INTRODUCTION
ASK THE EDUCATED layperson about hedge funds, and the answer will involve descriptions of colorful names (Tiger, Jaguar, Quantum); of men (and yes, the managers are almost always men) with little taste for restraint; and, of course, of the 1990s financial crises. Hedge funds have entered the collective psyche as financial behemoths that sow the seeds of destruction wherever they tread. George Soros’s hedge fund is famed for forcing the pound sterling’s exit from the European Monetary System, and the 1998 collapse of Long-Term Capital Management nearly brought down the global financial system as we know it. Many are convinced that hedge funds exacerbated—if not caused—Asia’s multiple crises in the 1990s as well as the subsequent ones in Argentina and Brazil.
As with all stereotypes, the above is not without truth. Hedge funds are flexible and unregulated financial structures that, through leverage (see below), channel large flows into concentrated investments. The combination of size and flexibility can be insurmountable. When hedge funds target a certain asset (for example, an exchange rate or a company share), their force can be overwhelming and difficult to resist.
The term “hedge fund” covers a number of very different financial structures. While some funds have been responsible for crises, others, by being the first to buy distressed assets, have stopped the hemorrhage after a crisis. Hedge funds play an important liquidity-providing role, eliminate market distortions, and offer hedging to those who need it.
Journalists writing about hedge funds should be familiar with their history, the techniques they use, the various types of hedge funds in existence, what distinguishes them from traditional financial institutions, their role in causing (and reversing) crises, and proposals to regulate them.
WHAT ARE HEDGE FUNDS?
At their most basic, hedge funds are limited financial partnerships that manage money for high net-worth individuals. They are flexible, aggressive, profit from asset prices going up or down, and magnify their investment positions by borrowing against their capital.
Hedge funds are a recent financial phenomenon. Their start is credited to an Alfred Winslow Jones, a journalist who, in 1950, set up a fund that combined “shorting” with “leverage” to produce relatively high returns and limited volatility. (“Shorting” and “leverage” will be defined below). According to Tremont-CSFB (a consultancy that monitors hedge funds), there are around 7,000 hedge funds in operation today managing some $600 billion. Hedge funds tend to become popular during bear markets: their number rose by a third since the U.S. equity market bubble burst in 2001.
HOW DO HEDGE FUNDS OPERATE?
To understand how hedge funds operate, keep in mind an important distinction: the return on an investment comprises “market” and “idiosyncratic” components. Take the example of a company share. Its price can rise either because the overall market rose (higher confidence and economic growth, lower interest rates) or because of stock-specific reasons (a new contract, a new invention, higher earnings). Theory tells us that “market” movements are difficult to predict but “idiosyncratic” ones are easier to foresee.
The basic insight into hedge funds’ operations is that they isolate the “market” component and focus their investments on the “idiosyncratic” one. They do so by “short selling.”
Short selling is a technique that permits investors to turn a profit when asset prices fall and lose money when they rise. The idea is fairly simple. An investor sells an asset he or she does not own (usually after borrowing it). If the asset’s price falls, the investor buys it from the open market (at the now cheaper price), returns it to the lender, and pockets the profit.Consider an example. You conclude that the share price of “Disaster,” now trading at $15, is overvalued and that the price will soon fall. What would you do? You would go to somebody who owns the share but has a temporary need for cash. You lend him the money and, in return, borrow the share. You also promise that, within three months, you will deliver back the stock in return for your cash. (This process is known as a “repurchase agreement” or a “repo operation”). You sell the borrowed stock for $15 in the open market. If you are proved right and Disaster’s shares trade down (say, to $10), you go out to the open market, buy the share for $10, hand it over to the lender who, in turn, gives you back your $15. And voila: you made a $5 profit. Obviously, had the price rallied to $18, you would have lost $3 on your investment.
Lets get back to hedge funds, which, as we noted, “isolate” market components. Hedge funds buy assets they like and short others that serve as a market proxy. In this way, they “hedge” overall market moves but benefit from changes that are particular (“idiosyncratic”) to the assets they like.
