Hedge Funds and Their Implications to the Financial Stability - Case Study Example

Introduction The rapid growth of economies all over the world and intense competition among the different corporate groups had resulted in various innovations on all business operations. Product innovation is seen as one of the most important driving factors for business in the recent years. When it comes to product innovation, no business is far behind. Even the financial markets have been a domain of product innovations in the recent past. One such innovation in the highly lucrative financial markets is The Hedge Funds. Hedge Fund refers to “an aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).” (Investopedia, 2011) The nature of Hedge Fund is different from many other investment setups. Hedge Fund is an investment partnership of limited wealthy investors or institutions. The minimum investment requirement for entering a hedge fund is much higher than many other investment options. It is also a highly illiquid investment as the fund stays invested at least for a period of one year. Hedge fund is as similar as a mutual fund but differs in quantum of its investments and number of its participants. It is also less regulated than a mutual fund. Hedge funds are managed by a team of experts headed by portfolio managers. Most of the investors will have a say in the management of the fund. This essay will give a brief idea about the strategies adopted by hedge funds for managing funds and the implication of its operations in the overall financial sector. Hedge funds and its mode of operation Hedge funds operate in various methods to handle investment risk. There are several strategies being adopted by Hedge Funds to minimise the investment risk. Some of the most important strategies are Long/Short Equity, Global Macro, Event Driven, Emerging markets, Equity Market-Neutral, Convertible Arbitrage, Fixed-Income Arbitrage, Short Sellers and Managed Futures. These strategies will be dealt in detail further. Long/short equity: As the name implies this strategy involves taking both long and short positions on stocks. The core concept of this strategy is to go short on overvalued stock and long on undervalued stocks. This strategy is adopted to make profit irrespective of whether the market rise or fall. It is used by hedge fund managers to make profit on both sides. The undervalued stock will increase in value to make profits while at the same time the value of overvalued stock will come down thus making profit on its short positions. “Thus, the goal of any equity long-short strategy is to minimise exposure to the market in general, and profit from a change in the difference, or spread, between two stocks.” (Barclay Hedge, 2011) Global Macro: Global Macro is a more sustainable investment strategy in the sense that it is based on top down analysis or the fundamentals. As the name signifies, this strategy considers the macro economic variables. Company specific investments are also based on factors like management quality, market share, company profits, market competition, financial position, and the like. This strategy also invests in all kinds of investment options like equities, commodities, currencies, etc. Hedge fund managers also hedge such portfolio with the use of necessary derivatives and other instruments. This has been proved to be one of the most successful strategies adopted by Hedge Funds. Event Driven: “An event-driven investment manager is typically looking to invest in situations where there is some form of corporate activity or catalytic change taking place.” (Leary, 2004) The events include mergers and acquisitions, bankruptcy, asset sales, or any other restructuring pertaining to a particular company. Hedge fund managers predict the movement of the share price based on the nature of the event related to the company. For example a possibility of bankruptcy is an opportunity to go short on the stock. Similarly in the case of an acquisition deal possibilities are that the price of the company to be acquired will rise. Some of the famous event driven strategies based on the nature of the events are, merger or risk arbitrage, capital structure arbitrage, distressed debt, etc. Among the above, merger or risk arbitrage is the most common event drive strategy. Some of the modes of investments used by event driven strategists are risk arbitrage, distressed securities, regulation D and high yield securities. Emerging markets: This type of hedge funds focus their investments on emerging market securities. Emerging markets include most of the developing nations. Currently, China, India, Russia, Brazil, etc are the major emerging markets. Emerging market hedge funds invest in numerous investment avenues in these markets. This is in fact a strategy based on the fundamentals and growth opportunities of the markets. However, this strategy has high risk potential at times due to reasons such as volatility, less transparency, country specific risk, illiquidity, and the like. This strategy has gained popularity in the recent years especially with higher economic growth happening in the developing nations. (Credit Suisse, 2007) The trend over the past years shows that emerging market hedge funds have outperformed the performance of normal hedge funds. However, the economic downturn 1 year back has taken a tall on this strategy. Equity market-neutral: This strategy is a slighter variation of long/short equity strategy. “Equity market neutral strategies rely on the stock picking ability of a manager to find the most undervalued stocks for the long portfolio and the most overpriced for the short portfolio.” (Bortolotti, 2009) Market neutral strategists go neutral not only on company specific stocks but also on industry specific stocks. Equity market neutral is found to be one of the least volatile investment strategies. There is always a control over the risks on upside as well as downside. Right stock picking is the major success factor of this strategy. In this strategy the investors indentify the hidden opportunities in a group of stocks of similar or different industries. Two of the main strategies in equity market neutral include pairs trading and statistical arbitrage. A pairs trading involves trading on two securities based on studying its relationships. Statistical arbitrage is highly quantitative and statistical methods that are based on identifying individual equity overvaluation and undervaluation. Convertible arbitrage: Convertible arbitrage is the strategy in which investment is made in convertible securities. Convertible securities are those instruments that can be converted into common stock of the company after a certain period of time. The main advantage of this instrument is that it has features of both debt