The following excerpt is from Chapter II of the September 2004 Global Financial Stability Report. Footnote, table, box, and figure numbers have not been modified and therefore do not begin at 1.
Interest in the hedge fund industry by institutional investors has grown significantly in the last five years, resulting in large capital inflows, even as the industry continues to address earlier public and private sector recommendations. The significant growth of hedge funds, driven by institutional investors (e.g., pension funds, foundations, and endowments), has heightened the desire by the official sector to better understand hedge funds and their activities. The hedge fund industry is important to financial stability considerations for several reasons: (1) it is an active and leveraged counterparty to systemically important and regulated financial institutions; (2) broadly speaking, hedge funds can employ leverage much more extensively and diversely than other investment vehicles; and (3) industry assets are growing rapidly, and it is an increasingly important investor base in the international capital markets. As such, people continue to ask if hedge funds may again be a source of systemic vulnerability or market dislocations, similar to the events of 1998 and Long Term Capital Management (LTCM).
The hedge fund industry is composed of a heterogeneous group of pooled investment vehicles—there is no “typical” hedge fund. Nevertheless, hedge funds share several characteristics that distinguish them from traditional asset managers:
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they employ a wider range of financial instruments and investment strategies, including the use of leveraged positions;
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the manager’s particular investment strategy is more important to performance than asset class or geographic market selection;
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they may hold large short positions, and often employ active trading strategies; and
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hedge fund managers rely primarily on performance fees for much of their revenue.
In general, the hedge fund structure seeks to ease constraints typically faced by traditional fund managers.
Our study examines how we may achieve a better understanding of hedge funds and their market activities, particularly for financial stability considerations. We will not examine issues concerning investor protection, particularly relevant to retail investors, or safeguards against fraud. This study will review and update developments in the hedge fund industry since the previous IMF study in 1998, and consider what progress has been made to satisfy various recommendations and proposals from that time.4 Our objective is to address the broadly held view that not enough is known about hedge fund activities (i.e., to “de-mystify” the hedge fund industry). Our operating assumption is that markets work, and that market discipline can be very effective in such areas. However, in conducting our review of progress since the earlier studies, we note that such studies largely concluded that market discipline failed in 1998 with regard to LTCM. Pursuant to our study, we focus on the following issues: (1) counterparty exposure; (2) use of leverage; (3) disclosure and transparency; (4) market discipline; and (5) the impact of hedge funds on smaller and developing markets. A concluding section discusses the possible future direction of further industry and policy actions.5 We plan to continue this project, aiming to provide more detail regarding particular hedge fund and counterparty practices, and to cooperate with other official bodies on related work.
Growth of the Industry
The desire by institutional investors to improve risk-adjusted returns has led to significant capital flows into hedge funds. Assets under management among hedge funds were estimated to be over $800 billion at end-2003, and are projected to rise to approximately $1 trillion in 2004, growing on average 15 percent a year since 1999 and accelerating since 2002 (Table 2.5). The number of hedge funds was estimated to be 8,100 at end-2003, compared with approximately 6,000 in 1998. Industry representatives and previous studies have also noted that proprietary trading desks of banks and securities firms have increasingly engaged in trading activities similar to those of hedge funds. While hedge fund assets remain small compared with traditional asset managers, such as mutual funds (approximately $5 trillion in the United States alone), the increasing interest from pension funds and other institutional investors means hedge funds will likely continue to receive significant capital flows into the foreseeable future.6
Hedge Funds: Number of Funds and Assets Under Management1
Historical data and projections for 2004 are estimates by Van Hedge Fund Advisors International.
In billions of U.S. dollars.
Hedge Funds: Number of Funds and Assets Under Management1
| 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | ||
|---|---|---|---|---|---|---|---|
| United States | |||||||
| Number of funds | 4,150 | 4,250 | 4,400 | 4,600 | 4,875 | … | |
| Assets under management2 | 225 | 280 | 315 | 340 | 420 | … | |
| Europe and Japan/Asia | |||||||
| Number of funds | 2,050 | 2,250 | 2,600 | 2,900 | 3,225 | … | |
| Assets under management2 | 225 | 240 | 285 | 310 | 400 | … | |
| Global | |||||||
| Number of funds | 6,200 | 6,500 | 7,000 | 7,500 | 8,100 | 8,800 | |
| Assets under management2 | 480 | 520 | 600 | 650 | 820 | 970 | |
Historical data and projections for 2004 are estimates by Van Hedge Fund Advisors International.
