MONEY and BANKING PAPERS LOW GRAPHICS

 

 
Hedge Fund Policy: Is There A Better Possibility
?

by Erica Hoff
 

 

What makes a hedge fund such a unique investment? And why is it so controversial? Many feel the risks of a hedge fund strongly outweigh its benefits. And with some funds, it does. But when a hedge fund strives, it has impeccable potential. It is arguable that the regulation on hedge funds, or lack there of, is what allows for so many to falter. However, despite various suggestions for policy changes, a few lemons still remain. Would changes in policy and regulation of a Hedge Fund allow it to be a more attractive investment opportunity? Although some alterations could make the hedge fund a safer investment, some risks are completely unavoidable. Ultimately, these changes may not only create more problems, but also take away from the uniqueness of this remarkable form of investment.

A hedge fund is typically a private partnership invested primarily in publicly traded securities or futures. They are limited to 99 investors and require large minimum investments, which can range from $25,000 to several million dollars. Sixty five percent of the investors must have a net worth of at least $1 million. A general partner, who uses sophisticated strategies to make bets on the fund’s direction, and generally receives 20% of the profits, leads the fund.

            Hedge fund strategies fall into four open categories: absolute return, long/short equity, event driven, and global asset allocation. Absolute driven strategies are known as "market-neutral" funds, which seek to moderate the effects of overall market forces. Long/Short hedge funds, which represent about half of the assets in the hedge fund industry, seek to profit from underpricings by buying long, and overpricing through short selling. Event driven hedge funds benefit from corporate mispricings, typically through events such as mergers and acquisitions or bankruptcies. And investors in the final hedge fund strategy, global asset allocation, invest in currencies, commodities, equities and debt around the world.

 

There is no such thing as an average hedge fund. Because of different strategies, along with various management styles, there is an extremely wide array of hedge fund returns.  Although they have potential for large profits, hedge funds are exposed to a number of risks. Factors such as leverage, portfolio concentration, and liquidity may make hedge funds riskier than other investments like bonds or mutual funds. The name hedge fund was thus derived to avoid, or hedge, some of these risks. This can be done, for example, by shorting stock or selling put options.

            Alfred Winslow formed the first hedge fund in 1949. He believed he had a better system for managing money, which included selling short stock to protect against market risk and borrowing money to boost the potential return on assets. In 1952, he later limited his partnership and charged incentive fees for his management. The success of his new idea caught on, and by 1966 there were nearly 200 hedge funds.

Good management skills were proved to be an essential factor in the survival of the hedge fund in the decades to come. Many leveraged long, in particularly risky and uncooperative markets, which led to only 68 identifiable hedge funds in 1984. However, as new ideas were developed, such as investing in the currency markets or using futures and options, the hedge fund industry exploded, and now measures more than 4500 funds today, with assets totaling $300 billion.

            Government regulation serves to protect investors, ensure the reliability of markets, and promote overall stability. Because there are so many unique characteristics of a hedge fund, it is not surprising that their regulatory policies deviate from standard government supervision.

Good management skills were proved to be an essential factor in the survival of the hedge fund in the decades to come. Many leveraged long, in particularly risky and uncooperative markets, which led to only 68 identifiable hedge funds in 1984. However, as new ideas were developed, such as investing in the currency markets or using futures and options, the hedge fund industry exploded, and now measures more than 4500 funds today, with assets totaling $300 billion.

            Government regulation serves to protect investors, ensure the reliability of markets, and promote overall stability. Because there are so many unique characteristics of a hedge fund, it is not surprising that their regulatory policies deviate from standard government supervision.

 

The most controversial regulation policies are the ones that seek to limit pressure to the financial system. Supervision attempts that affect hedge funds in particular include margin requirements, collateral requirements, and limits on activities with financial intermediaries. The government also seeks to manage the risks connected with lending to hedge funds, as well as brokers and banks, by requesting daily payments and collateralizing their lending. They monitor hedge fund investment strategies, monthly returns, and investor withdrawals. 

There are many advantages to hedge funds that other investments cannot match. Those who invest in hedge funds are exceptionally secure in their financial positions. The high minimums required for hedge fund investments significantly increase its opportunity for larger than normal returns. This advantage also allows hedge funds to have a great degree of freedom in investment strategies, and keeps participants locked in for many periods at a time. When a market is failing, hedge funds can wait it out, as opposed to mutual funds that may have to liquidate assets or pay off withdrawals.

Hedge funds also profit from their many trading advantages. Some of these advantages include lower transaction costs, better market access, and size advantages. Other financial institutions, such as mutual funds, also possess some of these advantages. But hedge funds have greater investment flexibility. For example, hedge funds can profit from borrowing in up markets and short selling in down markets. These activities can increase market liquidity and can help depreciating currency to stabilize. Mutual funds, on the other hand, can't use leverage, leaving them no other option for funding but to raise cash.

Although they have the ability to be extremely profitable, there are some disadvantages that can make hedge funds very vulnerable. When things go wrong with hedge funds, they go very wrong. Their use of leverage, which is far greater than the typical closed investment, can pose a great threat when the fund's investment strategies contrast with the market.

