Hedge Funds, Financial Stability and Market Integrity Appendix 1: Some Basic Facts About Hedge Funds

There is no standard definition of a hedge fund. Their typical characteristics are: they are limited partnerships whose main function is investment management; they are generally run out of the US, though legally are domiciled in offshore tax havens; they do not solicit funds directly from the public or advertise, but attract investors by word of mouth; and they have high minimum investment levels, ranging between US$100,000 to US$5 million, with US$1 million common. These latter characteristics allow them to gain exemptions from various US federal securities laws, such as Securities and Exchange Commission (SEC) reporting, regulatory restrictions on leverage and trading strategies, and investor protector legislation.

Hedge funds may be grouped into four broad categories, defined by investment strategy:

1. market-neutral or relative-value funds which invest in fixed income and/or equity instruments and adopt strategies which do not depend on the general direction of markets. Managers exploit market inefficiencies, looking for disparities in pricing relationships between instruments with similar pricing characteristics (including fixed interest arbitrage, convertible bond arbitrage and mortgage-backed securities arbitrage, and derivatives arbitrage, and where the price anomalies are generally driven by government intervention, policy changes or forced selling).^[1] These funds had traditionally been regarded as the most conservative of hedge funds because they limit their operations to arbitrage, which was seen as a low-risk activity. However, the episode involving Long-Term Capital Management, which was counted in this group of funds, showed that such activities can be very risky if they are funded by a high level of leverage. According to the IMF (1998), market-neutral funds comprise about 25 per cent of funds and 20 per cent of assets.
2. event-driven funds which are also active in fixed interest and equity markets but base their strategies on the actual or anticipated occurrence of a particular event, such as a merger, bankruptcy announcement or corporate re-organisation. According to the IMF (1998), event-driven funds comprise about 15 per cent of funds and 10 per cent of assets.
3. long/short funds which invest in fixed interest and, especially, equity markets, combining short sales with long investments to reduce, but not eliminate, market exposure. This may entail, for example, borrowing securities the hedge fund judges to be overvalued from brokers, and then selling them on the market in the expectation that the price will be lower when the fund has to buy the securities back to be able to return them to the brokers. These funds can take positions along the whole risk-return spectrum and try to distinguish their performance from that of the asset class as a whole. According to the IMF (1998), these funds account for only a very small part of the market, but they are given much more prominence in the report by Goldman Sachs and Financial Risk Management Ltd.
4. tactical-trading funds, including most macro and global funds, which speculate on the direction of market prices of currencies, commodities, and equities and bonds on spot or futures markets. Global funds invest in emerging markets or specific regions, of which Tiger Fund is probably the most famous. The most famous macro fund group is probably George Soros's Quantum Group. Management of tactical funds is described as either systematic or discretionary. Systematic managers follow trends identified by technical analysis using proprietary computer models, while discretionary managers use a less quantitative approach, relying on both fundamental and technical analysis. Tactical-trading funds are the most volatile of the different types of funds. According to the IMF (1998), these funds account for 54 per cent of funds and 67 per cent of assets.

There is no authoritative source of information about hedge funds. Any information is provided voluntarily by the funds themselves and without due diligence, so data are sketchy and should be used with caution. Hedge funds are not allowed to advertise and so they depend on ‘word of mouth’ to generate investor funds. One way that they do this is to provide information to various industry groups, like Van Hedge Fund Advisors, Hedge Fund Research, and MarHedge. For a fee (in thousands of US dollars), these groups provide investors with statistics on earnings and some basic figures on balance-sheet size and leverage. These figures are not subject to scrutiny and no assurance is given that definitions are applied consistently and that data are comparable. For example, groups like MarHedge do not specify a definition of leverage, but rather leave it to the discretion of the fund to report leverage statistics on whatever basis it chooses.

There is even considerable uncertainty about the number of hedge funds and the size of their assets. Goldman Sachs and Financial Risk Management Ltd (July 1998) estimate, for example, that there are 1,300 hedge fund management groups which operate over 3,500 hedge funds (with different risk and investment characteristics). Total capital is estimated to be about US$200 billion and total assets at about US$400 billion. Van Hedge Fund (July 1998), a data collection group, says there are 4,000 funds, while The Economist (17 October 1998) estimates that there are about 3,000 funds. These numbers are considerably larger than those set out in IMF (1998), which reports that there were about 1,000 fund managers with about US$110 billion in assets in 1997. Even reasonable estimates of the number of hedge funds can vary by a factor of up to four!

On an aggregate level, the actual funds invested with hedge funds may appear fairly small relative to total funds in the financial sector. For instance, the Bundesbank in its March 1999 report estimates that capital invested with hedge funds in 1995 was around US$300 billion, or 1.3 per cent of the US$23,400 billion in total funds invested with traditional institutional investors in the OECD countries. Such a comparison, however, does not necessarily offer a good insight into the potential market impact of hedge funds, due to the effect of leverage and ‘herd behaviour’.

In spite of their relatively small size, hedge funds are significant market players. Their trading strategy of eschewing benchmarks and seeking maximum absolute returns in a range of asset classes means that their investment positions can change rapidly and by large amounts, thereby having an impact on market prices. Investors find them attractive because of their generally low correlation with overall market performance. As the OECD's recent report states ‘hedge funds have become an integral component of the new financial landscape and are considered by most observers to be a permanent feature’ (OECD 1999 p.7). In relation to this point, the Bundesbank noted that because many hedge funds depend upon the exploitation, and thus the elimination, of market imperfections, it is likely that at some point diminishing returns may set in. This might then result in hedge funds taking on riskier, more highly leveraged positions than previously, in an attempt to maintain their high rates of return.