In billions of U.S. dollars.
Hedge Funds: Number of Funds and Assets Under Management1
| 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | ||
|---|---|---|---|---|---|---|---|
| United States | |||||||
| Number of funds | 4,150 | 4,250 | 4,400 | 4,600 | 4,875 | … | |
| Assets under management2 | 225 | 280 | 315 | 340 | 420 | … | |
| Europe and Japan/Asia | |||||||
| Number of funds | 2,050 | 2,250 | 2,600 | 2,900 | 3,225 | … | |
| Assets under management2 | 225 | 240 | 285 | 310 | 400 | … | |
| Global | |||||||
| Number of funds | 6,200 | 6,500 | 7,000 | 7,500 | 8,100 | 8,800 | |
| Assets under management2 | 480 | 520 | 600 | 650 | 820 | 970 | |
Historical data and projections for 2004 are estimates by Van Hedge Fund Advisors International.
In billions of U.S. dollars.
Institutional investors have increased their focus on active asset management. Many large institutional investors have historically pursued passive investment strategies, focused on various broad equity or fixed-income benchmark indices. However, increasingly these investors are looking to integrate investment and risk management practices, and thus seek a blend of “strategies” to meet their investment objectives, while aiming to maintain risks at acceptable levels. A greater emphasis on diversification and asset correlations is reflected in portfolio construction. As such, investors increasingly seek to isolate and enhance returns from active asset management (alpha), and wish to reduce the volatility and returns associated with general market risks (beta). Such investment objectives have encouraged greater hedge fund exposure.
Given the rapid industry growth, market participants question the capacity of some strategies and large funds to generate “alpha.” Due to the significant flow of capital and new fund managers into the industry, most market participants anticipate diminishing returns in some hedge fund strategies. From a policy perspective, the concern is that managers will employ more leverage to enhance or maintain historical performance, and some evidence of this exists today. Without adequate transparency, it is often difficult to determine if such activity is taking place or whether it may be destabilizing in some markets. Consequently, many policymakers, regulators, and market participants have raised the question of how to monitor hedge fund activities, and whether regulation may be required.7 We attempt to address these questions in the context of the five factors that are the focus of our review.
Counterparty Exposure and Risk Management
Counterparty risk management by banks and prime brokers with regard to hedge funds has improved during the last five years.8 As in the past, collateral remains a cornerstone of risk management at prime brokers and banks, and their trading and credit activities with hedge funds, particularly equity market activities.9 In contrast, financing for fixed-income transactions may be more fragmented, with an individual counterparty (often a bank) extending credit with relatively less collateral protection.10 The collateral coverage relative to the credit extended (i.e., the haircut), credit terms, and trading margin are now usually set by formal and established credit assessment procedures. Discussions with leading counterparties (banks and brokers) suggest that such assessments generally include many of the following factors: (1) the transparency of the investment strategy; (2) the amount of leverage required by the strategy to be economically viable; (3) the underlying liquidity, concentration, and volatility of investment positions; (4) the amount of liquidity (i.e., cash and equivalents) held by the fund; (5) the size and operational infrastructure of the fund; (6) the degree of “strategy drift” detected in the fund or the fund manager’s operating history; and (7) the length and quality of a fund manager’s track record.
Established banks and brokers use collateral and other credit terms in an effort to achieve AA or AAA credit quality. Banks and brokers actively manage counterparty exposure using multiple sources of information, including trading and other relationships, and a variety of risk management tools, including derivatives.11 Some prime brokers (dealing particularly with equity trades) maintain less than 1 percent uncollateralized exposure to all counterparties (not just hedge funds) on a current and potential exposure basis.12
Most prime brokers and banks believe that “hard” requirements for collateral and other credit terms may be inappropriate. Such hard limits may force hedge funds to liquidate positions at the worst time, and possibly exacerbate deteriorating market conditions and weaken the counterparty’s position. Consequently, counterparties actively monitor these exposures, requiring more detailed and frequent reporting of portfolio positions, and use qualitative judgments to complement quantitative rules to proactively adjust exposures. In this regard, the larger banks and established brokers seek to combine traditional credit analytics with trading and market experience, and often encourage hedge funds (by offering preferential trading terms) to bring more of their overall business to them in order to gain a fuller picture of their risk profile (albeit with relatively little success to date).