Consider an example. Say a hedge fund likes the prospects for a firm (called Reckless) but is less certain about those for the overall market. The hedge fund manager buys a share of Reckless, say for $100, and “shorts” the same amount of another stock that proxies the market (for example, a basket of stocks that mimics the S&P 500). The manager makes no profit if the overall market, including Reckless, rallies by 10 percent since the profit made on owning Reckless is offset by losses incurred by shorting the market. By contrast, if Reckless rallies by 10 percent (for a profit of $10) but the overall market rallies by only 8 percent (for a loss of $8), the manager pockets a $2 profit.
It should be clear that the profit/loss associated with a hedged investment is smaller than the one from an unhedged investment.
For example, if the manager had held an unhedged position in Reckless, the profit from a 10 percent rally would have been $10. Instead, by hedging the position, the profit was only $2.
To make a hedged position particularly profitable, hedge funds magnify it. This is where leverage comes in. Leverage is the process of borrowing against capital to concentrate an investment position.
For instance, had the investor in the above example borrowed ten times his capital and bought ten shares of Reckless rather than the one share we assumed above, his or her profit would have been $20 rather than the $2 calculated above.
Key to keep in mind when thinking about leverage is that, just like it magnifies profits, leverage can also magnify losses. Leverage can be very risky.
Consider the following example. Say our investor had a $10 capital. He or she borrows another $90 (that is, a 9 to 1 leverage) and buys one share of Reckless. Let’s say he or she hedges the investment by shorting $100 worth of the S&P 500. If the price of Reckless falls by 10 percent while the whole market stays unchanged, the investor’s loss ($10) will completely wipe out his capital. Think of it this way: thanks to leverage, a relatively modest fall in the stock price (10 percent) translated into a 100 percent loss in capital.
TYPES OF HEDGE FUNDS
Despite popular belief, there is no one type of hedge fund. Some trade fixed-income instruments, others equity or foreign exchange. Some focus on one geographic area, others invest worldwide. Some are generalists while others are extremely specialized. A few manage hundreds of million of dollars, while others oversee only a few millions. Some invest money for outsiders, others (including bank “proprietary desks”) invest insider capital. Some have multiple autonomous portfolio managers, while others focus all decisions on one trader. Some employ massive leverage, while others borrow only a relatively small multiple of their capital. Some employ derivatives while others use only spot transactions.
These differences notwithstanding, one can distinguish between two broad categories of hedge funds:
Macro hedge funds are those that bet on large market moves. Their analysis is “top down,” in that they analyze macrodynamics (hence the name), including growth, inflation, balance of payments, and demographics. Such funds are less interested in particular securities and more in the general market direction. If, for example, they assess that a country is close to trouble, they would short any liquid asset, including the currency and the largest share in the local stock market. Contrary to the name, macro funds do not hedge but typically take on “naked” positions. George Soros’s hedge fund is perhaps the most famous example of a macro fund having bet (successfully) that the UK will not be able to maintain its European Monetary System membership. Julian Robertson’s Tiger Fund is another famous macro fund.
Relative-value funds emphasize security selection. Such funds are much less interested in the overall market direction—indeed, they completely hedge out the market component. Their profit/loss comes from the performance of a particular security relative to the overall market. Relative-value hedge funds use mathematical models to identify “cheap,” as opposed to “expensive,” securities. They typically buy the cheap security and short (as a hedge) the expensive security. They make money when the difference between the two securities converges. Relative-value hedge funds employ leverage intensely. LTCM is the most famous of relative-value hedge funds, having bet (unsuccessfully) on “convergence” trades in the fixed-income markets; its losses were magnified by massive leverage.
WHAT MAKES HEDGE FUNDS UNIQUE?
Hedge funds differ from other traditional financial institutions in important ways.
Short selling. Hedge funds can bet on asset prices going up as well as down. Most traditional money managers are allowed “long only” strategies.
Leverage. Hedge funds, especially relative-value funds, leverage their investments often multiple times. Most traditional money managers are not allowed to employ leverage.
