Reply #12: As Hedge Funds Go Mainstream, Risk Is Magnified [View All]

http://www.washingtonpost.com/wp-dyn/content/article/2005/08/10/AR2005081002092.html

NEW YORK -- Hedge funds used to reek of exclusivity. They were run by the most cunning traders on Wall Street, who employed exotic trading techniques designed to make money regardless of whether markets rose, fell or stayed flat. Their clients included only the super-rich.

Those days are over.

Hedge funds are now a $1 trillion industry. Millions of middle-class people invest in them through pension funds or mutual funds.

The Virginia Retirement System, for example, recently increased its investments in hedge funds to $1.6 billion, or close to 4 percent of its assets. The Baltimore City Fire & Police Employees' Retirement System put $80 million into hedge funds last year, while the City of Baltimore Employees' Retirement System invested about $55 million, or 5 percent of its assets.

Some experts say pension funds and university endowments are plowing money into the high-fee funds at the worst possible time. Investment returns have dropped, inexperienced managers are piling in and some sophisticated investors appear to be pulling money out. Hedge funds make -- and risk -- big money by making big bets, mostly with borrowed money. They bet on movements in multiple markets, whether it be in stocks, bonds, currencies, commodities, options, derivatives or any combination of the above.

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Greenspin starting to worry a bit about his once darling hedge funds and derivatives? Seems to have changed his tune this year.

http://www.washingtonpost.com/wp-dyn/content/article/2005/06/09/AR2005060902077.html

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With a trillion dollars in assets leveraged up to the hilt, hedge fund capital has become the x-factor in virtually every market you can think of -- stocks, bonds, commodities, currencies, futures, options, derivatives and swaps. These unregulated pools of global capital now account for an enormous portion of daily trading volumes, a sizable percentage of the profits of Wall Street investment houses, and a worrisome share of the credit exposure of major banks. The people who run these funds take home annual compensation that makes corporate chief executives look like pikers -- $1 billion last year in the case of Edward Lampert of ESL Investments, according to Institutional Investor.

But to hear it from Mr. Greenspan -- who has lavishly praised them for making global financial markets more liquid, more efficient and more shock-resistant -- hedge funds are headed for a fall.

When they were small and new, Greenspan explained, hedge funds could achieve above-average returns by finding small inefficiencies in the markets, buying up financial risk that was priced too low or selling short risk that was priced too high. To identify these anomalies, hedge fund traders relied on sophisticated computer models and historical data to calculate probabilities and correlations out to the second decimal point. And to fully leverage this knowledge, they relied increasingly on complex derivative instruments to slice and dice and repackage various kinds of risks.

But, in time, as more money poured into more funds, all looking to profit from the same anomalies, the chance to make above-average returns began to disappear. As a result, "significant numbers of trading strategies are already destined to prove disappointing," according to Greenspan. So far this year, the average return has been nil.

"Consequently, after its recent very rapid advance, the hedge fund industry could temporarily shrink, and many wealthy fund managers and investors could become less wealthy," Greenspan explained to his Beijing audience via satellite hookup. "But so long as banks and other lenders to these ventures are managing their credit risks effectively, this necessary adjustment should not pose a threat to financial stability."

Greenspan's message was clear: Don't look to the Fed to ride to the rescue with arms full of cheap money and implicit guarantees when hedge fund investors start rushing for the exits. We may have erred in that direction in 1998 by nudging Wall Street to prevent the collapse of Long-Term Capital Management, an early hedge fund. But this time, you're on your own.

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http://www.federalreserve.gov/boarddocs/speeches/2005/20050505/default.htm

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The Growing Role of Hedge Funds in Derivatives Markets and the Financial System Generally
Of course, much of the unease about credit risk transfer outside the banking system reflects the growing role that hedge funds play in those markets and in the financial system generally. Although comprehensive data on the size of the hedge fund sector do not exist, total assets under management are estimated to be around $1 trillion. Inflows to hedge funds have been especially heavy since 2001, as investors have sought alternatives to long-only investment strategies in the wake of the bursting of the equity bubble. By some estimates, the size of the hedge fund sector doubled between 2001 and 2004. A substantial portion of the inflows to hedge funds in recent years reportedly has come from pension funds, endowments, and other institutional investors rather than from wealthy individuals.

Hedge funds have become increasingly valuable in our financial markets. They actively pursue arbitrage opportunities across markets and in the process often reduce or eliminate mispricing of financial assets. Their willingness to take short positions can act as an antidote to the sometimes-excessive enthusiasm of long-only investors. Perhaps most important, they often provide valuable liquidity to financial markets, both in normal market conditions and especially during periods of stress. They can ordinarily perform these functions more effectively than other types of financial intermediaries because their investors often have a greater appetite for risk and because they are largely free from regulatory constraints on investment strategies.

But some legitimate concerns have been expressed about the possible adverse effect of hedge funds' activities on market liquidity in some circumstances. One such concern is the potential for rapid outflows from the sector in the event that returns prove disappointing. Disappointments seem highly likely given the number of recent investors in this sector, all seeking arbitrage opportunities that of necessity will diminish as more capital is directed to exploiting them. Furthermore, some (perhaps many) hedge fund managers are likely to prove incapable of delivering the returns that investors apparently expect. Indeed, investors have already forced many hedge funds to fold after producing disappointing returns. Provided that investors do not force exiting funds to suddenly liquidate their assets, such exits contribute to the efficiency of the financial system and do not adversely affect market liquidity. Historically, investors have not been able to force the sudden liquidation of a hedge fund because investments have been subject to lengthy redemption or "lock up" requirements. However, there are reports that institutional investors have been able to negotiate much shorter redemption periods. If institutional money proves to be "hot money," hedge funds could become subject to funding pressures that would impair their ability to supply liquidity to markets and might cause them to add to demands on market liquidity.

Another circumstance in which hedge funds could negatively affect market liquidity is if they became so leveraged that adverse market movements could lead to their failure and force their counterparties to close out their positions and liquidate their collateral. For example, the fear of the market effects of closeout and liquidation of LTCM's very large net positions motivated its counterparties to recapitalize the hedge fund in 1998. LTCM was able to become so large and so highly leveraged because its derivatives and repo market counterparties, perhaps awed by the reputations of its principals, failed to effectively manage their credit risk to LTCM.

In the wake of the LTCM episode, the large banks and securities firms that were counterparties to hedge funds strengthened their management of hedge fund risk very significantly. Those improvements were motivated by their self-interest, which was reinforced by recommendations from their prudential supervisors and from the Counterparty Risk Management Policy Group (CRMPG), a group of twelve banks and securities firms that were among the most significant counterparties to hedge funds.4 However, recently there have been reports that competitive pressures have resulted in some weakening of risk-management practices.

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