DERIVATIVES STUDY CENTER
www.financialpolicy.org 1600 L Street, NW, Suite 1200
Hedge funds pool money from wealthy individuals and institutional investors in order to invest in stocks, bonds, foreign currency and derivatives. They are organized as limited partnerships, and the minimum investment is usually set at $1 million in order to avoid regulation by the Securities and Exchange Commission. Some hedge funds pursue highly leveraged investment strategies that take on high risk in order to gain a higher rate of return. Others employ more conventional approaches to investing.
There are an estimated 5,800 hedge funds worldwide, most of which are operated out of the U.S. even though they are often registered off-shore to avoid taxation, with $311 billion in capital.
The name hedge fund is somewhat of a misnomer. It originated in 1949 to describe the investment strategy of Alfred Winslow Jones. His idea was to take a long position by purchasing certain stocks and at the same time take a short position by short-selling other stocks. The combined positioned balanced or hedged the investment fund against changes in the overall level of the market, and allowed him to profit from a change in the relative price of the two positions. Today, this is known as a "relative value" investment strategy. Thus the original meaning of the term "hedge fund" does not mean that the investment is completely hedged, but rather that it is hedged against the risk of a change in direction of the overall market.
There are several types of investment strategies pursued by hedge funds, the most common are described below.
In the words of hedge fund operator George Soros, Our type of hedge fund invests in a wide range of securities and diversifies its risk by hedging, leveraging and operating in many different markets. It acts more like a sophisticated private investor than an institution handling other people’s money.
Soros is known for several instances in which his fund profited heavily from directional investments by speculating against what he perceived was a weak currency. He is credited with the collapse in the value of the British pound in September of 1992, and accused of bringing down the Malaysian ringgit in 1997.
Australia’s central bank, the Reserve Bank of Australia, produced two reports in 1999 on the potentially destructive role of highly leveraged institutions such as hedge funds. The reports claims that hedge funds contributed to the instability of its exchange rate in 1998, and it describe how hedge funds can have a destabilizing impact on not only the currencies of emerging economies but also on currencies such as the Australian dollar which has the eighth largest global trading volume.
The most notorious hedge fund failure, Long Term Capital Management, involved a variety of investment strategies. They took a directional bet on Russian bonds, while the greatest share of their investments were relative value plays on the interest rates on various bonds and swaps. In one instance they went short the 30-year bond and long the 29-year bond in the expectation of profiting from a fall in the spread between their yields. In order to execute this strategy they made extensive use of leverage in the repurchase agreement or "repo" market by financing about 99% of their purchase of the 29-year bond and borrowing the 30-year bond in order to sell it short.
It is important to point out that other financial institutions, including investment banks and commercial banks, have 'proprietary trading desks' that often act in the same way as hedge funds. They take a "view" or "position" on the market that can involve a directional bet or a relative value play. However, instead of the partnership’s capital, they use the firm’s capital.
There are several regulatory issues involving hedge funds. One issue is their role in destabilizing or attacking foreign exchange rate systems. Although they have a small proportion of the capital in financial markets, they use leverage to take significantly large size positions in those markets. In addition, their market reputation creates followers and induces trend investors to take the same bets so that the combined effect is often the self-fulfilling investment strategy against the value of a nation’s currency.
Another issue is their use of direct credit from banks and broker-dealers to financial their trading operations, and the use of indirect credit through repurchase agreement and securities lending markets to take highly leveraged positions in securities and derivatives markets. These credit relationships mean that a failure of a hedge fund could undermine the solvency of banks which hold government insured deposits and money center banks which also serve critical roles in the economy’s cash payment and securities clearing systems.
Yet another issue raised by hedge funds is their lack of transparency. Not only do they participate in the non-transparent over-the-counter derivatives markets, but the hedge funds as financial institutions are not required to report their positions, trading activities or creditworthiness.