Market participants emphasized that liquidity risk continues to represent a significant challenge. One of the lessons from the failure of LTCM is that liquidity can disappear quickly during periods of market stress, especially when hedge funds and similar activities by proprietary trading desks within banks and securities firms accumulate significant and/or concentrated positions.13 To manage their liquidity risks, most hedge funds seek to limit concentrations with specific counterparties and instruments, and have explicit (often hard) exit strategies on positions in anticipation of possible market disruptions. Nevertheless, many fund and risk managers, as well as investors, question whether such strategies are realistic for less liquid asset classes or markets dominated by hedge funds and bank trading desks (e.g., distressed securities, and fixed-income or convertible arbitrage strategies). Typically, hedge funds also utilize “lock-up” agreements, often for extended periods (up to two or three years), to manage investor or fund liquidity and capital withdrawals, which is another way that hedge funds manage liquidity risk—thereby transferring or sharing this risk with investors.
Use and Measurement of Leverage
Since 1998, credit providers and hedge funds have developed a better understanding of leverage and, broadly speaking, hedge fund leverage is at relatively moderate levels today. At present, many equity hedge funds report leverage typically less than two times capital, and other styles and strategies are similarly reporting leverage at or below historical norms.14 Nevertheless, leverage can magnify liquidity, market, and credit risks, as well as returns, and is one of the most important factors contributing to a hedge fund’s overall risk profile. Moreover, hedge fund and risk managers have noted that leverage has shifted to newer and riskier strategies. Many sophisticated investors carefully assess the use and appropriate degree of leverage, which varies from strategy to strategy, and are cautious about investing in highly leveraged strategies.
However, increased competition among prime brokers, particularly newer entrants, has made it easier for hedge funds to obtain leverage.15
Market participants recognize that leverage must be monitored against acceptable norms for different strategies (Table 2.6 and Box 2.9). As noted above, leverage varies from strategy to strategy, and certain strategies (typically fixed-income and various arbitrage strategies) generally employ more leverage. Despite best practices recommended by hedge fund associations, most hedge funds only report accounting leverage, which is often stated as the market value of gross exposures (the sum of long and short positions) relative to a fund’s net asset value.16 One limitation of this measure is that it does not gauge how underlying market risks are affected by changes in asset prices, which is what an economic measure of leverage would provide. Economic measures of leverage generally begin with a VaR calculation, and may incorporate stress scenarios and some measures of concentration and liquidity of a fund’s positions.
Leverage Estimates by Hedge Fund Strategy1
Leverage may not be reported consistently across hedge funds. This number can refer to the current reporting period or to some period average, as reported by the hedge fund. In addition, no specific guidance is available as to how the figure is computed. Data for the period December 1997-December 2003, and at December 2003, as appropriate.
See Box 2.9 for strategy definitions.
Volatility is calculated as the standard deviation of the data reported by hedge funds within each strategy.
Leverage Estimates by Hedge Fund Strategy1
| Fund Strategies2 | Total Number of Funds |
Simple Average Leverage Within Each Strategy |
Asset-Weighted Average Leverage Within Each Strategy |
Leverage | Volatility of Returns Within Each Strategy3 (percent) |
|
|---|---|---|---|---|---|---|
| Minimum | Maximum | |||||
| Fixed income: diversified | 21 | 5.4 | 8.3 | 1.0 | 18.0 | 6.7 |
| Fixed income: mortgage-backed | 30 | 3.9 | 4.3 | 1.0 | 10.0 | 10.0 |
| Fixed income: high yield | 7 | 3.0 | 3.3 | 1.3 | 5.2 | 10.3 |
| Convertible arbitrage | 108 | 2.5 | 3.0 | 1.0 | 7.0 | 4.9 |
| Equity nonhedge | 74 | 2.2 | 2.9 | 1.0 | 12.0 | 8.1 |
| Fixed income: arbitrage | 74 | 2.0 | 2.1 | 1.0 | 12.0 | 7.5 |
| Global macro | 54 | 2.0 | 2.4 | 1.0 | 5.0 | 11.2 |
| Equity market neutral | 36 | 1.7 | 1.8 | 1.0 | 3.0 | 6.4 |
| Event-driven multi-strategy | 68 | 1.5 | 1.4 | 1.0 | 10.0 | 12.4 |
| Merger/risk arbitrage | 80 | 1.4 | 1.6 | 1.0 | 10.0 | 6.0 |
| Equity hedge | 499 | 1.4 | 1.4 | 0.7 | 20.0 | 14.5 |
| Distressed securities | 89 | 1.3 | 1.2 | 1.0 | 3.0 | 4.9 |
| Emerging markets | 118 | 1.3 | 1.4 | 1.0 | 3.0 | 27.3 |
| Short selling | 19 | 1.2 | 1.1 | 1.0 | 2.0 | 15.2 |
| Sector composite | 103 | 1.2 | 1.2 | 1.0 | 2.0 | 17.1 |
| Memorandum item: | ||||||
| Fund of funds | 482 | 1.2 | 1.2 | 1.0 | 25.0 | 9.1 |
Leverage may not be reported consistently across hedge funds. This number can refer to the current reporting period or to some period average, as reported by the hedge fund. In addition, no specific guidance is available as to how the figure is computed. Data for the period December 1997-December 2003, and at December 2003, as appropriate.