Total return vehicles. Traditional money managers are measured against an index (for example, the S&P 500 or the EMBI). By contrast, hedge funds are “total-return” vehicles whose performance is measured in absolute terms. This distinction alters incentive structures in important ways. Traditional money managers may not care if their fund registers negative returns so long as the loss is smaller than that of the index. By contrast, a hedge fund tries hard to avoid absolute losses. In a similar vein, a traditional money manager may have the incentive to “hug” the index by mimicking its components. A hedge fund manager has, by contrast, the incentive to take on more aggressive bets.
The client base. Hedge funds attract high-net-worth investors who seek high-return, high-risk investment vehicles. The number of investors in a hedge fund has to be small for the fund to maintain its unregulated status (see below). By contrast, traditional money managers market their funds to the retail sector and institutional investors (for example, pension funds, insurance companies, university endowments). The nature of the client bases explains, to a large extent, the differing attitudes toward risk between the two types of money managers.
Capital structure. Hedge fund managers are almost always obliged to invest their own capital in the fund; some are even required to reinvest part of their performance fees (see below). This is meant to align the incentive structure of managers with those who invest in the fund. By contrast, traditional money managers are employees—rather than partners—whose own capital is not at risk.
Profit-sharing arrangements. Hedge funds are rewarded based on their performance. A typical hedge fund charges an annual administrative fee (usually 1 percent of assets under management) and keeps a certain percentage of the profit (usually 20 percent). Hedge funds employ the concept of “water marks,” whereby if the fund loses money, it will not receive a performance fee until that amount is recuperated (that is, if the profit level reverts back to the watermark). By contrast, traditional money mangers are paid a constant fee regardless of performance.
Flexibility. Hedge funds are more flexible than traditional money managers. Partly because they are unregulated (see below), and partly because their clients are wealthy individuals with a high appetite for risk and tolerance for volatility, hedge fund investment guidelines are lightly worded. In practice, this means that hedge funds can invest in all asset classes, can use derivatives and leverage, and have liberal position-size limits. Traditional money managers, by contrast, invest money for more conservative clients who impose strict operational guidelines. Flexibility allows hedge funds to be quick to the draw and aggressive in expressing investment views.
Quality of managers. Reflecting profit-sharing arrangements, hedge fund managers are generally better remunerated than traditional money managers. As a result, hedge funds tend to attract the “best and the brightest.”
Regulatory framework. Hedge funds are much less regulated than traditional money managers. This issue is covered in detail below.
ARE HEDGE FUNDS RESPONSIBLE FOR CRISES?
Hedge funds always seem to be at the center of crises. They are fast. They are aggressive. They are usually the first to come in and the first to balk when signs of trouble appear. The role of hedge funds became politicized when Malaysian Prime Minister Mahathir Mohamed blamed them for the Asian crisis. Hedge funds have also become lightning rods for the antiglobalization movement. Politicians of all stripes, often cheered on by the media, equate hedge funds with crises.
There are four issues to think through when assessing the role of hedge funds in crises:
Herd activity. Hedge funds are flexible and fast. When they zero in on a target, they tend to lead and are then followed by the much larger, but slower, traditional financial institutions. This has given the impression that investors move in a herd. This impression is sometimes correct—but not always. In the Indonesia and Brazil crises, for example, local banks were the first to sell local assets, with hedge funds jumping on the bandwagon afterwards.
Size. Leverage is powerful. Through it, a hedge fund mobilizes multiples of its capital. Moreover, hedge funds are not governed by diversification rules and, as such, can concentrate their investments in one position. Large and concentrated positions are visible and give the (sometimes correct) impression that hedge funds cause dramatic asset price movements. For instance, some estimate that George Soros’s Quantum fund mobilized a whopping $15 billion against the UK sterling in 1992, eventually forcing its floatation. The investment—as well as the $1 billion profit the financier reportedly reaped—made headline news and became one of the most famous financial transactions in modern history.
