Guide to hedge funds, p.10
Guide to Hedge Funds, page 10
Prime brokers can get away with the third charge because they provide a consolidation service for funds, keeping track of the trades they make and the positions they have taken.
Prime broking is not the only way in which hedge funds interact with investment banks. They can use a bank as the administrator (the person who makes sure all the paperwork is correct). The bank also provides the hedge fund with research, suggesting which securities are the best to buy. Nicholas Roe, European head of equity finance at Citigroup, says:
Hedge funds are the best customers of investment banks. They are better payers than those who use the antiquated voting system for research.
The relationship was once even cosier. As Patric de Gentile-Williams, former CEO of PCE Investors, says:
It used to be the case that brokers would provide managers with free office space in return for trading commissions but that’s not allowed any more.
Nevertheless, Dresdner Kleinwort has estimated that hedge funds earn around $50 billion a year for the investment banking sector. That does raise the question of whether they can really be the effective watchdogs for an industry that pays them so well.
Managing their own risk
The more sophisticated hedge funds take risk seriously. After all, they do not want to go out of business because of a mistake in assessing the volatility of their portfolios. Pat Trew is chief risk officer at CQS, a London-based hedge fund manager. He points out that managers face four distinct types of risk. The most obvious is market risk (that prices move against you), but there is also liquidity risk (an inability to sell your positions or have the right level of margin on a leveraged portfolio), counterparty risk (that the firm you trade with fails to pay up) and operational risk (which covers anything from valuing positions incorrectly to failing to comply with regulations).
Trew has accordingly developed what he calls the “seven pillars of risk assessment”, which he uses to subject the funds to a series of stresses, including the time it would take to offload the vast bulk of a fund’s portfolio. He says:
You have to consider whether the portfolio is appropriate given the duration of your capital and the depth of the market. The worst scenario is to be a big player in a market that deteriorates rapidly and every investor wants out.
CQS also has over 30 people in its information technology and operations departments. The latter is responsible for confirming that transactions are processed as accurately and smoothly as possible and has played its part in industry forums, such as the IOSCO working group on valuation. Its basic philosophy is that hedge funds are paid to take risk in the markets, not in their operations and how they run their business.
Some of this work could be outsourced, of course, but risk control is something that the funds-of-funds groups and the consultants who advise hedge funds take very seriously these days.
Regulators would like to see both hedge funds and prime brokers use “stress tests” to work out what might happen if things go wrong. But part of the problem with stress tests is the tendency to base them on events that have happened in the past. However, the next crisis is rarely like the last, as the credit crunch showed. A Financial Stability Forum report in May 2007 worried whether:6
… firms take sufficient account of low probability events that would impose very large losses on them and other market participants. Internal incentives may work against firms taking full account of such events in limit setting, capital charging and other risk management policies.
In other words, if hedge funds or prime brokers take too cautious a view, they will miss out on the chance for profit. And profit can translate into some juicy bonuses.
One potential weakness is the use of value at risk or VAR models. These try to assess the maximum amount a portfolio can lose in any short period; inevitably the assessment is based on past data (which can prove misleading). When volatility is low, VAR models provoke firms into increasing their capital-at-risk, only to cut it when volatility increases. But if everyone is using these models, they will all want to sell when volatility spikes, a process that will push volatility up even further. That sounds like a recipe for crashes.
All told, the Financial Stability Forum report concluded:
Areas of continuing weakness in many funds have been identified. These include: pricing and valuation of illiquid securities; analysing market correlations; lack of stress-testing, absence of concentration limits, overreliance on statistical value-at-risk measures; inadequate tracking of liquidity; insufficient use of electronic platforms and the need to further standardise industry documentation.
In particular, the report said that smaller managers and those who had not attracted institutional investors had not developed their risk controls. The industry still has plenty of work to do.
5 Hedge funds: for and against
Hedge funds attract some pretty strong opinions. A friend of the author, someone who has spent an entire career in investment management, described them as “a menace; they’re not interested in the business or in the long term at all”. Trade unionists and left-wing politicians express their concern in much more graphic terms.
