Hedge Funds
I. The role of hedge funds in the
financial markets
The world financial
markets include many participants, such as banks, mutual funds, pension funds,
private equity funds, hedge funds and investment banks. Hedge funds currently
occupy a good share among these participants. It is estimated that presently
the hedge funds have about $1 trillion under management around the world, with
about 8300 actively operating hedge funds.
Even more important is
probably the fact that hedge fund industry is growing quite fast, posting a
double digit growth, which according to some estimates reaches 20% per year. The global hedge fund industry has
substantially changed since 2003. While in the beginning hedge funds was a
domain of very rich individuals and had some quite of exclusivity, it has been
opening to other investors that started looking at hedge funds when returns
from traditional investment, such as mutual funds or pension funds, were becoming
lower. As a result, even insurance and pension funds themselves started
investing into hedge funds (Singh 2005, p.3).
The UK is quite
prominent with regard to hosting hedge funds. According to the information
recently published in the Financial Times, the London's share of world hedge
funds assets more than doubled in the last 5 years. The more precise figures
were available in the recently issued London's annual report on hedge funds
(International Financial Services), which stated that in 2006 about 20% of the
global funds assets were managed from London, versus only 10% in 2002. For
comparison, the share of New York that used to be a leader in hedge funds
assets has been steadily decreasing (Willman 2007).
Presently hedge funds that are based in the
United Kingdom account for about 30% of the whole trading on the London Stock
Exchange, the biggest stock market in Europe. This fact again delineate how
substantial is the present share of the hedge funds in the financial
markets.
To summarize, hedge funds play quite an important role in the global
financial markets, adding liquidity to the whole system, possibility for
additional diversification and lower risks.
II. The criticism of the hedge funds
Despite a significant
role that the hedge funds play in the financial markets, there is also a lot of
critique directed at them. There are several major points of critique that I found
plausible and that I summarized below:
1) Hedge funds are not
obliged to reveal any information about their activities to the public, as a
result they can do operations can actually make the financial markets more
risky or practice some methods potentially hurting other financial market
participants. It was identified in several sources that some hedge funds
rejected IPOs because of the requirement to bring to public some of the fund
information in the course of issuing an IPO. And this is done despite many
benefits that an IPO can bring, such as additional funds to manage or
possibility to get some additional cash for the fund shareholders (White &
Mackintosh, 2007).
2) Hedge funds are presently not
regulated, unlike almost all the rest of the financial markets participants,
such as mutual funds, insurance companies and banks. This may pose some risks
to the global financial system, the stability of which depends a lot on its
transparency and fair rules of the game for all participants. John Sunderland,
the President of Confederation of British Industry, has recently criticized hedge
funds "for their short-term investment strategies and lack of transparency
and accountability" (Singh 2005, p.4). Also, for the first time the
Financial Services Authority (FSA), UK financial regulatory authority, got
concerned about the hedge funds. In its recent discussion paper, Financial
Services Authority the FSA cautioned that “some hedge funds are testing the
boundaries of acceptable practice concerning insider trading and market
manipulation”. Going further, the FSA has also announced that its plan to
establish a new unit that shall monitor and supervise the trading activities of
hedge funds (Singh 2005, p.4).
3) Additional
volatility that hedge funds bring to the financial markets. Quite often hedge
funds are using a lot of leverage and practice speculative trading. This point
of criticism has some validity especially due to a well-known collapse of a hedge
fund called Long-Term Capital Management (LTCM) in 1998. After Russia defaulted
on its debt in 1998, Long Term Capital Management was greatly injured, when
five-year swap spreads nearly doubled from 0.5 percent to 0.8 percent (Brealey
& Myers 2003, p.761). Additionally, due to the fact that hedge funds are
the clients of other financial institutions, the collapse of a big enough hedge
fund can lead to a domino effect and a broader crisis in the whole financial
market. At a present era of globalised financial markets, such domino effect
can even spread around the world.