Self-fulfilling prophecies. Market pressures can cause crises even if there is no “fundamental” reason. Consider Asia in 1997. The crisis countries were not indebted and boasted prudent fiscal stances. However, as their currencies devalued, their debt levels (much of which was dollar denominated) rose dramatically and what started off as low-debt countries suddenly became highly indebted. As creditworthiness deteriorated, a vicious cycle emerged, with more risk-averse investors selling Asian assets. Some argued that, had the currencies not depreciated so dramatically, the crises would not have occurred or, at worst, would have been contained. And since hedge funds were behind the exchange rate pressures, the argument went, they were responsible for the crises. (This argument, of course, ignores the fact that Asia’s problems were not fiscal but banking-related and that in some cases, especially in Indonesia, local banks initiated the currency selling rather than hedge funds).
Interconnectivity and contagion. Hedge funds work within a complicated web of financial linkages. If those linkages are severed, what could start off as a localized crisis can turn into a systemic and global one.
The Russia crisis and the eventual collapse of LTCM are good cases in point; they triggered a global financial meltdown that went well beyond the economic size of Russia and the financial prowess of LTCM. Why this disproportionate effect? Leverage explains much. For one thing, before the crises, hedge funds had bought Russian assets and financed them through leverage. As the price of Russian bonds collapsed, lenders asked for more collateral (“margin calls”). To raise the required amounts, hedge funds sold positions in assets unrelated to Russia. Indeed, the leverage was so large that the ensuing distressed selling caused price collapses in virtually all fixed-income assets, with the largest price drops accounted for by the riskiest and most illiquid assets.
Enter LTCM. The hedge fund itself was not a particularly large holder of Russian assets. Instead, it had invested hundreds of billion dollars in so-called convergence plays, whereby the fund bought illiquid but cheap assets and shorted virtually identical but more expensive liquid assets, hoping that the two prices, usually different by miniscule amounts, will eventually come closer together. To magnify the profit from these miniscule price differentials, the hedge fund leveraged its positions dramatically. Now, as the Russia crisis hit and as hedge funds sold their illiquid positions and piled into the safer (and more liquid) assets, price differentials, instead of converging, diverged, and LTCM’s losses ran into the billions—every day! Banks that had lent LTCM money had, themselves, borrowed the funds elsewhere. As LTCM approached bankruptcy, the specter of a chain of financial defaults emerged. Faced with the threat of a systemic collapse, the U.S. government was forced to intervene.
DO THE HEDGE FUNDS PLAY A STABILIZING ROLE?
The role of hedge funds in crises receives extensive coverage. Less has been written about their stabilizing roles.
Provide liquidity. Hedge funds are very active traders, getting in and out of positions at sometimes-breakneck speed. While not “market makers” in the classic sense, the trading activity of hedge funds increases the depth of otherwise illiquid markets. Put differently, in markets where hedge funds are active, traditional money managers usually find it easier to sell their position or build a new one whenever they need to.
Ensure efficiency. Asset markets can be inefficient. Why, for example, should a U.S. Treasury bond that matures in March 2013 be priced any differently than one that matures three months earlier? Sometimes, there are fundamental reasons for such anomalies. But at other times, there are none. Hedge funds are extremely good at spotting such dislocations and “arbitraging” them away.
Stop hemorrhage. When crises start, they take on a life of their own. Vicious cycles develop, and asset prices “overshoot” (see the point on “self-fulfilling prophecies,” above). When the traditional investor base is balking en masse, hedge funds—fast, efficient, and contrarian—step in. As the Indonesia rupiah reached the absurd level of 16,000 to the dollar in June 1998, hedge funds bought it, taking it up to the more reasonable 8000 to the dollar. The rally reversed the, until then, unstoppable wave of (dollar-indebted) corporate bankruptcies.
SHOULD HEDGE FUNDS BE REGULATED?
A feature of hedge funds that most find striking is that they are unregulated. This is so since they are private partnerships catering to a limited number of rich and financially sophisticated investors who require little protection. Formally, regulation is not necessary if a money manager has a small number of investors and if each investor is an “accredited investor” (defined as an investor with either $1 million in net worth or an income of more than $200,000 per year). Funds that satisfy these conditions are not registered (in the United States; they are in the UK); they face minimal capital requirements; they are not subject to information disclosure rules; they are not prohibited from engaging in any lawful financial investment; and they are subject to relatively light tax regimes.