The case against hedge funds comes in three distinct varieties. The first is political, and is closely linked with the general case against free-market liberalism. At its heart, hedge fund critics simply dislike the ability of managers to make so much money and worry that this is made at the expense of ordinary people. In their eyes, hedge funds are simply the latest example of rapacious capitalists, from a long line that includes multinational corporations, investment bankers and private equity groups. Resentment is particularly high in continental Europe, where hostile takeovers and active shareholders are recent innovations. The credit crunch gave such critics the chance to take their revenge on the industry, regardless of its role in the crisis. As one fund manager says:
When a fight breaks out in a bar, you don’t hit the bloke who started it. You hit the nearest bloke you don’t like.
Similar arguments were made against the corporate raiders in the 1980s and were outlined by Will Hutton in his book The State We’re In.1 Hedge funds destroy rather than create; they are interested in short-term profits and not the long-term health of a business. They push companies to return cash to shareholders, or to get taken over. That stops executives from investing in new plant and equipment, or from taking on new employees; indeed, hedge fund actions seem to result in a loss of jobs.
The second variety of criticism focuses on the risks that hedge funds take. As this book has made clear, hedge funds are only lightly regulated; the positions they take are not open for analysis by outsiders; they can also use borrowed money to enhance returns. In the case of LTCM, they used an awful lot of borrowed money and the Federal Reserve started to worry about the stability of the financial system. With even more hedge funds around today, is the financial system even more at risk?
This line of attack also gained more adherents during the credit crunch. In particular, it was felt that the hedge funds were undermining the banks. During the crisis, the financial health of the banks was judged in two ways: via the share price and via the cost of insuring against default on their bonds (credit default swaps). The two measures played against each other. As fear of default increased the share price fell, and a falling share price made default seem more likely. The hedge funds could play both sides of the trade, shorting the shares and buying protection against default. They could, in effect, make a bank failure a self-fulfilling prophecy. Governments duly restricted the ability to sell short shares in banks (and some other financial groups).
Later on in the crisis, hedge funds faced a combination of falling asset prices and demands from clients to get their money back. Although such a problem was also faced by conventional managers (of mutual funds and unit trusts), it was argued that hedge funds were under more pressure to sell because their use of leverage caused the value of their funds to fall more sharply. In other words, the existence of hedge funds made prices fall faster and further.
The third type of criticism centres on the deal that investors receive. Hedge fund fees are too high in a world of low nominal returns. They may ensure that managers get rich, but the same will not be true for the clients. It is a rewrite of the old Wall Street tale about a trainee who is taken to the harbour; he is shown the hedge fund managers’ yachts and then the yachts of the prime brokers that serve them. “But”, asks the naive youngster, “where are the customers’ yachts?”
The role of hedge funds in society
It certainly seems hard to claim, at first sight, that hedge funds earn rewards commensurate with their contribution to society. Doctors, firemen and policemen all perform roles that appear much more useful.
So how can a case be constructed in their favour? Hedge funds provide liquidity to the market, and thus make it easier for businesses to raise money. Indeed, they may well lower the cost of capital. And to the extent that businesses find it easier to grow, more people will be employed and the whole society will be more prosperous. If that is worth, say, $20 a year to each person in the United States and Europe, it adds up to $10 billion to be shared around by the hedge fund managers.
This line of reasoning may sound like special pleading from a free-market fundamentalist. But think, for a second, about risk and insurance. In a world without insurance, companies would rapidly go out of business if their factories burned down. By pooling together risks, insurance companies play a valuable role in society; they make it easier for businesses to be established and to survive.
Financial risks may be less obvious but they can be just as damaging as physical ones. Exchange rates may move in the wrong direction, interest rates may soar, plunging stockmarkets may deplete a company pension fund. These risks can be parcelled up and dispersed, just like the risk of fire and theft; hedge funds play a part in this process. By adding liquidity to the markets, they make it easier and cheaper to insure against those risks.
