Hedging their bets

How hedge funds became the ideal focus for anxiety about market instability.

Daniel Ben-Ami

Topics Politics

Hedge funds have become a source of concern recently. The Financial Services Authority, Britain’s main financial regulator, is due to publish two papers on hedge funds over the next two months. It was hedge funds that helped to fund the American millionaire Malcolm Glazer’s controversial takeover of Manchester United.

Meanwhile, in Germany, Franz Müntefering, the chairman of the ruling Social Democratic Party, described hedge funds and other foreign investors as ‘locusts’. Soon afterwards, German chancellor Gerhard Schröder called for a review of hedge funds. The European Commission is also currently reviewing the hedge fund industry, as are senior international financial regulators and top financiers.

But what are these mysterious hedge funds – and what’s wrong with them?

In fact, there is no agreement on what constitutes a hedge fund. As a study by the Securities and Exchange Commission (SEC), America’s main financial regulator, noted: ‘Although financial service providers, regulators and the media commonly refer to “hedge funds”, the term has no precise legal or universally accepted definition.’ (1) There are attempts at working definitions. The Economist’s website defines hedge funds as ‘lightly regulated investment funds that take high risks to earn high returns’. While this is certainly how many people see hedge funds, it is a far from perfect definition. There are funds that seek high returns that are not hedge funds, and not all hedge funds emphasise maximising returns.

Hedge funds generally differ in several related ways from mainstream investment funds (though these differences are becoming increasingly blurred) (2):

— Unconventional techniques. While conventional funds tend to bet on the upward movement of financial assets such as bonds, shares and property, hedge funds have more flexibility to use unconventional techniques. These include using instruments such as derivatives (whose prices are derived from those of underlying assets) as well as techniques such as short-selling (betting on falling prices of financial assets) and arbitrage (exploiting price anomalies in the market).

— Absolute return strategies. Conventional funds tend to benchmark their returns relative to the assets in which they invest. For example, a fund that invests in American stocks would typically measure its performance relative to an index such as the S&P 500. One that invested in British shares might use the FTSE 100 as a benchmark. In financial market jargon, such conventional funds are ‘long-only’, as they bet on financial markets rising. In contrast, hedge funds’ greater flexibility should allow them to thrive in both rising and falling markets. The worst conditions for hedge funds tend to be markets that move little in either direction.

— Light regulation. Conventional funds, which are primarily savings vehicles for the middle class, tend to be relatively tightly regulated. In contrast, hedge funds, which are often used by the rich, have a less stringent regulatory burden. In addition, the minimum investments into hedge funds are generally much higher than those into conventional funds.

— Leverage. Hedge funds, unlike most conventional funds, tend to borrow heavily to invest – or in financial market jargon, they are highly ‘leveraged’. Leverage can be an advantage when things are going well as it increases returns to funds. However, when problems arise, such as unexpected rises in interest rates, it can amplify the problems that hedge funds face. Leverage is a particular concern in the current climate of rising interest rates. Many hedge funds borrow at low short-term interest rates to finance their investments.

These general characteristics suggest why it is that hedge funds are disliked. The fact they are relatively lightly regulated and mainly for the rich is enough to make them unpopular. In today’s climate of extensive regulation to restrain the market, it is not surprising that hedge funds’ are viewed with suspicion.

However, it is not true that hedge funds represent a desire for greater risk taking. In fact, a key reason that hedge funds have become more popular in recent years is to allow large investors to manage their risk. By spreading their investments to include different types of vehicle, such as hedge funds, large investors can diversify their overall risk. As the SEC study notes: ‘The growth in hedge funds has been fuelled primarily by the increased interest of institutional investors such as pension plans, endowments and foundations seeking to diversify their portfolios with investments in vehicles that feature absolute return strategies.’ (3) In addition, a large part of the growth of hedge funds in recent years has been in funds of hedge funds – that is, funds which themselves invest in a range of hedge funds.

Even when hedge funds make spectacular losses it is not generally because of reckless risk-taking. Long-Term Capital Management (LTCM), which was bailed out in 1998 after sustaining $4 billion in losses, is a prime example. The hedge fund employed top financial economists, including two Nobel laureates, to calculate sophisticated models to allow the firm to manage its risk. Unfortunately for LTCM, they got their sums wrong. Adverse events that they calculated should only occur once every 80 trillion years happened twice within a few days of each other (4).

The growth of hedge funds reflects capitalism’s increasing reliance on ‘financial engineering’ techniques. This was certainly clear in the case of Enron, one of the largest bankruptcies in American corporate history. Enron started off as essentially an energy company, but its main business soon became trading in financial instruments. As The Economist remarked soon after Enron’s bankruptcy, it had become ‘in effect, a hedge fund with a gas pipeline on the side’ (5).

Admittedly, most firms do not go as far as Enron; most still produce goods or services for their customers. But it has become common, especially for large firms, to make heavy use of sophisticated financial instruments. Managing the risks facing the firm in some cases becomes more important than the products for which it is known. Large firms nowadays tend to closely monitor the structure of their balance sheets, and will also use derivatives to protect themselves against risks, such as changes in interest rates or adverse currency movements. Many are also concerned with managing their pension fund liabilities, and some even sell financial services directly to consumers. Although few firms have the flexibility to go as far as hedge funds, which represent ‘financial engineering’ in its purest form, many have developed similar characteristics.

For the critics, attacking hedge funds seems to be a way of expressing their unease about contemporary capitalism. They can demand greater regulation and restraint of the market by attacking what is seen as one of its most excessive features. This means that critics can take up a symptom of the market, without questioning its fundamental workings. If substantial volatility does emerge in the financial markets, which is certainly possible, it is easier to blame hedge funds than to examine weaknesses in the real economy.

In some cases, attacks on hedge funds no doubt have a nationalist edge. The recent verbal assaults on hedge funds in Germany, for example, seem at least partly motivated by anti-Americanism. From such a perspective, the hedge fund industry goes against the supposedly more civilised norms of Europe’s economic model.

It is perhaps an advantage to the critics that there is no precise agreed definition of hedge funds – it makes it easier to attack them without specifying exactly what it is they are objecting to. Railing against hedge funds provides a way of criticising the turbulence of the market without questioning its fundamental characteristics.

Daniel Ben-Ami is the author of Cowardly Capitalism: The Myth of the Global Financial Casino, John Wiley and Sons, 2001 (buy this book from Amazon (UK) or Amazon (USA)).

(1) ‘Implications of the growth of hedge funds’ (.pdf), Staff Report to the United States Securities and Exchange Commission, September 2003, pviii

(2) On the differences between hedge funds and US mutual funds see ‘The differences between mutual funds and hedge funds’, Investment Company Institute, March 2005. For a list of different hedge fund strategies see IMF Global Financial Stability Report September 2004, p52

(3) ‘Implications of the growth of hedge funds’ (.pdf), Staff Report to the United States Securities and Exchange Commission, September 2003, pvii

(4) ‘C D Deshmukh Memorial Lecture at Mumbai, India’, Howard Davies, 7 February 2000

(5)’Enron’s fall: Upended’, The Economist, 29 November 2001

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Topics Politics


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