Attitudes toward hedge funds have changed materially since the mid-1990s. The role of hedge funds in crises has raised their public profile; their regulation has become a political imperative. The interlinking nature of leverage, moreover, has turned hedge funds from localized vehicles to ones whose failure can cause systemic crises. In addition, hedge funds have recently become popular among the retail sector, whose wealth and sophistication are much less than that of the traditional hedge fund investors. These reasons have generated calls for strengthening oversight over hedge funds.
To this end, there are many proposals being debated.
Increasing transparency and information disclosure.
Requiring commercial and investment banks to carry out detailed credit analysis on their hedge fund clients before they are allowed to extend credit to them. Banks would also be required to modulate the lending size, its cost, and collateral (“margin”) on the basis of the hedge fund’s credit quality.
Restrict hedge funds’ ability to short sell. A less radical proposal is to preclude the practice of “naked” shorting: that is, when the hedge fund sells an asset it does not even possess as opposed to when it sells a security it had borrowed.
Require hedge funds to register. Registration—already a requirement in the UK but not in the United States—would require hedge funds to provide the SEC with biographic information on their managers and agree to occasional audits.
Strengthen oversight over hedge funds’ potential money-laundering activities and abuse of off-shore tax deferral schemes.
The push to regulate hedge funds has intensified in recent years. In the United States (where the majority of hedge funds operate), the effort is being led by the Securities and Exchange Commission. State-level district attorneys (especially in New York) are also active in the process. The U.S. congress has held a number of hearings on the topic. Hedge funds are understandably resistant to excessive regulations. They see them as increasing operational costs and curtailing their flexibility and nimbleness. Hedge funds are also resisting information-disclosure proposals on the ground that they make their investment positions public inviting counterparty threats.
TIPS FOR REPORTERS
The best source on the amount of a “short” in a particular asset is the “repo” desk at investment banks. Those desks arrange for lending securities to hedge funds that engage in short selling.
“Financing” desks in investment banks arrange for “leveraging” for hedge funds. Reporters should talk to them about prevailing margin requirements (that is, “collateral”), which tend to rise during periods of instability.
The Chicago Board of Trade publishes, on a daily basis, the amount of “shorting” on particular assets and commodities. A spike usually suggests increased hedge fund activity.
Tremont-CSFB, a consultancy that monitors hedge funds, publishes a monthly index on hedge funds’ performance. The results can make for interesting stories.
The ongoing debate on regulating hedge funds is intense. It involves myriad regulatory bodies and working groups from both the public and private sectors. Politicians have jumped on the cause. This will likely be an evolving story that may be worth keeping an eye on.
Depending on the story a reporter is working on, he or she should make sure to know whether the fund is a macro or a relative-value hedge fund. Reporters should wear their “economist” hats with the former and their “finance” hats with the latter.
Hedge funds are extremely secretive. Getting quotes on their particular positions is virtually impossible. However, hedge fund managers may not mind talking about what they are doing—so long as it is on deep background. These “chats” can be extremely useful in getting a sense of what hedge funds are thinking about.
LINKS FOR MORE INFORMATION
1. Economist and columnist Paul Krugman wrote extensively about hedge funds during the Asia crisis. These, and newer writings, can be found on his Web site. http://www.wws.princeton.edu/~pkrugman.
3. Magnum.com is a useful Web site that offers background on various hedge funds and updates, definitions, and links to official sites with find policy papers on the hedge fund regulation debate. http://www.magnum.com.
4. Nouriel Roubini, an NYU professor, publishes an excellent “Global Macroeconomic and Financial Policy Site.” In it, you will find a page on hedge funds that updates relevant academic, policy, and journalistic writings on the topic. http://www.stern.nyu.edu/globalmacro.
5. The Hedge Fund Association is a trade group that represents hedge fund managers. http://www.thehfa.org.