Peter Bernstein says in his book Capital Ideas that “because the stockmarket makes diversification easy and inexpensive, the average level of risk-taking in society is enhanced”.2 We need only to look at countries where it is hard to set up businesses because of regulation or corruption to realise the benefit of more open societies.
A cynic might still say, “Well, where is my $20?” It is probably made up of a small amount of incremental gains; lower prices from a company here, better employment opportunities there, and better, or more efficient, services somewhere else.
If that argument seems a little contrived, the subject could be approached from the opposite direction. What would the world be like if we banned hedge funds from operating? The process would involve a lot of government interference. To regulate fees, the authorities would have to prevent a client from entering into a commercial arrangement with a fund manager. And if they stopped clients from paying hedge funds too much, why not lawyers, accountants or footballers?
As of late 2009, the EU seemed to be suggesting that hedge funds (and private equity) should be subject to the same pay rules as banks, with bonuses paid only over the longer term. It is not clear how the rules would work; the best guess is that managers would be forced to invest their bonuses in the funds they manage. But since they usually invest a lot of their money this way, it is not clear how their behaviour would change.
We could attempt to cap the incomes of individual hedge fund managers by taxation. But the era of high taxation (an effective 98% rate in Britain in the 1970s) was hardly an economic golden age. The same tax rate would catch other successful people and be a disincentive to work hard.
This is not to say top tax rates could not be higher than they are at the moment; there is always room for argument at the margin. However, in an era of labour mobility, any one country could not push its tax rate too high without driving a lot of business abroad. So any attempt to cap hedge fund incomes would need to be co-ordinated at the global level. After all, there would be high incentives for any country to undercut the others, so as to attract all those rich people. This is why so many hedge funds have their nominal headquarters in the Caribbean. Taxing financial transactions (a levy on every deal) would run into the same problem, and would undoubtedly raise the cost of doing business for everyone.
Another approach would be to restrict what hedge funds could do by, for example, banning short-selling as occurred during the credit crunch. But, as was argued in the Introduction, short-selling plays an important role in setting prices accurately. Indeed, hedge fund managers were some of the most acute observers of the dodgy strategies being pursued by banks during the credit boom. Instead of being listened to, they were usually attacked. A restriction on short-selling only creates the scope for even bigger bubbles.
Or we could try to restrict the ability of hedge funds to get involved in takeovers by imposing a minimum holding period before investors could use their votes. Again, we would expect investors to demand a higher return for buying shares with restricted rights; in other words, the cost of capital would go up. It is far from clear that countries that restrict the ability of companies to be taken over end up more prosperous as a result; all that results is complacent executives who milk the company for benefits rather than pursue the best interests of shareholders.
Protecting national champions from takeover sounds superficially attractive. But think about the British car industry, churning out a lot more cars through Nissan, Ford and General Motors than it would surely have done under the old British Leyland. Or take the financial services industry itself, Britain’s most important industry. Quite a lot of it is in foreign hands but the result is that London is challenging New York for the title of premier global financial centre.
Industry protectionism leads to higher prices for consumers, since the result is local monopolies. It also prevents economies from benefiting from the process of creative destruction, as capital is reallocated from inefficient businesses to more efficient ones. Hedge funds give this process a helpful shove.
An academic study,3 cited in Chapter 1, which looked at the actions of activist hedge funds over the period 2004–05, found no support for the view that hedge funds destroyed value or were short-term in focus. It found that campaigns run by activist funds resulted in abnormal returns for investors and focused on companies with a low price to book, or asset, value. The highest returns occurred when the sale of the company was targeted; hostile approaches were more successful than friendly ones.
Hedge funds and risk
When the dotcom bubble was at its height in 1999–2000, American retail investors piled into technology mutual funds and British investors bought technology unit trusts. Within three years, several of those funds had lost 90% of their value. Yet few people talk about the riskiness of the mutual fund industry.
This is the sort of thing that frustrates hedge fund enthusiasts. After all, their industry spends a great deal of time trying to control risk. The worst examples of risk management occurred at the banks, which were heavily regulated in every country. But a few examples (Long-Term Capital Management or the 2007 near wipe-out of two Bear Stearns credit funds) taint the whole industry.