The
counterargument for this criticism is given by Dion Friedland, Chairman of
Magnum Fund, in the statement that "In reality,
less than 5% of hedge funds are global macro funds (which means that can be
highly volatile). Most hedge funds use derivatives only for hedging or don't
use derivatives at all, and many use no leverage" (2007). However, due to potential bias of Dion Friedland, it needs probably additional arguments and research to make
it clear whether hedge funds at present time add more volatility to the market
or not.
4)
Adverse influence that hedge funds can have outside of the purely financial
markets in the business world. Such possibility for influence of business
decisions may be misused by some interested parties, especially taking into
account lack of regulation of hedge funds and absence of public disclosure
requirements for hedge funds. The best example of this point of criticism can
be probably provided from the recent attempt bid of Deutsche Borse for a London
Stock Exchange. The UK based hedge fund, the Children's Investment Fund,
holding only about 8% of the equity of Deutsche Borse, played a critical role
in firing the CEO of Deutsche Borse and blocking its bid for the London Stock
Exchange (Singh 2005, p.3).
III. Importance of hedge funds as clients of investment banks
Currently hedge funds play quite an important role for investment banks,
as one of their major clients. A significant share of the profits of investment
banks come from the services that they provide to the hedge funds from such
highly profitable businesses as prime brokerage, credit default swaps,
mortgage-backed securities, etc.
Many big investment banks have prime brokerage operations that they do for
hedge funds. Prime brokerage means that the investment bank executes daily
trading activities for hedge funds, hold their securities, evaluate the losses
and gains achieved by the hedge funds as a result of trading, lend funds to the
hedge funds, etc. When taking into account that hedge funds manage billion of
dollars, the profit of investment banks from fees for such services is also
substantial.
Another additional relationship between investment banks and hedge funds
stems from investment banks actually owing stakes in the hedge funds. As was
mentioned before, hedge funds sometimes are reluctant to issue IPOs to inject
additional capital to the hedge funds. As an alternative to the IPO, hedge
funds sometimes sell some of their equity stakes to the investment banks.
Therefore, the direct result of the growth of hedge funds in recent
years was also the increase of profits for investment banks and their increased
dependency on hedge funds. Of course, such dependency is not very high at a
present time. But as hedge funds gain more and more popularity around the
world, their influence on performance of investment banks can also grow.
IV. Hedge funds investment styles
With
respect to investment styles, hedge funds are not homogenous at all. There are
many investment approaches and strategies currently utilized by the hedge
funds. Those strategies can differ a lot in terms of return, risk and
volatility that they bring. Taking this into account, I think it may be wrong
to tell that all hedge funds, as a category of financial markets participants,
and safer or riskier than other financial players. Depending on the strategies
used, the hedge funds can substantially differ from one another.
According
to Dion Friedland from Magnum Funds, there are 14 distinct investment
strategies applied by the hedge funds, each associated with a certain risk and
return. In this paper, I would like to describe four selected investment styles
used by the hedge funds, namely, global macro, event-driven, market neutral
arbitrage and opportunistic investment styles.
1)
Global macro is the investment style, using which hedge funds invest globally
in debt and equity, currency and commodities trying to profit from the changes
in the national policies or actions, which in turn would affect those
securities. The example of such change can be change of the interest rate,
which in turn would affect currency and debt markets. When using global macro
approach, in most cases hedge funds also resort to high leverage and hedging
through derivatives in order to enhance the impact of market changes. Owing to
its nature, global macro hedge fund can be quite dynamically growing, but also
riskier and more volatile that the other hedge funds applying different and
more cautious strategies.
Macro hedge funds are also probably one of the
most famous hedge funds and receiving most of publicity. For example, macro
investment style was the one used by George Soros in his bet against the
British pound in 1992. At that time he put a bet of $10 billion, big part of
which was borrowed, on the devaluation of the pound sterling. As a result of a
successful bid, his fund realized $2 billion in profits (Friedland, 2007).
