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Hedge funds: revealing the lamp under a bushel Back  
The hedge fund, abused and lauded in equal measure, has become an essential part of the range of investment vehicles available to institutional and sophisticated investors. The Bank for International Settlements in its most recent Quarterly Review published a comprehensive article by Kostas Tsatsaronis on this particular piggy bank, tracing its origin to 1949, interesting given Ireland’s increasing strength in hedge fund management.
by Kostas Tsatsaronis

In early 1949, Alfred Winslow Jones, a sociologist and financial journalist, set up an investment partnership that was eventually to be regarded as the first hedge fund. His innovative strategy used a mix of short and long stock market positions with leverage, which emphasised the effect of security selection on the portfolio’s performance while neutralising the effect of market-wide movements (hence the term hedge). Despite a solid performance record, Mr Jones’s partnership remained a little-known fund on the fringes of Wall Street and his strategy found few imitators until a 1966 financial press article popularised it among the broad investor community. The first boom of the hedge fund industry was under way.

Since that time, the growth and deepening of financial markets has been phenomenal, supported by a global trend towards market liberalisation and the rapid development of financial technology. Opportunistic and nimble investment vehicles, such as hedge funds, have been well positioned to take full advantage of the new opportunities created in this environment. As a result, the industry has grown in both size and importance while offering generous rewards to investors and principals.

At the same time, however, the industry has also acquired notoriety, having been associated, directly or indirectly, with nearly every major episode of financial market turmoil during the 1990s. In September 1998, almost 50 years to the day since the inception of Jones’s fund, the financial troubles of another hedge fund seemed to be at the very centre of a storm that threatened the stability of the world’s financial system. The potential failure of Long-Term Capital Management, which featured some of the most revered names in finance among its partner list, threatened to push already strained markets over the threshold of a systemic crisis.

This episode highlighted the potential for disruption to financial market functioning from the funds’ activities, and prompted a broad reassessment, in both official and private forums, of the appropriateness of the operating framework of hedge funds. It has also influenced the attitudes of counterparties, creditors and, indeed, the industry itself towards the quantity and quality of information disclosed by hedge funds and the practices governing their business transactions. In a sense, the events of 1998 can be seen as marking the start of a new period in the evolution of the hedge fund industry. A period characterised by greater focus on consistency of performance and less emphasis on the mystique and personality cult of fund managers with fabled investing skills.

Structure, characteristics and attractiveness
Hedge funds are investment companies with legal and organisational structures conducive to an aggressive investment style. They typically operate as limited partnerships or choose to register offshore, in order to minimise reporting and regulatory requirements that apply to more widely marketed investment companies such as mutual funds. To minimise liquidity requirements, the funds place restrictions on withdrawals by investors. More importantly, the incentive structure for the managers encourages aggressive investment strategies. Management fees are highly sensitive to performance, which is in turn measured in absolute terms rather than relative to a peer group as is often the case with other professional asset managers.

In addition, fee structures often contain ‘high watermark’ provisions that require the manager to make up for losses before receiving further incentive fees. In return, fund managers typically invest a substantial amount of their own money in the fund. These attributes imply constraints on the size of the fund both because of legal restrictions on the maximum number of investors and on permitted marketing channels and because the inherent inertia of larger portfolios can cramp the opportunistic investment style.

Market size
The absence of reporting requirements for most hedge funds means that there are no comprehensive data on the size of the industry. Estimates by the main commercial suppliers of hedge fund information range between 2,500 and 5,000 funds with between $200 and $300 billion in assets under management.

According to one of these sources, the average fund had just under $100 million in assets under management at end 1998, with more than 50 per cent of all funds being smaller than $25 million. There were only 32 funds with more than $1 billion in assets under management. Nevertheless, the two largest families of macro funds managed sums in the neighbourhood of $20 billion each at their peak in mid-1998.

Yet the size of assets under management alone is not an accurate indicator of the potential impact of a single player on financial markets, since control over a much larger portfolio can be obtained through leverage.

The hedge fund industry has experienced rapid growth over the past several years, with the number of funds increasing each year since 1988. At end-1999, some industry observers estimated that there were more than 5,000 funds in operation, a fourfold increase from 10 years earlier. Assets under management have grown at twice this pace to surpass $300 billion. One remarkable feature of this steady growth is that the industry as a whole has weathered adverse market conditions relatively well, even the volatility that has characterised markets for most of this year. Indeed, on average, hedge funds have generated handsome returns for their investors, outpacing market benchmarks as well as other investment vehicles such as mutual funds. The fact that this investment performance typically exhibits a low correlation with broad market indices is an additional attractive feature of hedge fund investments. This last characteristic is a direct consequence of an opportunistic investment style that favours dynamic investment strategies and high portfolio turnover compared with other types of institutional investor that typically operate with a longer investment horizon. Hence, hedge funds offer considerable scope for yield enhancement and diversification to the sophisticated investor, at the cost of greater risk. This risk is evident not only from the relatively high volatility of typical hedge fund returns but also from the high attrition rates in the industry. It is estimated that each year on average 7 per cent to 10 per cent of all funds cease operations.