However, we have to recognise that risks have to be taken to generate any return that is greater than cash. Hedge funds are not completely hedged. International Asset Management, a funds-of-funds group, has a nice definition:4
It is better to think of a hedge fund as a fund that hedges away any risk not related to its speculative strategy.
The risks that concern regulators about hedge funds are threefold. The first, as highlighted in the last chapter, is the problem of fraud. The Madoff case should make institutions more involved in assessing hedge fund managers, checking their backgrounds and monitoring their systems. The second is the scope for market abuse; it should be possible to adapt existing rules to cope with this problem.
The most important risk is the question of leverage. Although not all hedge funds use leverage, the concept is inherent to the industry. Traditional long-only equity managers have a great advantage; the market normally goes up, often delivering double-digit annual percentage returns. If hedge fund managers are properly hedged, it would be hard to match that kind of return; the gap between their long and their short positions is not likely to be that wide. But provided their skill is real and persistent, the managers can use leverage to gear up their returns so they are competitive with the market, and can justify their fees.
This use of leverage means that hedge funds can be a lot more important to the system than their assets under management would suggest. A 2007 report by Fitch, a rating agency, suggested that credit-oriented funds, with some $300 billion under management, had geared up to buy some $1.5 trillion–1.8 trillion in debt. When things went wrong, such leveraged investors had to sell quickly before all their capital was eroded. If the hedge fund is big enough and leveraged enough, that can be a problem.
When LTCM wobbled in 1998, the fund’s positions were so large that most of the big banks were potentially affected. The Federal Reserve, America’s central bank, was worried that the markets would freeze, as institutions worried about the health of those they traded with. That was the problem that led the Fed to organise a rescue; a central bank should not normally worry about hedge fund investors on the basis that they should be able to look after themselves.
Ever since the LTCM saga, central banks have made it their job to try to monitor the relationship between banks and hedge funds. The April 2007 issue of the Bank of England’s financial stability report, for example, contained a two-page section on hedge funds and financial stability. Its conclusions were reasonably benign, pointing out that the market easily coped with problems faced by the Amaranth hedge fund in 2006. However, it added:
Prime broking is not the only way in which hedge funds interact with investment banks. They can use a bank as the administrator (the person who makes sure all the paperwork is correct). The bank also provides the hedge fund with research, suggesting which securities are the best to buy. Nicholas Roe, European head of equity finance at Citigroup, says:
Hedge funds are the best customers of investment banks. They are better payers than those who use the antiquated voting system for research.
The relationship was once even cosier. As Patric de Gentile-Williams, former CEO of PCE Investors, says:
It used to be the case that brokers would provide managers with free office space in return for trading commissions but that’s not allowed any more.
Nevertheless, Dresdner Kleinwort has estimated that hedge funds earn around $50 billion a year for the investment banking sector. That does raise the question of whether they can really be the effective watchdogs for an industry that pays them so well.
Managing their own risk
The more sophisticated hedge funds take risk seriously. After all, they do not want to go out of business because of a mistake in assessing the volatility of their portfolios. Pat Trew is chief risk officer at CQS, a London-based hedge fund manager. He points out that managers face four distinct types of risk. The most obvious is market risk (that prices move against you), but there is also liquidity risk (an inability to sell your positions or have the right level of margin on a leveraged portfolio), counterparty risk (that the firm you trade with fails to pay up) and operational risk (which covers anything from valuing positions incorrectly to failing to comply with regulations).
Trew has accordingly developed what he calls the “seven pillars of risk assessment”, which he uses to subject the funds to a series of stresses, including the time it would take to offload the vast bulk of a fund’s portfolio. He says:
You have to consider whether the portfolio is appropriate given the duration of your capital and the depth of the market. The worst scenario is to be a big player in a market that deteriorates rapidly and every investor wants out.
CQS also has over 30 people in its information technology and operations departments. The latter is responsible for confirming that transactions are processed as accurately and smoothly as possible and has played its part in industry forums, such as the IOSCO working group on valuation. Its basic philosophy is that hedge funds are paid to take risk in the markets, not in their operations and how they run their business.