However, there are also many examples of negative bids and a lot of money lost
as a result of applying macro investment style.
2)
Event-driven is the investment style, using which hedge funds try to profit
from some specific types of event promising to bring above-market returns. For
example, hedge funds can invest into distressed securities. Following this
investment strategies, hedge funds can buy equity, debt or some other
obligations from the companies who are in a poor financial conditions, are
under re-organization or on the verge of bankruptcy.
Due
to the fact that many institutional investors are not allowed to hold
securities with such risks, hedge funds have the opportunity to receive
above-market profits from such transaction, especially taking into account that
distressed securities are often very grossly under-valued (i.e. the current investors
of distressed securities want to sell them, while there are not so many
financial investors who would like to buy them, therefore, much lower liquidity
and much higher transaction settlement price). Additional benefit from this
strategy is that the results generally do not depend on the overall tendencies
in the equity/bond markets. The risk associated with this strategy is moderate.
3)
Market neutral arbitrage is the investment style, using which hedge funds try
to make profit through finding arbitrage opportunities in some specific
securities, while keeping a neutral position with regard to specific sector,
country of the market as a whole. The strategy is based on taking opposite
positions in different financial securities, offered in the same sector or even
by the same company.
A
good example of market neutral arbitrage can be a hedge fund that buys short equity
of a certain company, while selling long convertible bonds issued by the same
company. The choice whether the long positions are hedged with the short
positions or vice versa depends on the bet that the hedge fund is doing,
whether long-term or short-term performance will be better in the sector.
Therefore, such investment style attempts to become a hedge fund independent of
the strength of a specific sector or sector-wide events. As a result of such a
cautious strategy, hedge fund applying this investment style is exposed to
relatively low risks, but also is not probable to realize very high returns and
experience dynamic growth.
4)
Opportunistic is the investment style, using which hedge funds are trying to
realize gains by taking advantage of any special events or unique opportunities
for investments they can come across. For example, opportunistic hedge funds
can invest into distressed securities, if they find such an opportunity
probable to yield extraordinary results, IPOs, the equity of companies that is
to be acquired or the equity of acquirer, the equity of the companies that are
threatened by a hostile takeover or the one with disappointing results. All of
such events can devaluate the stock price for a certain period of time – the
opportunity from which hedge funds strive to profit using opportunistic
investment style.
There
are no specific boundaries for the opportunistic investment style. It can be a
blend of different approaches being in a state of flux. Due to such uncertainty
with regard to specifics of possible investments, the risk and return
associated with this investment style can greatly vary from time to time,
changing from low to high and bounding back.
V. Conclusions
To
summarize, hedge funds are important players of the modern global financial
markets. They play an important role, adding liquidity and diversification to
the market. There are also drawbacks associated with the hedge funds, with the
present lack of their regulation and potentially added volatility to the market
as most loudly pronounced arguments of criticisms. Hedge funds do not form a
homogenous category. They can substantially differ in terms of risk and return
as a result of the investment style applied. Many investment styles currently
utilized by the hedge funds are sometimes blended together and are often
themselves in a state of flux.
References
Brealey, R., Myers, S.
(2003). Corporate Finance. New York: McGrew-Hill/Irwin.
Friedland, D. 2007 'About Hedge Funds'. Magnum Funds. Available at:
http://www.magnum.com/hedgefunds/abouthedgefunds.asp#strategies
Friedland, D. 2007 'Global Macro Investing'. Magnum Funds. Available
at:
http://www.magnum.com/hedgefunds/globalmacroinvesting.asp
Singh, K. 'Globalization of Locusts''. July 09,
2005. Available at:
http://www.zmag.org/content/showarticle.cfm?ItemID=8264
White,
B., Mackintosh, J. 'Hedge fund AQR
considering flotation'. Financial Times. April 20, 2007.
Willman, J. 'London
doubles share of hedge fund assets'. Financial Times. April 17, 2007.