Episodes of financial market turmoil
It is useful to distinguish between two types of potential disruption to market functioning arising from the activity of any financial institution. Financial stability can be compromised when a market player is able to amass enough resources to single-handedly influence specific asset prices or tactically exploit its influence on other participants’ behaviour to tilt market momentum in favour of its own positions. In such circumstances, both the information content of market prices and their relationship with fundamentals are severely weakened, possibly giving rise to heightened price volatility. A quite different type of disruption arises when a highly leveraged institution with large and concentrated positions is confronted with a liquidity or solvency crisis. In this case, not only may the functioning of the markets where the institution has been particularly active be disrupted, but the institution’s counterparties, which helped it finance these positions, are also likely to experience serious losses. In both cases, the costs of misjudged investment decisions are likely to spread well beyond the equity holders of the leveraged institution. Indeed, depending on the nature of exposures and prevailing market circumstances, there may potentially be systemic implications. Hedge funds have been linked to both types of market disruption.

The near collapse of LTCM
The disorderly market conditions that prevailed as investors sharply repriced risk in the wake of the Russian debt moratorium gave rise to highly atypical asset price dynamics and played havoc with investment strategies based on historical pricing relationships. Long-Term Capital Management (LTCM), a large hedge fund marketed as specialising in leveraged relative value arbitrage strategies, found its portfolio heavily exposed and its management was unable to contain the deterioration of its financial position. Funded by credit at favourable terms supplied by many leading institutions, the fund had been able to build a portfolio that exceeded its assets under management by more than 25 times. Moreover, the fund was arguably the most active user of interest rate swaps in the world, with such contracts accounting for $750 billion of its total notional derivatives exposure of more than $1 trillion in August 1998. The uncertainty about the potential ramifications of a disorderly bankruptcy of LTCM both for its immediate counterparties and, given the already fragile state of financial markets at the time, for the financial system at large prompted the intervention by the Federal Reserve to facilitate a private sector solution. A consortium of 14 of the fund’s creditors injected $3.6 billion of new capital into the fund in exchange for a 90 per cent ownership stake and the assumption of control over the reduction in the fund’s leverage and the unwinding of its portfolio.

In the wake of the LTCM episode several groups, from both the official and private sectors, were established to consider the issues and propose action. Given the sophistication of hedge fund investors and creditors, the focus of these groups was on intervention that would limit the potential economic costs from the funds activity that are external to these parties. Particular attention was paid to how best to minimise the potential for market disruption without distorting market players’ incentives or compromising the efficiency of the market mechanism. The bulk of the proposals focus squarely on the main channel through which a fund’s difficulties may be transmitted more widely: its effect on creditors. Sound risk management practices by hedge fund counterparties represent the most effective safeguard against the build-up of excessive leverage.

Hedge funds post-1998: dinosaurs or Darwinian survivors?
Arguably, the LTCM episode represented a landmark event in the evolution of the hedge fund industry. In its aftermath, an extensive re-examination of the role and the business framework of hedge funds by the industry itself, its counterparties and the policy community has resulted in a number of significant changes. One could broadly describe the situation as one of ‘cleansing’ to rid the financial system of the combination of high leverage and ill-controlled counterparty exposures related to hedge funds, and one of ‘institutionalisation’ of investment in hedge funds as a legitimate alternative asset class for institutional portfolios. Over the past two years, three of the most celebrated fund names have withdrawn from the front stage of the investment world and the macro fund sector has experienced a haemorrhage of investors’ funds.

Reassessment of role
The two years since the LTCM episode have been a period of reassessment of the role of hedge funds in the financial system. Drawing on its own experience and the proposals of official bodies, the private sector has begun to address the practices that left many institutions vulnerable to the failure of HLIs. Similarly, the hedge fund industry itself appears to be in the process of moving gradually away from the image of aggressive and secretive speculators, and towards one of controlled, sophisticated investment vehicles that offer opportunities for a well planned diversification and yield enhancement to ioreal moneyle investors. While these trends enhance the resilience and efficiency of financial markets, it is important that current gains are consolidated and further improvements are made along the same lines. This would be the only way to ensure that appropriate structures are in place to deal with market turmoil long after the memories of autumn 1998 have faded.

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