See Box 2.9 for strategy definitions.
Volatility is calculated as the standard deviation of the data reported by hedge funds within each strategy.
Leverage Estimates by Hedge Fund Strategy1
| Fund Strategies2 | Total Number of Funds |
Simple Average Leverage Within Each Strategy |
Asset-Weighted Average Leverage Within Each Strategy |
Leverage | Volatility of Returns Within Each Strategy3 (percent) |
|
|---|---|---|---|---|---|---|
| Minimum | Maximum | |||||
| Fixed income: diversified | 21 | 5.4 | 8.3 | 1.0 | 18.0 | 6.7 |
| Fixed income: mortgage-backed | 30 | 3.9 | 4.3 | 1.0 | 10.0 | 10.0 |
| Fixed income: high yield | 7 | 3.0 | 3.3 | 1.3 | 5.2 | 10.3 |
| Convertible arbitrage | 108 | 2.5 | 3.0 | 1.0 | 7.0 | 4.9 |
| Equity nonhedge | 74 | 2.2 | 2.9 | 1.0 | 12.0 | 8.1 |
| Fixed income: arbitrage | 74 | 2.0 | 2.1 | 1.0 | 12.0 | 7.5 |
| Global macro | 54 | 2.0 | 2.4 | 1.0 | 5.0 | 11.2 |
| Equity market neutral | 36 | 1.7 | 1.8 | 1.0 | 3.0 | 6.4 |
| Event-driven multi-strategy | 68 | 1.5 | 1.4 | 1.0 | 10.0 | 12.4 |
| Merger/risk arbitrage | 80 | 1.4 | 1.6 | 1.0 | 10.0 | 6.0 |
| Equity hedge | 499 | 1.4 | 1.4 | 0.7 | 20.0 | 14.5 |
| Distressed securities | 89 | 1.3 | 1.2 | 1.0 | 3.0 | 4.9 |
| Emerging markets | 118 | 1.3 | 1.4 | 1.0 | 3.0 | 27.3 |
| Short selling | 19 | 1.2 | 1.1 | 1.0 | 2.0 | 15.2 |
| Sector composite | 103 | 1.2 | 1.2 | 1.0 | 2.0 | 17.1 |
| Memorandum item: | ||||||
| Fund of funds | 482 | 1.2 | 1.2 | 1.0 | 25.0 | 9.1 |
Leverage may not be reported consistently across hedge funds. This number can refer to the current reporting period or to some period average, as reported by the hedge fund. In addition, no specific guidance is available as to how the figure is computed. Data for the period December 1997-December 2003, and at December 2003, as appropriate.
See Box 2.9 for strategy definitions.
Volatility is calculated as the standard deviation of the data reported by hedge funds within each strategy.
Hedge Fund Strategy Definitions
Relative Value Strategies
1. Equity Market Neutral
Seeks to profit by exploiting pricing inefficiencies between related securities, neutralizing exposure to market risk by combining long and short positions.
2. Convertible Arbitrage
Involves purchasing a portfolio of convertible securities and hedging a portion of the equity risk by selling short the underlying common stocks.
3. Fixed Income
Fixed-Income Composite funds include funds that invest in Fixed-Income Arbitrage, Fixed-Income Diversified, Fixed-Income High-Yield, Fixed-Income Mortgage-Backed.