Some of this work could be outsourced, of course, but risk control is something that the funds-of-funds groups and the consultants who advise hedge funds take very seriously these days.
Regulators would like to see both hedge funds and prime brokers use “stress tests” to work out what might happen if things go wrong. But part of the problem with stress tests is the tendency to base them on events that have happened in the past. However, the next crisis is rarely like the last, as the credit crunch showed. A Financial Stability Forum report in May 2007 worried whether:6
… firms take sufficient account of low probability events that would impose very large losses on them and other market participants. Internal incentives may work against firms taking full account of such events in limit setting, capital charging and other risk management policies.
In other words, if hedge funds or prime brokers take too cautious a view, they will miss out on the chance for profit. And profit can translate into some juicy bonuses.
One potential weakness is the use of value at risk or VAR models. These try to assess the maximum amount a portfolio can lose in any short period; inevitably the assessment is based on past data (which can prove misleading). When volatility is low, VAR models provoke firms into increasing their capital-at-risk, only to cut it when volatility increases. But if everyone is using these models, they will all want to sell when volatility spikes, a process that will push volatility up even further. That sounds like a recipe for crashes.
All told, the Financial Stability Forum report concluded:
Areas of continuing weakness in many funds have been identified. These include: pricing and valuation of illiquid securities; analysing market correlations; lack of stress-testing, absence of concentration limits, overreliance on statistical value-at-risk measures; inadequate tracking of liquidity; insufficient use of electronic platforms and the need to further standardise industry documentation.
In particular, the report said that smaller managers and those who had not attracted institutional investors had not developed their risk controls. The industry still has plenty of work to do.
5 Hedge funds: for and against
Hedge funds attract some pretty strong opinions. A friend of the author, someone who has spent an entire career in investment management, described them as “a menace; they’re not interested in the business or in the long term at all”. Trade unionists and left-wing politicians express their concern in much more graphic terms.
The case against hedge funds comes in three distinct varieties. The first is political, and is closely linked with the general case against free-market liberalism. At its heart, hedge fund critics simply dislike the ability of managers to make so much money and worry that this is made at the expense of ordinary people. In their eyes, hedge funds are simply the latest example of rapacious capitalists, from a long line that includes multinational corporations, investment bankers and private equity groups. Resentment is particularly high in continental Europe, where hostile takeovers and active shareholders are recent innovations. The credit crunch gave such critics the chance to take their revenge on the industry, regardless of its role in the crisis. As one fund manager says:
When a fight breaks out in a bar, you don’t hit the bloke who started it. You hit the nearest bloke you don’t like.
Similar arguments were made against the corporate raiders in the 1980s and were outlined by Will Hutton in his book The State We’re In.1 Hedge funds destroy rather than create; they are interested in short-term profits and not the long-term health of a business. They push companies to return cash to shareholders, or to get taken over. That stops executives from investing in new plant and equipment, or from taking on new employees; indeed, hedge fund actions seem to result in a loss of jobs.
The second variety of criticism focuses on the risks that hedge funds take. As this book has made clear, hedge funds are only lightly regulated; the positions they take are not open for analysis by outsiders; they can also use borrowed money to enhance returns. In the case of LTCM, they used an awful lot of borrowed money and the Federal Reserve started to worry about the stability of the financial system. With even more hedge funds around today, is the financial system even more at risk?
This line of attack also gained more adherents during the credit crunch. In particular, it was felt that the hedge funds were undermining the banks. During the crisis, the financial health of the banks was judged in two ways: via the share price and via the cost of insuring against default on their bonds (credit default swaps). The two measures played against each other. As fear of default increased the share price fell, and a falling share price made default seem more likely. The hedge funds could play both sides of the trade, shorting the shares and buying protection against default. They could, in effect, make a bank failure a self-fulfilling prophecy. Governments duly restricted the ability to sell short shares in banks (and some other financial groups).