The OECD reports that, while the bulk of investment in funds come from market-savvy wealthy individual investors (about 80 per cent), investment by institutional investors, particularly university foundations and endowments, has expanded in recent years, accounting for about 30 per cent of new funds. Some of these investments have been very large; for example, according to the OECD, Cornell University now invests over 10 per cent of its total $2.3 billion endowment in hedge funds, while the Yale University endowment invests roughly one-quarter of its total assets in these funds.

The events of late 1998 have not led to the demise or fundamental weakening of the hedge fund industry. Table 1 contains details of asset flows into and out of the approximate 1,200-odd hedge funds which choose to report to Mar/Hedge. These funds represented around US$110 billion of funds under management as at the end of December 1998. The categories have been expanded from those mentioned above.

While investors in hedge funds did withdraw assets in 1998, the size of the withdrawals were small (about 5 per cent). Not surprisingly, global funds, and the large global macro funds in particular, saw the largest redemptions, as these are perceived to be the riskiest category (that is, while they have had the highest returns, they also demonstrate the greatest volatility of returns). The Soros funds, for instance, experienced an outflow of US$566 million in December. This was soon reversed, however, with the next two months seeing inflows of US$783 million and US$231 million.

February represented something of a turning point following the crisis, with a net inflow into hedge funds of over US$1 billion. There are also reports that an increasing number of both pension/superannuation funds and educational endowments are now considering investing in hedge funds as part of their risk diversification strategy. Reports of increased interest in hedge funds have also noted the rapid pace of startups and the healthy state of the employment market in hedge funds, with many traders from mainstream financial institutions joining the trading desks of hedge funds.

Not only are hedge funds attractive to investors, but they are also attractive to commercial and investment banks as clients because they generate a lot of market turnover and therefore income for banks' dealing rooms. The OECD notes that: ‘because some hedge funds often transact in enormous size, there are specialist derivatives desks dedicated solely to hedge fund clients’ and hedge funds are very big users of swaps and credit derivatives provided by banks (OECD, p 8–9). In addition, a growing number of banks are either running in-house funds or managing funds of funds. Formal and informal staff connections are also important, with staff moving between banks and hedge funds.

Hedge funds make use of a wide range of financial instruments. Many take long or short positions, or both, in equity or fixed income securities. They may also use exchange traded futures contracts or over-the-counter derivatives, while others are active in the foreign exchange or commodities markets. The President's Working Group notes that ‘in general, hedge funds are more active users of derivatives and of short positions than are mutual funds or many other classes of asset managers’. Often there is better liquidity to be found in the derivatives markets than in the underlying instrument, and costs are usually lower. Additionally, derivatives offer a method of obtaining leverage, beyond that of simply borrowing money from other financial institutions.^[2]

The use of leverage by hedge funds varies tremendously, although assessments are complicated by inadequate reporting requirements, the absence of a standard definition of leverage, and by the treatment of off-balance sheet activities. The OECD argues that ‘the use of leverage is a mainstay of some hedge fund strategies, with the degree of leverage a function of the manager's appetite for risk, the riskiness of the bets involved, and the “costs” of leveraging’ (page 8). The IMF (1998, pages 7–8) estimates that 30 per cent of hedge funds do not use any leverage, and that only 16 per cent of hedge funds have a borrowing to capital ratio in excess of 1. In contrast, Goldman Sachs and Financial Risk Management Ltd suggest that average leverage is about 2. Information gained from Commodity Pool Operator^[3] (CPO) filings indicate that most reporting hedge funds have balance sheet leverage ratios (total assets to capital) of less than 2-to-1. The President's Working Group notes exceptions to this. According to September 1998 filings, at least ten hedge funds with capital exceeding US$100 million had leveraged their capital more than ten times, with the most leveraged fund displaying leverage of more than 30 times. Due to the presence of economic or off-balance sheet leverage, none of these sets of statistics, or others that are available, necessarily provide a reliable guide to the exposure of hedge funds to changes in financial prices (although one might assume a fund with balance sheet leverage of 30 times is more likely to take aggressive positions).

Table 2 sets out monthly median returns for the different categories of hedge funds and for the Standard and Poors 500 index. Over 1998, no category of fund managed to outperform the S&P500 index (while hedge funds typically do not benchmarks, preferring to measure their performance in absolute terms, the S&P500 at least provides an indication of overall market performance). Not surprisingly, emerging market funds produced by far the worst returns over the year, on average losing around 31 per cent of their asset values, and no category managed to post returns above 5 per cent. In 1999, results have been mixed, with quite few funds still experiencing negative returns. Two of the most well known funds, George Soros's Quantum Fund and Julian Robertson's Tiger Management, posted large negative returns (−13.8 per cent and −8.5 per cent respectively) over the first four months of 1999. Nonetheless, as noted earlier, this has not prevented a resumption of investor subscriptions.

Footnotes

This is not the traditional definition of arbitrage, which is based on risk-free transactions. In contrast, the transactions undertaken by hedge funds are in fact speculative and are described by the Economist (17 October 1998) as ‘expectations arbitrage’ since they are based on an expectation that deviations from historical relationships between financial prices will be corrected. The OECD reports that the first hedge fund was set up by Alfred Winslow Jones in 1949 to balance short and long positions held by him in the equity market to reduce overall risk. [1]

The President's Working Group defines leverage in two ways; as balance-sheet leverage, which refers to the ratio of assets to net worth; and economic, or off-balance sheet, leverage, which is a measure of economic risk relative to capital. Economic leverage can be obtained through the use of repurchase agreements, short positions, and derivatives contracts. [2]

Sponsors of hedge funds that trade on organised futures exchanges and have US investors are usually required to register with the Commodity Futures Trading Commission (CFTC) as Commodity Pool Operators, and are subject to periodic reporting, record keeping and disclosure requirements. [3]