Policy Review Discussion Group

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Policy Review Discussion Group

• Thursday 23rd August 2007
• Topic Should Hedge Funds Be Banned?
• Presenter Dr. Rob Bianchi

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Q What are Hedge Funds?
IMF (1998) Hedge funds are collective investment
vehicles, often organized as private
partnerships and resident offshore for tax and
regulatory purposes. Their legal status places
few restrictions on their portfolios and
transactions, leaving their manager free to use
short sales, derivative securities, and leverage
to raise returns and cushion risk. Presidents
Working Group on Financial Markets
(1999) Although it is not statutorily defined,
the term (hedge fund) encompasses any pooled
investment vehicle that is privately organised,
administered by professional investment managers,
and not widely available to the public.
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Q What are Hedge Funds?
U.S. Securities Exchange (2003) Although there
is no universally accepted definition of the term
hedge fund, the term is generally used to
refer to an entity that holds a pool of
securities and perhaps other assets, whose
interests are not sold in a registered public
offering and which is not registered as an
investment company under the Investment Company
Act. Australian Prudential Regulation Authority
(APRA) (2003) Although the term is widely used,
there is no clear definition of what constitutes
a hedge fund. For the purposes of this
article, hedge funds are regarded as funds that
have some of the following characteristics, (i)
funds that rely heavily on a single strategy,
with broad delegations for the use of gearing and
derivatives, (ii) funds that have a reliance upon
a single individual to execute the investment
management process, (iii) a relatively short
trading history and/or (iv) target an absolute
return rather than a benchmark return.
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Hedge Fund Investment Strategies

• Equity Market Neutral
• Long/Short Equity
• Global Macro
• Fixed Income Arbitrage
• Convertible Arbitrage
• Merger (Risk) Arbitrage
• Dedicated Short Bias
• Managed Futures
• Multistrategy
• Fund of Funds
• and more ..

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The Role of Hedge Funds in Global Financial
Markets

• Bernanke (2007) most economists agree that the
  rise of hedge funds has been a positive
  development for investors and for financial
  markets. They have stimulated an extraordinary
  amount of financial innovation in recent years,
  and, using many of these new financial tools,
  they have greatly enhanced the liquidity,
  efficiency, and risk-sharing capabilities of our
  financial system.
• Risky transactions used to be the domain of
  banks. With the advent of Basel I and II, banks
  are becoming risk averse and the funding of risky
  transactions has been transferred to the
  non-banking sector via the hedge fund industry.

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The Good, The Bad and the Ugly

• The Good
• Quantum Fund - George Soros.
• GAMUT - Bruce Kovner.
• Citadel - Ken Griffin.
• Renaissance Tech Jim Simons
• The Bad Ugly
• LTCM - Myron Scholes, Rob Merton.
• Amaranth - Nick Maounis, Brian Hunter.
• Basis Capital - Steve Howell, Stuart Fowler.
• QUESTIONS
• Should investors be protected by government?
• Do Hedge Funds induce potential systemic risk to
  the global financial system?

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Proposals for Hedge Fund RegulationMarket vs
Government Approach

• At present, there is a market based approach
  (proposed by Fed Reserve) to hedge fund financial
  regulation, ie. investors and creditors provide a
  powerful market mechanism for controlling
  risk-taking, however, LTCM is the eg. of market
  discipline failure.
• The alternative is government regulation,
  (proposed by ECB and Bundesbank) however, moral
  hazard may relieve investors of risk assessment
  of hedge funds. Govt regulation may curtail
  efficiency, innovation and flexibility in hedge
  funds.

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BACK TO THE FUTURE

• QUESTION
• What would J.M. Keynes have thought about hedge
  funds ?

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Keynes was a Hedge Fund Manager !

• Chua and Woodward (1983) in the Journal of
  Finance documents J.M Keynes as the First Bursar
  of the Chest Fund at Kings College, Cambridge
  from 1927 to 1945. The fund held positions in
  common stocks, currencies and commodity futures.
• In todays terminology, the Chest Fund would have
  been regarded as a global macro hedge fund.
• The Chest Funds 1927-1945 investment performance
  by Chua and Woodward (1983) suggests Keynes was
  an astute investment manager.