and equity. The risk factor is comparatively less in case of convertible securities because it fluctuates less in comparison to the common stock of the company in the event of a market downturn. Some hedge fund managers strategically go short on the company’s stock in the ratio in which they hold the convertible bond. Therefore, a convertible arbitrage results in two main sources of return mainly from regular interest on the convertible securities and the other from trading on the underlying stocks. Fixed Income Arbitrage: This hedge fund strategy is aimed at taking advantage of the price differentials existing between fixed income securities. This is made by applying the mathematical and historical relations between the two securities. The securities that are used mostly in this strategy are government debt, municipal debts, sovereign debts, swaps, etc. Most of the fixed income arbitrage hedge funds operate globally. The core aim of this strategy is to operate with low volatility. Short sellers: Short sellers are the most common in not only Hedge funds but in most of the investment categories. Short sellers only go short on the stocks in order to benefit from the falling markets. “To profit from the stock price going down, short sellers can borrow a security and sell it, expecting that it will decrease in value so that they can buy it back at a lower price and keep the difference.” (Hedge fund index.com) Therefore, this is a strategy that can be applied only in the case of a falling market. But short selling can be a very risky strategy in the market performs well instead of going down. Managed futures: As the name states, managed futures goes long or short on futures market. Managed futures are aimed at speculating the movement of futures and options market. The investments will be made in commodity as well as financial futures. Studies have shown that a portfolio diversification into managed futures will lower the portfolio risk. Better liquidity and transparency are the two main advantages of managed futures. Now that we have seen the various ways in which hedge funds handle the investment risks. Most of the hedge funds use all or some of the above strategies to handle their investment risks. It is now important to look at the implications for the financial markets by the growth of hedge funds. Implications of hedge funds to the financial markets Though the hedge fund growth rate has been high year on year, it still represents only a minor percentage of the asset management industry. The aggressive growth of hedge funds and the aggressive strategies adopted by them have been questioned by many on the grounds of its impact on financial stability. European Central Bank has conducted an analysis of the hedge fund operation from a financial stability perspective. This study gives out certain valuable arguments about its implications. The study argues that hedge funds have helped to the integration of financial markets by way of providing diversification possibilities and also provides many combinations for hedging risks. Nevertheless, the study also shows the negative impact of hedge funds to the financial markets. Such negative effects occur because of the fact that banks and other major financial institutions involve in the hedge funds either through investment or through their distribution. One major reason for difficulty in regulating hedge funds is the reason that hedge funds can easily move their domicile to avoid regulation. Another biggest cause of concern is the availability of hedge funds and allied products to the retail customers. Investor protection is at stake in this case. (Garbaravicious & Dierick, 2005) The big ticket hedge fund is also proved to be capable of manipulating the economic condition of a country through its aggressive operation. A report by Brown, 2008 shows the capability of hedge funds in manipulating the economic stability of a nation. The South East Asia Crisis is one of the situation in which there was a huge outflow of fund from the region, thus impacting its stability for a while. Intense currency trading and speculation was the cause then. Currency based strategies of hedge funds are too risky to even impact the currency value of a nation. The unregulated operation of hedge funds is being pointed out as a cause of concern in the report. Even driven strategies adopted by the hedge funds seem to gather immense popularity in the recent years. Conclusion Most of the studies in this area pin point to one main factor. That is the systemic risk in the event of failure of a hedge fund. While looking at the strategies mentioned earlier in this report it can be seen that there is hardly any investment avenues where hedge fund is not involved. The mix and match formulas adopted by hedge funds seem to be very complex for a sustainable financial market. Though the hedge funds represent only a small portion of the asset management business, the leverage used by them is too high to impact the financial stability. The collapse of LTCM is a clear evidence for this. Though it represented only a small pie of the segment, the leverage resulted in the ripple effect. The only solution for the situation is to improve the regulations over hedge fund and its operations. Strategies like short selling should be properly regulated. Once the regulatory side is improved, the rest will follow. Works cited Investopedia, 2011. Hedge Funds. [Online] Available at: http://www.investopedia.com/terms/h/hedgefund.asp [Accessed 14 February 2011] BarclayHedge, 2011. Hedge Fund Strategy – Equity Long-Short. [Online] Available at: http://www.barclayhedge.com/research/educational-articles/hedge-fund-strategy-definition/hedge-fund-strategy-equity-long-short.html [Accessed 15 February 2011] Paul, Leary. 2004. Event Driven Hedge Funds – Strategy Online. [Online] Available at: http://www.eurekahedge.com/news/04may_archive_japan_event_driven.asp [Accessed 15 February 2011] Credit Suisse, 2007. Emerging Markets Trends in The Hedge Funds Industry. [Online] Available at: http://www.hedgeindex.com/hedgeindex/documents/Credit%20Suisse%20Tremont%20Research%20Reveals%20Resilient%20Emerging%20Markets%20Research%20Paper.pdf [Accessed 16 February 2011] Andre, Borolotti, 2009. Back to Basics with Equity Market Neutral Hedge Funds. [Online] Available at: http://www.hedgetracker.com/article/Back-to-Basics-with-Equity-Market-Neutral-Hedge-Funds [Accessed 17 February 2011] Hedgefundindex.com, 2011. Short Selling. [Online] Available at: http://www.hedgefund-index.com/d_shortselling.asp [Accessed 18 February 2011] Tomas, garbaravivious & Frank, Dierick, 2005. Hedge Funds and Their Implications for Financial Stability. [Online] Available at: http://www.ecb.int/pub/pdf/scpops/ecbocp34.pdf [Accessed 18 February 2011] Read More