Center, 2009)

Based on this pattern hedge fund managers could either predict a leveling off of or an increase in treasury bill yield since the Libor-rates serve as benchmark for fixed income securities. (Euro Dollar Future, 2006). If rates increase relative to certain corporate bond rates, these bonds would then have to be priced lower to remain competitive as an investment instrument (Anthony, et al. 2007)

CRITIQUES TO HEDGE FUND OPERATIONS High Risk

Hedge funds are more likely than other types of funds to take on investments that are very risky, such as high yield bonds, distressed securities and collateralized debt obligations based on sub-prime mortgages. (Hedge Fund 2009)

Adding to the risk is that hedge funds will typically borrow money in addition to the money put in by the investor. These borrowings could amount to sums many times greater than the initial investment. For instance, if a hedge fund has borrowed $9 for every $1 received from investors, a loss of only 10% of investment value of the hedge fund will reducet 100% of the value of the investor’s stake in the fund, once the creditors have called in their loans. As an example to the high risk of leverage in hedge funds, shortly before its collapse, Long Term Capital Management had $125 billion of assets on a base of $4 billion of investors’ money, a leverage of over 30 times. It also had off-balance sheet positions with a notional value of approximately $1 trillion. (Hedge Fund, 2009)

Just as the gains could be very high, the losses that can be incurred on a losing bet may also be limitless with hedge funds due to the nature of short selling. Where a hedge fund uses short selling as an investment strategy rather than as a hedging strategy it can suffer very high losses if the market turns out against its expectation. (Hedge Fund 2009)

Lack of Regulation and Transparency

There are several regulatory issues involving hedge funds. One issue is their role in destabilizing foreign exchange rate systems. Leverage is used to take significantly large size positions in those markets. In addition, their market reputation creates followers and induces trend investors to take the same bets. The combined effect is often the self-fulfilling investment strategy against the value of a nation’s currency. (Hedge Fund Studies 2006) Hedge fund managers are often regarded as “astute and quick off the mark”. Mere rumor that they are taking a position may encourage other investors to follow. (Eichengreen & Mathieson, 1999)

A report from the Reserve Bank of Australia stated the” potentially destructive role of highly leveraged institutions such as hedge funds”. It described how hedge funds can have a destabilizing impact on not only the currencies of emerging economies but also on currencies such as the Australian dollar which has the eighth largest global trading volume. (Hedge Fund Studies 2006)

Another criticism to hedge funds is the lack of transparency. Not only do they participate in the non-transparent over-the-counter derivatives markets, but the hedge funds as financial institutions are not required to report their positions, trading activities or creditworthiness (Hedge Fund Studies 2006) Since they operate through private placements and restrict share ownership to high net worth individuals and institutions frees them from most disclosure and regulation requirements that apply to mutual funds and banks. Funds legally placed outside the main financial market countries are generally subject to even less regulation. (Eichengreen & Mathieson, 1999 )

Another issue is their use of direct credit from banks and broker-dealers to finance their market activities. They also use indirect credit through repurchase agreement and securities lending markets to take highly leveraged positions in securities and derivatives markets. These credit relationships mean that if a hedge hedge fund fails on a highly leveraged transaction, it could undermine the solvency of banks which hold government insured deposits and money center banks which also serve critical roles in the economy’s cash payment and securities clearing systems. (Hedge Fund Studies 2006)

All these criticism on hedge funds have increased as large scale ponzi schemes (such as the Madoff Scandal) have been much publicized. These have led governments and regulators to converged and take action for stricter regulations in the financial markets. (Madoff Scandal 2009)

CONCLUSION

Financial markets have been quite resilient in the past though today they may be marred by scandal (such as the Madoff ponzi scheme). Hedge funds and financial leverage post as a source of potential risk to the financial system although they have also provided liquidity in the system during risk averse times (Geithner 2004).

The times now call for the reassessment of these risks because of the large sums involved in hedge fund operation and the increasing complexity of financial transactions. Capital and leverage requirements may be implemented. A more discerning approach by hedge fund investors should be taken because a lot of the money circulating through theses transactions comes from institutional money. Others may be a source of education, retirement, or charitable funds that may go down the drain if the riskiness of the hedge funds is not regulated (Geithner 2004).

There may be difficulty however on how and where to collect the leveraging data when transactions are so complex and entered into in a global scale. As governments try to find solution to such policy issues, what can be initially done are for the different countries to provide macroeconomic information (economic polcies, intentions, conditions) so people will have background information enough to take their own investment stand and not follow what the rest are doing (Eichengreen & Mathieson, 1999)

There is comfort in knowing that risk is reduced because there is information to make better judgement and informed decisions while investment managers will also be on their guard knowing that their actions are monitored. As Timothy Geithner was quoted on the efforts to make the hedge fund market more transparent, “these efforts motivated in part by discomfort about what we do not now know and a sense that knowledge itself, by reducing uncertainty, could reduce risks. And they are also motivated by the view that greater disclosure would act as a desirable restraint on risk taking, and make it possible for market discipline to work more effectively”. (Geithner 2004)

BIBLIOGRAPHY

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