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THE ECONOMICS OF HEDGE FUND HAPPINESS
ltAce Greenberg, CEO, Bear Stearns
Lloyd Blankfein, CEO, Goldman Sachsgt
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References

• Australian Prudential Regulation Authority
  (APRA), 2003, APRA alerts super industry to the
  drawbacks of hedge funds, Media Release No.
  03.25, Wednesday 5th March.
• Bernanke, B., 2007, Financial Regulation and the
  Invisible Hand, New York University Law School,
  11th April, New York, New York.
• Chua, J. and Woodward, R., 1983, J.M. Keyness
  investment performance A note, Journal of
  Finance 38, 232-235.
• International Monetary Fund (IMF), 1998, Hedge
  funds and financial market dynamics, Occasional
  Paper 166, May, Washington D.C., U.S.A.
• Presidents Working Group on Financial Markets,
  1999, Hedge funds, leverage and the lessons of
  Long Term Capital Management, Washington, D.C.,
  April.
• U.S. Securities and Exchange Commission, 2003,
  Implications of the growth of hedge funds, SEC
  Special Studies, 29th Sept.

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No, hands off! By Alex Stanley

• Theres no externalities the investors in hedge
  funds are large and know what risks they are
  taking.
• The inherently risky choices made by hedge funds
  are simple business decisions
• Hedge funds are still constrained by the need for
  reputation, disclosure rules, and all the other
  requirements made of investment funds. They
  simply have bigger clients.

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Why hedge funds should be outlawedChris
Coleman-Fenn

• In the United States, hedge funds are open to
  accredited investors only. Because of this
  restriction, they are usually exempt from any
  direct regulation by the SEC and other regulatory
  bodies.
• As hedge funds are essentially a private pool of
  managed assets, and as their public access is
  commonly restricted by the government, they have
  little to no incentive to release their private
  information to the public.
• However, these institutional investors may be
  managing funds of less informed investors who
  simply tick a box on a form saying Alternative
  investments without any idea that this involves
  hedge funds.

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Why hedge funds should be outlawed

• Because hedge funds typically use leverage /
  gearing or debt to invest, the positions they can
  take in the financial markets are larger than
  their assets under management.
• Prime example is Long-Term Capital Management
  The company had developed complex mathematical
  models to take advantage of fixed income
  arbitrage deals with government bonds
• By a series of financial transactions
  (essentially amounting to buying the cheaper
  'off-the-run' bond and short selling the more
  expensive, but more liquid, 'on-the-run' bond) it
  would be possible to make a profit as the
  difference in the value of the bonds narrowed
  when a new bond came on the run.

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Why hedge funds should be outlawed

• As LTCM's capital base grew, they felt pressed to
  invest that capital somewhere and had run out of
  good bond-arbitrage bets. This led LTCM to
  undertake trading strategies outside their
  expertise. Although these trading strategies were
  non-market directional, i.e. they were not
  dependent on overall interest rates or stock
  prices going up (or down), they were not
  convergence trades as such.
• The fund needed to take highly-leveraged
  positions to make a significant profit. At the
  beginning of 1998, the firm had equity of 4.72
  billion and had borrowed over 124.5 billion with
  assets of around 129 billion. It had off-balance
  sheet derivative positions amounting to 1.25
  trillion, most of which were in derivatives

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Why hedge funds should be outlawed

• However, in mid 1998, net returns from the fund
  reduced LTCM's capital by 461 million. Such
  losses were accentuated through the Russian
  financial crisis when their defaulted on their
  bonds. Panicked investors sold Japanese and
  European bonds to buy U.S. treasury bonds. The
  profits that were supposed to occur as the value
  of these bonds converged became huge losses as
  the value of the bonds diverged. By the end of
  August the fund had lost 1.85 billion in
  capital.
• The company, which was providing annual returns
  of almost 40 up to this point, experienced a
  flight-to-liquidity. In the first 3 weeks of
  September LTCM's equity tumbled from 2.3 billion
  to 600 million without shrinking the portfolio,
  leading to a significant elevation of the already
  high leverage. 1.225 in nominal value with 600
  mill of capital leads to a leveraging of 2042.