 

Another disadvantage is that there is no current way to measure the amount of credit hedge funds obtains from other countries. Low amounts of government supervision can sometimes work to the hedge fund's advantage. However, the manager may not always see the first signs of trouble, and added assets in foreign markets may increase the problem when the fund begins to falter. This problem arose with LTCM (the Long Tem Capital Management hedge fund), where the United States and Switzerland were unaware of each other’s participation in the fund. This not only created risks for LTCM, but also significantly contributed to the vulnerability of the international financial system as a whole.        

            Since the creation of hedge funds, regulators have struggled to find a happy medium in the proper amount of government supervision. Policies are implemented to minimize securities laws and the amount of information hedge funds are required to disclose. But because so many funds have failed, supervisors question whether or not they should shorten what is arguably a very long leash. The vast majority of proposed solutions seek to decrease the hedge fund's risk and/or increase its regulation requirements.

One idea to improve hedge fund policies is to raise requirements on bank lending to hedge funds. This can be done, for example, by charging banks that lend money to funds, which fail to make public disclosures regarding information on their trades and positions. In 1994, a House Banking Committee considered such improvements by creating a "Large Trader Reporting System," but the idea quickly died when brought to congress. Others suggest raising margin and collateral requirements on exchange-traded products. This would further increase limitations on the amount of borrowing done by hedge funds.

            Policy makers could instead aim to limit the positions taken by hedge funds in the domestic financial markets. One recommendation is to, like Chile, tax short-term capital inflows. Doing so would discourage hedge fund managers from taking long positions, and may even encourage them to suddenly close out. To decrease short positions, others suggest prohibiting financial institutions from giving domestic credit needed to short the currency, and lending the securities needed to short equity markets.

 

Many have also proposed stronger communication guidelines. One idea is to require banks to disclose information on their borrowing to hedge funds. This "credit registry" would allow supervisors to collect information on their banks' exposure and report it to an international registry, resembling the quarterly publications by the Bank for International Settlements. It may also be beneficial to ask hedge funds to publicly summarize information on their portfolios. According to the U.S. President's Joint Task Force on Hedge Funds, doing so would strengthen market discipline of their bank creditors. 

            Rather than setting standards to decrease the freedom of hedge funds, others suggest rewarding those who act favorably with regulators. One idea given by Federal Reserve officials and the chairman of the Securities and Exchange Commission was to set voluntary courses of action to extend credit to those funds participating in centralized exchanges, instead of less familiar off-shore markets.

Despite various proposed solutions, it is apparent to many that some problems with hedge funds are completely unavoidable. If banks become forced to publicly disclose credits given to hedge funds, it could create the idea that all participants really know their exposure to high risks, when it may not necessarily be the case. Such exposure would produce asymmetric information, leading in particular to moral hazard for lenders. This is because lenders might think managing authorities would turn to other sources, such as investment banks, to provide information.

            One would agree it is beneficial for banks and their regulators to be fully aware of each hedge fund's total borrowings. But these actions are unattractive to hedge fund managers, and it is far too easy for them to arrange transactions in unregulated or offshore markets. This would consequently neutralize all efforts to watch over these funds more carefully.

Further, by discouraging trading in markets where positions can easily be taken and liquidated, hedge funds may be encouraged, along with many other investors, to enter inflexible markets. Doing so would not only slow down the development of domestic financial markets. Even further, overall economic growth could decline.

            Though many have suggested various ways to resolve the so-called problems regarding hedge fund policies, it is not obvious as to whether or not these problems can fix. One concern is that hedge fund positions move at an extremely rapid rate. It is therefore not clear how an increase in regulation, by forcing public disclosures for example, could be a useful solution. In the case of LTCM, the focus of regulatory concern was why banking regulators never saw the early warning signs that would have indicated banks had loaned too much credit to a fund which was already taking a turn for the worse. Many blame human error. According to Paul Roth, vice chairman of the American Bar Association's task force on hedge funds, "Someone was asleep at the switch. (The problem with hedge funds is) whether or not people were paying attention."

 

Others feel that there is no form of flawless regulation. Instead of human error, it is said that some can easily challenge the system. "Anything the government comes up with,” said Thomas Petri, “you will find some really smart people to manipulate it."

            Also constant is each investor's individual risk preference. Some consumers are risk lovers, favoring the investments that may lead to high profits, but are full of high risks.  Because hedge funds fall into this type of investment, there will always be people interested in risking large investments.

Perhaps more importantly, is the argument if these problems should be fixed. "Long-Term Capital would have never been able to grow and have the leverage it had, if it had not been lent the money," said Bert Ely. Though many may argue that hedge funds do more harm than good, they are still extremely popular investments and have proven to be very successful.

            Many have benefited with the current hedge fund policy and see no need for regulatory changes. Various proposed changes may not, in fact, be entirely beneficial. Once implemented, the suggested solutions could create more problems for the hedge fund world. And such changes would alter the characteristics that attract so many to such incredible investment opportunities. In the end, a better hedge fund policy is neither plausible nor desirable.

Sources:

http://library.hbs.edu/hedgefunds.htm

http://www-personal.umd.umich.edu/~mtwomey/newspapers/100198he.html

http://www.bernstein.com/perfstrat/products/ts_020401.htm

 

 

 

 

 

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