Later on in the crisis, hedge funds faced a combination of falling asset prices and demands from clients to get their money back. Although such a problem was also faced by conventional managers (of mutual funds and unit trusts), it was argued that hedge funds were under more pressure to sell because their use of leverage caused the value of their funds to fall more sharply. In other words, the existence of hedge funds made prices fall faster and further.
The third type of criticism centres on the deal that investors receive. Hedge fund fees are too high in a world of low nominal returns. They may ensure that managers get rich, but the same will not be true for the clients. It is a rewrite of the old Wall Street tale about a trainee who is taken to the harbour; he is shown the hedge fund managers’ yachts and then the yachts of the prime brokers that serve them. “But”, asks the naive youngster, “where are the customers’ yachts?”
The role of hedge funds in society
It certainly seems hard to claim, at first sight, that hedge funds earn rewards commensurate with their contribution to society. Doctors, firemen and policemen all perform roles that appear much more useful.
So how can a case be constructed in their favour? Hedge funds provide liquidity to the market, and thus make it easier for businesses to raise money. Indeed, they may well lower the cost of capital. And to the extent that businesses find it easier to grow, more people will be employed and the whole society will be more prosperous. If that is worth, say, $20 a year to each person in the United States and Europe, it adds up to $10 billion to be shared around by the hedge fund managers.
This line of reasoning may sound like special pleading from a free-market fundamentalist. But think, for a second, about risk and insurance. In a world without insurance, companies would rapidly go out of business if their factories burned down. By pooling together risks, insurance companies play a valuable role in society; they make it easier for businesses to be established and to survive.
Financial risks may be less obvious but they can be just as damaging as physical ones. Exchange rates may move in the wrong direction, interest rates may soar, plunging stockmarkets may deplete a company pension fund. These risks can be parcelled up and dispersed, just like the risk of fire and theft; hedge funds play a part in this process. By adding liquidity to the markets, they make it easier and cheaper to insure against those risks.
Peter Bernstein says in his book Capital Ideas that “because the stockmarket makes diversification easy and inexpensive, the average level of risk-taking in society is enhanced”.2 We need only to look at countries where it is hard to set up businesses because of regulation or corruption to realise the benefit of more open societies.
A cynic might still say, “Well, where is my $20?” It is probably made up of a small amount of incremental gains; lower prices from a company here, better employment opportunities there, and better, or more efficient, services somewhere else.
If that argument seems a little contrived, the subject could be approached from the opposite direction. What would the world be like if we banned hedge funds from operating? The process would involve a lot of government interference. To regulate fees, the authorities would have to prevent a client from entering into a commercial arrangement with a fund manager. And if they stopped clients from paying hedge funds too much, why not lawyers, accountants or footballers?
As of late 2009, the EU seemed to be suggesting that hedge funds (and private equity) should be subject to the same pay rules as banks, with bonuses paid only over the longer term. It is not clear how the rules would work; the best guess is that managers would be forced to invest their bonuses in the funds they manage. But since they usually invest a lot of their money this way, it is not clear how their behaviour would change.
We could attempt to cap the incomes of individual hedge fund managers by taxation. But the era of high taxation (an effective 98% rate in Britain in the 1970s) was hardly an economic golden age. The same tax rate would catch other successful people and be a disincentive to work hard.
This is not to say top tax rates could not be higher than they are at the moment; there is always room for argument at the margin. However, in an era of labour mobility, any one country could not push its tax rate too high without driving a lot of business abroad. So any attempt to cap hedge fund incomes would need to be co-ordinated at the global level. After all, there would be high incentives for any country to undercut the others, so as to attract all those rich people. This is why so many hedge funds have their nominal headquarters in the Caribbean. Taxing financial transactions (a levy on every deal) would run into the same problem, and would undoubtedly raise the cost of doing business for everyone.
Another approach would be to restrict what hedge funds could do by, for example, banning short-selling as occurred during the credit crunch. But, as was argued in the Introduction, short-selling plays an important role in setting prices accurately. Indeed, hedge fund managers were some of the most acute observers of the dodgy strategies being pursued by banks during the credit boom. Instead of being listened to, they were usually attacked. A restriction on short-selling only creates the scope for even bigger bubbles.