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Why hedge funds should be outlawed

• The Fed Bank organized a bail-out of 3.6 billion
  by the major creditors to avoid a wider collapse
  in the financial markets. The fear was that there
  would be a chain reaction as the company
  liquidated its securities to cover its debt,
  leading to a drop in prices which would force
  other companies to liquidate their own debt
  creating a vicious cycle.
• The total losses were found to be 4.6 billion.
  The losses in the major investment categories
  were (ordered by magnitude)
• 1.6 bn in swaps 1.3 bn in equity volatility
  430 mn in Russian and other emrging markets
  371 mn in directional trades in develped 215
  mn in yield curve arbitrages 203 mn in SP 500
  stocks
• 100 mn in junk bond arbitrage
• LTCMs strategy has been likened to picking up
  pennies in front of a steamroller

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Why hedge funds should be outlawed

• The European Central Bank has issued a warning on
  hedge fund risk for financial stability and
  systemic risk "... the increasingly similar
  positioning of individual hedge funds within
  broad hedge fund investment strategies is another
  major risk for financial stability which warrants
  close monitoring despite the essential lack of
  any possible remedies. This risk is further
  magnified by evidence that broad hedge fund
  investment strategies have also become
  increasingly correlated, thereby further
  increasing the potential adverse effects of
  disorderly exits from crowded trades."

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Why hedge funds should be outlawed

• Because of the excessive leverage employed, hedge
  funds are particularly paranoid when markets
  start to move against them. Therefore, they react
  excessively to even minute changes in market
  conditions.
• In particular, if one fund looks likely to suffer
  significant losses, there is a belief the fund
  may suffer a similar fate to LTCM or at least
  substantial losses and other funds withdraw their
  positions quickly to limit exposure. This creates
  a flight-to-liquidity in this market.
• Due to the huge nominal value controlled by these
  funds, funded by borrowing, they place enormous
  downward pressure on the market as a whole with
  contagion into other markets and even instruments.

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Why hedge funds should be outlawed

• The Chairman of the Federal Reserve Bank of New
  York has said "The same factors that may have
  reduced the probability of future systemic
  events, however, may amplify the damage caused by
  and complicate the management of very severe
  financial shocks."
• But the sup-prime crisis has lent support to RBA
  Chairman Glenn Stevens' contention that liquidity
  in highly leveraged and securitised markets is
  ephemeral and does not survive under pressure.
• One sign of the market malfunction last week was
  the announcement by Goldman Sachs that its Global
  Equities hedge fund had lost 3.6 billion when
  its computerised trading failed to cope with the
  size of the market move. The OECD has drawn
  attention to the risks taken by hedge funds
  running computerised programs to deliver capital
  guaranteed returns to investors.

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Why hedge funds should be outlawed

• An OECD study released earlier this year noted
  that these products carry a mix of high and
  low-risk investments and automatically adjust the
  mix as markets move, increasing holdings of
  high-risk, high-return investments as markets
  fall.
• It is under abnormal conditions, when liquidity
  in markets is under pressure, that the leverage
  employed by some of the funds will be at its most
  damaging.

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Why hedge funds should be outlawed

• Efficient Markets Hypothesis states that no
  investor can consistently outperform the market.
  While some short term anomalies have been found,
  once discovered they are quickly exploited and
  removed.
• Is it hard to conceive that hedge funds are able
  to consistently out-predict the entire market,
  let alone the other hedge funds that charge these
  high fees.
• Therefore, when funds perform poorly investors
  suffer from either losses in value or the
  opportunity cost of investing in a simple tracker
  fund. When the fund performs well, they charge
  the client for their luck.