Hedge Funds in the United States - Essay Example

Hedge Funds in the United s Introduction Hedge funds are growing in the U.S. financial market despite market turbulences. Since its birth in the middle of the 20th century, they have increased in terms of number and total assets. This research paper focuses on the expansion of hedge fund industry in the United States. It also addresses the issue on hedge funds as optimal investment strategies. Background Definition of Hedge Fund Hedge fund, as reported by the President's on Working Group on Financial Markets (1999), is defined usually as a variety of different kinds of investment vehicles which have some features in common. The term "hedge fund" involves any pooled investment medium that is (1) organized in private, (2) directed by experienced and professional investment managers, and (3) not accessible to the public. Hedge funds are supported by rich personalities and institutional investors who are regarded as primary investors. Other investors include (1) endowment funds, (2) pension plans, (3) funds of funds, and (4) retail investors. (Boyle, 2007) Other bodies characterized as hedge funds are systematic and limited partnerships and liability companies or most commonly reside outside the United States. (President's on Working Group on Financial Markets, 1999) Origin and Expansion of Hedge Fund Hedge fund originated in 1949. By 1968, 140 hedge funds were operating as reported by the U.S. Securities and Exchange Commission. Within the last 20 years, hedge fund industry bloomed and become common in the U.S. market. According to Phelim Boyle (2007), in the year 1990, a total number of 610 funds are controlling $39 billion worth of assets. By 2000, there were 3,873 funds directing $490 billion assets. The estimated size of the hedge fund industry in mid-1998 was in the range of 2,500 and 3,500 hedge funds controlling between $200 and $300 billion worth of capital, totaling more or less $800 up to $1 trillion in total assets. As compared with other U.S. financial market sectors, hedge funds are relatively small. As a matter of fact, in the latter portion of 1998, $4.1 trillion worth of total assets belong to commercial banks, $5 trillion worth of assets for mutual funds, $4.3 trillion for private pension funds, $2.3 trillion for local retirement funds, and $3.7 trillion worth of assets claimed by insurance companies. (President's on Working Group on Financial Markets, 1999) The Marko Maslakovic (2008) reports that despite the existence of market destabilizations, the hedge fund industry continued to grow in management assets and the number and type of institutions investing in hedge funds. For the assets under management, the hedge fund for this category amounted to over $2,250 billion in the end of 2007. Figure 1 shows the trend of global hedge funds in relation to their assets under management. The number of hedge funds reached over 11,000 in 2007 or 12 percent increase from the previous year (2006). The presence of the increasing credit crisis and increased market volatility did not hinder hedge funds assets from growing by 30 percent in 2007. Hedge funds did not incur any significant influence on the credit crisis because only 5 percent of their assets were examined in mortgage-backed securities in September 2007. Boyle (2007) mentions six (6) reasons for the hedge funds growth: (1) technological innovations, (2) derivatives revolution, (3) specialization, (4) increase of market complexities such as catastrophe bonds and structured products, (5) recent poor market equity performance, and (6) low interest rates. Figure 1 For the distribution of hedge funds in the world, reports of Maslakovic (2008) show that the United States is the major source of hedge fund investments with 67 percent of the total hedge funds assets in 2007. Europe and Asia are the next large sources with 22 percent and 7 percent shares respectively. New York City is the world's leading city for hedge managers and it is followed by London. In New York, around 60 percent of hedge fund managers are stationed in this city. London has doubled its hedge funds investment since 2002. The reason for such increase is the growth of investment from institutional investors who are attracted by (1) risk diversification, (2) flexible investment options, and (3) the ability of hedge funds to provide non market correlated returns. (Maslakovic, 2008) Characteristics and Benefits of Hedge Fund Aside from the relatively small size in the financial market, hedge funds also differ from other ways involving alternative kinds of investment medium. Hedge funds can buy securities in leverage and sell securities in short. Advisory fees are also charged which is based on performance and they focus on short-term investment strategies. Hedge funds do not focus on single market strategy rather; it shows a huge variety of investment styles both quantitative and subjective factors. (President's on Working Group on Financial Markets, 1999) According to Boyle (2007) these investment styles have funds that aim most of the time for absolute returns, low in volatility, and low correlation with the market. Hedge funds have different uses in their various financial instruments. A number of hedge funds engage in trading either equity or fixed income securities which takes either long or short positions, or both simultaneously. Compared with other classes of asset managers such as mutual funds, hedge funds are more likely active users of derivatives and short positions. (President's on Working Group on Financial Markets, 1999) Boyle (2007) mentions four (4) benefits from hedge funds: (1) provide liquidity, (2) price efficiency, (3) enhanced risk distribution, and (4) give more choice for investors which in effect promote globalization. Risks of Hedge Fund Boyle (2007) cites five (5) main concerns and risks of hedge funds: (1) they can cause disturbances, (2) they lack transparency, (3) they are levered in high rates, (4) they are prone to herd behavior, and (5) they are vulnerable to frauds. Conclusion and Analysis Hedge funds despite the market instability are increasingly gaining the spotlight in the U.S. financial market. Having presented the benefits as well as the risks for investors engaging in hedge funds, this paper concludes that hedge funds still need some modifications and improvements to encourage investors to avail them. Although all market sectors have their own disadvantages, investors cannot risk their riches on something that they don't trust or they are not confident with. Works Cited: Boyle, Phelim. "What is the Optimal Investment in a Hedge Fund" Wilfrid Laurier University and Tirgarvil Capital. March 29, 2007: 1-44. Maslakovic, Marko. "Hedge Funds 2008." International Financial Services London Research July 2008: 1-8. The President's Working Group on Financial Markets. "Hedge Funds, Leverage, and the Lessons of Long Term Capital Management." April 28, 1999: 1-43. Read More