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Public Interest Demands Hedge Fund Rules

By Randall Dodd | Financial Policy Forum and Derivatives Study Center | January 12, 2007

The number of hedge funds is estimated to have reached 9,000 in 2006, or about one thousand more than the preceding year. Given that some funds failed or closed, this represents a large number of new funds. One public interest concern raised by the proliferation of the these investment companies is that, as one prominent market commentator put it, it is "amateur hour" in the hedge fund industry.

This proliferation of unregulated, high-yield investment companies brings to mind a comment made about the influence of the Velvet Underground on rock and roll music. Brian Eno quipped that although the Velvet Underground never sold many records, everyone who bought one started a band. The public danger from bringing forth art produced more by inspiration than talent is likely limited to mild hearing loss and public embarrassment later in life. The challenge of turning large amounts of capital into larger amounts of assets is far riskier.

The size of the hedge fund market, measured by the amount of capital invested in the funds, was $221 billion in 1999 before growing by over 450 percent to exceed $1,223 billion today.

The composition of the capital raised by hedge funds has also changed significantly since the 2000 report by the Financial Stability Forum (FSF). In 1999, 55 percent of hedge fund capital came from individuals, whereas today that is down to 40 percent. Meanwhile the amount of capital that is channeled to hedge funds from 'funds of funds' has risen from 19 percent to 28 percent, and that from corporations and 'institutions' has risen from 10 percent to 15 percent.

The share of capital raised from pension funds and endowments is roughly the same as six years ago—although the share of capital from 'funds of funds' is itself not broken out and may represent growth from pension funds or endowments. Of course maintaining a constant share of a market growing that fast means that pension funds and endowments today have $232 billion of their assets—plus an unknown share of funds channeled through funds of funds—invested in hedge funds. Hedge fund allocations among U.S. endowments are now 12.3 percent of their total assets according Greenwich Associates.

Hedge funds today are major participants in many important financial markets. Market reports claim that 18 to 22 percent of all trading volume on the New York Stock Exchange and 30 to 35 percent on the London Stock Exchange is by hedge funds. Similarly, 75 percent of actively traded convertible bonds are held by hedge funds. Hedge funds account for 45 percent of trading volume in emerging market bonds, 47 percent in distressed debt, and 25 percent of high-yield bonds.

In derivatives markets, hedge funds accounted for 55 percent of the credit derivatives trading volume. Their trading in interest rate derivatives rose 49 percent last year, while that in credit derivatives rose 50 percent. According to Greenwich Associates, "In many cases, the credit derivatives market now drives the pricing of the actual underlying corporate bonds and some real money managers have complained to Greenwich Associates that this new dynamic is increasing volatility in corporate bond pricing."

"In many ways, [hedge funds] have become the market," said Peter D'Amario of Greenwich Associates.

There are other important changes that mean the economic importance of hedge funds is different today. Today, they are raising capital in public securities markets—Citadel is raising over $2 billion in a public debt offering. Also, the range of investment strategies is wider.

The history of fraud, embezzlement, and market trading abuses is longer and deeper since 2000. The third largest bankruptcy in U.S. history occurred after it was discovered that Refco was using transactions with a hedge fund to hide massive debts. The recent failure of Amaranth set a new record for losses—more than $6 billion—and that followed by just a few weeks the $300 million loss of Mother Rock.

Hedge funds were caught late-trading and market timing mutual funds. That practice inflicted damaging costs on many mutual fund investors and severely embarrassed the whole mutual fund industry. Also, there are allegations and charges of insider trading, market price manipulation, naked short selling, and exercising undue control over corporate governance and credit committees to drive down company values where the hedge funds hold large net short positions.

Credit derivatives markets—the acclaimed gift from hedge funds to financial stability—were a relatively small market at the end of 1999 when the FSF report was drafted. The Bank for International Settlements did not start collecting data on these markets until 2004. But data from U.S. banks indicate that in 1999 the market was but a tiny fraction of today's $26 trillion plus market. U.S. banks held $278 billion at the end of 1999, and their holdings have grown by 2,654 percent. Applying the same growth rate to the global market means that markets were about 3.6 percent off their current size back in 1999.

In sum, the world of hedge funds is very different today than it was only six years ago. Dismissing public interest concerns about their role in the economy is irresponsible and does not reflect a thoughtful approach to thoroughly understanding the subject. Hedge funds are more numerous, have more capital, manage more assets and derivatives, operate at higher levels of leverage and play critical roles in many major financial markets. We regulate them as if they were so many child-operated lemonade stands, but in fact they are playing an economic role more like McDonald's.

Our understanding of the public interest in the growing role of these financial institutions should be keeping apace with their growth and development. Dismissing the possibility of any meaningful change in these markets is tantamount to reckless public policy.

Further Reading
Hedge Funds: Response to Deregulation, Randall Dodd, 12/21/06
On The Hedge Fund Question: A Program of Reckless Complacency, Randall Dodd, 10/30/06

Read More: Finance, Governance

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