Or we could try to restrict the ability of hedge funds to get involved in takeovers by imposing a minimum holding period before investors could use their votes. Again, we would expect investors to demand a higher return for buying shares with restricted rights; in other words, the cost of capital would go up. It is far from clear that countries that restrict the ability of companies to be taken over end up more prosperous as a result; all that results is complacent executives who milk the company for benefits rather than pursue the best interests of shareholders.
Protecting national champions from takeover sounds superficially attractive. But think about the British car industry, churning out a lot more cars through Nissan, Ford and General Motors than it would surely have done under the old British Leyland. Or take the financial services industry itself, Britain’s most important industry. Quite a lot of it is in foreign hands but the result is that London is challenging New York for the title of premier global financial centre.
Industry protectionism leads to higher prices for consumers, since the result is local monopolies. It also prevents economies from benefiting from the process of creative destruction, as capital is reallocated from inefficient businesses to more efficient ones. Hedge funds give this process a helpful shove.
An academic study,3 cited in Chapter 1, which looked at the actions of activist hedge funds over the period 2004–05, found no support for the view that hedge funds destroyed value or were short-term in focus. It found that campaigns run by activist funds resulted in abnormal returns for investors and focused on companies with a low price to book, or asset, value. The highest returns occurred when the sale of the company was targeted; hostile approaches were more successful than friendly ones.
Hedge funds and risk
When the dotcom bubble was at its height in 1999–2000, American retail investors piled into technology mutual funds and British investors bought technology unit trusts. Within three years, several of those funds had lost 90% of their value. Yet few people talk about the riskiness of the mutual fund industry.
This is the sort of thing that frustrates hedge fund enthusiasts. After all, their industry spends a great deal of time trying to control risk. The worst examples of risk management occurred at the banks, which were heavily regulated in every country. But a few examples (Long-Term Capital Management or the 2007 near wipe-out of two Bear Stearns credit funds) taint the whole industry.
However, we have to recognise that risks have to be taken to generate any return that is greater than cash. Hedge funds are not completely hedged. International Asset Management, a funds-of-funds group, has a nice definition:4
It is better to think of a hedge fund as a fund that hedges away any risk not related to its speculative strategy.
The risks that concern regulators about hedge funds are threefold. The first, as highlighted in the last chapter, is the problem of fraud. The Madoff case should make institutions more involved in assessing hedge fund managers, checking their backgrounds and monitoring their systems. The second is the scope for market abuse; it should be possible to adapt existing rules to cope with this problem.
The most important risk is the question of leverage. Although not all hedge funds use leverage, the concept is inherent to the industry. Traditional long-only equity managers have a great advantage; the market normally goes up, often delivering double-digit annual percentage returns. If hedge fund managers are properly hedged, it would be hard to match that kind of return; the gap between their long and their short positions is not likely to be that wide. But provided their skill is real and persistent, the managers can use leverage to gear up their returns so they are competitive with the market, and can justify their fees.
This use of leverage means that hedge funds can be a lot more important to the system than their assets under management would suggest. A 2007 report by Fitch, a rating agency, suggested that credit-oriented funds, with some $300 billion under management, had geared up to buy some $1.5 trillion–1.8 trillion in debt. When things went wrong, such leveraged investors had to sell quickly before all their capital was eroded. If the hedge fund is big enough and leveraged enough, that can be a problem.
When LTCM wobbled in 1998, the fund’s positions were so large that most of the big banks were potentially affected. The Federal Reserve, America’s central bank, was worried that the markets would freeze, as institutions worried about the health of those they traded with. That was the problem that led the Fed to organise a rescue; a central bank should not normally worry about hedge fund investors on the basis that they should be able to look after themselves.
Ever since the LTCM saga, central banks have made it their job to try to monitor the relationship between banks and hedge funds. The April 2007 issue of the Bank of England’s financial stability report, for example, contained a two-page section on hedge funds and financial stability. Its conclusions were reasonably benign, pointing out that the market easily coped with problems faced by the Amaranth hedge fund in 2006. However, it added:
