Benefits

An Essential Part of Competitiveness for U.S. Markets

Capital markets in the United States and elsewhere have been successful in providing capital and financing for economic growth and development worldwide. The fundamental integrity of U.S. markets—and the knowledge that money can be invested in a staggering array of products, free from fraud and overly burdensome government controls—creates a powerful incentive for businesses and individuals to invest.

Hedge funds play a critical role in the financial markets, broadening the use of investment strategies, increasing the number of participating investors, and enlarging the pools of capital available. For investors, hedge funds can serve a risk-management purpose since their returns are often uncorrelated to those in the equity and fixed-income markets. Their importance has been acknowledged by the President’s Working Group on Financial Markets, the Commodities Futures Trading Commission, the Securities and Exchange Commission, two chairs of the Federal Reserve Board, and Members of Congress. 23

Provide Liquidity, Help Investors Manage Risks

Markets work best when investors draw on diverse sources of information and utilize different strategies and securities to manage, or hedge against, risks. Private investment companies provide valuable liquidity to financial markets in normal market conditions and especially during periods of stress. “By buying irrationally cheap assets and selling irrationally expensive ones, they shift market prices until the irrationalities disappear, thus ultimately facilitating the efficient allocation of the world’s capital,” observes Sebastian Mallaby, a Fellow with the Council on Foreign Relations. 24 As a consequence, hedge funds can be less volatile than individual stocks or mutual funds.

The sheer variety of investing strategies that hedge funds employ also strengthens capital markets, particularly by improving opportunities for price discovery. Short selling, for example, “contributes to the market’s process of finding correct prices, and it’s valuable to have hedge funds doing this,” said Jeremy Seigel, Professor of Finance at the Wharton School of the University of Pennsylvania. 25

How have hedge funds improved liquidity?

“When the options and other fixed-income markets were under stress in the summer of 2003,” said Patrick M. Parkinson, then Deputy Director, Division of Research and Statistics, Federal Reserve, “the willingness of hedge funds to sell options following a spike in options prices helped restore market liquidity and limit losses to derivatives dealers and investors in fixed-rate mortgages and mortgage-backed securities.” 26

A study by the Federal Reserve Bank of Cleveland shows that hedge funds tend “to reduce, not increase, the volatility of price” by going against prevailing wisdom and taking positions, for example, against unsustainable movements in securities prices. Hedge funds do not reinforce asset bubbles, according to the researchers; instead, they may prevent them in the first place. 27

Private investment companies absorb risks by pursuing different investment strategies that use different products and securities, according to Mallaby. “For example, banks [may] have to limit their lending for fear that borrowers might default. But hedge funds are willing to buy credit derivatives that transfer the default risk from the banks to themselves—freeing the banks to finance more economic activity. If a currency or stock market starts to plummet, the best hope for stability lies in self-confident, deep-pocketed investors willing to bet that the fall has gone too far, and hedge funds are well designed to perform this function.” 36

A 2004 study by the New York Mercantile Exchange on the role of hedge funds in its natural gas and crude oil futures markets found that the funds’ “modest” role [accounting for 2.69 percent of trading in crude oil and 9.05 percent in natural gas] was a positive one. Hedge funds held positions significantly longer than the rest of the market, providing a “non-disruptive source” of liquidity. Their participation in natural gas futures resulted in “decreases in price volatility.” 37

As the global credit crisis took hold in 2007 and worsened in 2008, hedge funds experienced a sharp rise in redemptions to a record $31 billion by year-end 2008. In performance terms, hedge funds lost 18.36 percent in 2008, according to Hedge Fund Research, Inc. their worse year since 1998. That aggregate statistic, though, hides the wide range in performance; the top 10 percent of funds by performance were up 41 percent in 2008, offset by the bottom 10 percent, which declined by 62 percent. As the chart on page six shows, some strategies outperformed the S&P 500, while others experienced smaller losses than equity markets generally did. By the end of April 2009, hedge funds had begun to perform better, with the sector having its best month then in terms of performance since 2000. 38

Flexibility: Creates Opportunities, Spurs Innovation

The ability to trade different securities simultaneously in several markets maximizes opportunities for returns, improves risk management, and spurs innovation in financial products, services, and strategies.

Hedge funds have tremendous freedom to invest in just about any area where their managers believe they can outperform the market. They are able to scour global markets looking for opportunities, in contrast to mutual funds, which are primarily restricted to equities, bonds, and cash. “In particular, they can combine both long and short positions, concentrate investments rather than diversify, sometimes with risk, borrow and leverage their portfolios, invest in illiquid assets, trade derivatives, and hold unlisted securities,” author Francois-Serge Lhabitant observed. 51

Unlocks Shareholder Value

Activist hedge funds work to increase shareholder value through their ownership of a company and demands for improvements in management and business strategy. To unlock shareholder value, these funds’ managers may work to change a company’s leadership, encourage a merger or acquisition, overhaul the capital structure, reduce expenses, cut executive compensation, or disburse cash reserves to shareholders through dividends and buybacks.

One study of nearly 900 instances of hedge fund activism from 2001 through 2005 found that the stock of the average company singled out by a hedge fund outperformed the overall market by five to seven percentage points over a four-week period (the two weeks before and the two weeks after the hedge fund publicly acknowledged its interest in the company). 52 In the year after that initial month of market-beating performance, the average target company’s stock kept pace with the overall market. Over the subsequent two years, according to the researchers, the operating performance of the target companies improved markedly.

“Hedge funds provide an example of effective shareholder activism,” said one of that study’s researchers, Alon Brav, a Finance Professor at Duke University. “When other institutional investors engage in activism—such as pension funds or mutual funds—they typically have not been effective in improving firm performance.” 53

Enhances U.S. Competitiveness in Global Markets

Global equity market capitalization totaled more than $32.57 trillion in December 2008, according to the World Federation of Exchanges. 54 The United States is seeing financial services move not only to such traditional competitors as London and Hong Kong, but also to Mumbai, Dubai, and Bahrain, where rapidly accumulating wealth is being invested with local firms and markets.

U.S. capital markets, however, remain the largest by far, attracting 85 percent of the savings invested outside home markets, according to McKinsey & Co. 55 That position could erode if the United States loses its edge in innovation, its pools of capital shrink, and its financial markets become less efficient.

A vital hedge fund industry is key to maintaining America’s competitive edge by attracting human and financial capital, which in turn fuels a strong, growing economy. The flexibility afforded by statutes and regulations enables hedge funds to develop the best ideas in their strategies in many different markets.

Globalization, the proliferation of new financial risks, and the complexities of managing different investments worldwide necessitate unique, state-of-the-art instruments and strategies that U.S. financial institutions are pioneering. As a result of their leadership, U.S.-based hedge funds account for 50 percent of total hedge fund assets under management.

Almost two-thirds of institutional investors surveyed by Morningstar and Barron’s said in November 2008 that alternatives led by hedge funds will become as important as stocks, bonds, or mutual funds—or more so—in the next five years. Almost half of the institutions surveyed allocate more than 10 percent of their portfolios to alternative investments, and nearly 20 percent allocate more than 25 percent of their portfolios to alternatives. Hedge funds were responsible for driving growth, according to 38 percent of the institutional investors surveyed. Investments in hedge funds may increase for one-quarter of the institutions surveyed over the next five years. The majority (76 percent) of institutions said portfolio diversification was driving the growth of alternative investment. 56

Hedge funds also contribute to the efficiency of U.S. capital markets by helping to price securities close to their fundamental values. “By trading on the basis of sophisticated and extensive market research, hedge funds provide markets with price information that translates into pricing efficiency,” said George E. Hall, Chief Investment Officer of Clinton Group. “In targeting temporary price inefficiencies and market dislocations, hedge funds effectively help to minimize market distortions and eliminate these dislocations.” 57 That, in turn, leads to superior capital allocation, 58 which finances growth, innovation, and job creation.

Why Does Liquidity Matter?

Liquidity refers to the market’s ability to handle a large volume of trading without significant price swings. If a security is priced at $10 and the market is liquid, your sale of one share, or perhaps several thousand, should not cause that security’s price to fall much, if at all. In illiquid markets, your offer to sell may cause the share price to drop, sometimes sharply, and conversely, your offer to buy may fuel a steep price increase.

Why? Supply and demand. More supply, less demand leads to lower prices. Greater demand, less supply causes prices to rise. Securities are considered to be more liquid than real estate and collectibles. Liquidity attracts investors to the market because it assures them that they have flexibility in exchanging their securities for cash and vice versa, enabling them to take swift advantage of market shifts.

Liquidity has two dimensions: breadth—the range of securities that are liquid; and, depth—the amount of securities that can be bought or sold before the transaction itself influences the security’s value.

‘An Important Source of Capital’

“Even in light of all of the change and turmoil that is affecting all market participants, hedge funds will continue to play an important role and be an important source of capital and liquidity in world markets, by providing financing to new companies, industries and markets, as well as by committing capital in times of both market stress and market stability. Hedge funds’ role in helping to provide efficiencies in pricing of securities and other financial assets throughout the markets as a result of their extensive research and willingness to make investments in all market conditions will continue to be significant.”

Asset Managers’ Committee,

January 15, 2009

CalPERS Perspective on Hedge Funds’ Value