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3a. Fixed-Income: Arbitrage. A market neutral hedging strategy that seeks to profit by exploiting pricing inefficiencies between related fixed-income securities, while neutralizing exposure to interest rate risk.
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3b. Fixed-Income. These funds invest in non-investment grade debt. Objectives may range from high current income to acquisition of undervalued instruments. Emphasis is placed on assessing credit risk of the issuer. Some of the available high-yield instruments include extendible/reset securities, increasing-rate notes, pay-in-kind securities, step-up coupon securities, split-coupon securities and usable bonds.
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3c. Fixed-Income: Mortgage-Backed. These funds invest in mortgage-backed securities. Many funds focus solely on AAA-rated bonds. Instruments include government agency, government-sponsored enterprise, private-label fixed- or adjustable-rate mortgage pass-through securities, fixed- or adjustable-rate collateralized mortgage obligations (CMOs), real estate mortgage investment conduits (REMICs), and stripped mortgage-backed securities (SMBSs). Funds may look to capitalize on security-specific mispricings. Hedging of prepayment risk and interest rate risk is common. Leverage may be used, as well as futures, short sales, and options.
Event Driven Strategies
4. Distressed Securities
Strategies invest in, and may sell short, the securities of companies where the security’s price has been affected by a distressed situation like reorganization, bankruptcy, distressed sales, and other corporate restructuring.
5. Merger Arbitrage/Risk Arbitrage
Merger Arbitrage, sometimes called Risk Arbitrage, involves investment in event-driven situations such as leveraged buyouts, mergers, and hostile takeovers.
Other Strategies
6. Equity Hedge
The strategy is comprised of long stock positions with short sales of stock or stock index options/futures. The strategy has a long market bias.
7. Sector Composite
Sector funds invest in specific sectors. Investments are primarily long energy, financial, healthcare/biotechnology, real estate, and technology sectors.
8. Emerging Markets
Involves investing in securities of companies or the sovereign debt of developing or emerging countries. Investments are primarily long.
9. Global Macro
Macro strategies involves leveraged investments on anticipated price movements of stock markets, interest rates, foreign exchange, and physical commodities. Macro managers employ a “top-down” global approach.
10. Short Selling
Short Selling involves the sale of a security not owned by the seller; a technique used to take advantage of an anticipated price decline.
Source: Center for International Securities and Derivatives Markets (CISDM), Hedge Fund database.Market participants have become concerned about leverage being introduced at the fund of hedge funds (FOFs) and investor levels. Recently, some FOFs have used leverage to compensate for diminishing returns (e.g., due to diversification effects or capacity constraints), and presumably to address potential investor concerns related to their double fee structure.17 Despite the diversification achieved by FOFs, leverage employed at the FOFs level only serves to amplify the risk of leveraged hedge fund activity. Several established prime brokers indicated that they do not extend credit to FOFs, since they cannot effectively monitor the underlying hedge fund activities, with collateral once removed. Nevertheless, it is understood that FOFs are increasingly employing leverage to enhance returns. Similarly, some retail and institutional investors are being offered leveraged equity interests in hedge funds and FOFs, as well as a variety of structured products, including principal protected or capital guarantee products.18 In short, these multiple layers of leverage increase the risk profile of these institutions and investors.
Disclosure and Transparency
In general, disclosure has not changed significantly, and has become more varied since the recommendations of the President’s Working Group on Financial Markets (1999). The goal of disclosing more information for investors and counterparties to better assess the risk profiles of hedge fund portfolios, while not revealing proprietary information, generally remains elusive.19 Disclosure standards vary considerably depending on the target audience, such as investors, counterparties, or regulators, and to some degree improvements to disclosure practices have been cyclical, depending on the need for fund managers to accommodate investor and counterparty requests.20 Historically, large institutional investors were able to request and receive a high level of transparency. However, more recently, in large part because investor demand is so strong, many hedge funds do not wish to accept added administrative or reporting burdens. Although there was broad support for prior recommendations to improve disclosure practices by hedge funds, follow-through has been less enthusiastic. For example, in a recent update regarding the recommendations of the Multidisciplinary Working Group on Enhanced Disclosure concerning the disclosure of financial risks, the Joint Forum noted: “…the Working Group was unsuccessful in obtaining the cooperation of a sufficient number of hedge funds to provide a meaningful basis for further review.”21
Banks, prime brokers, and administrators have access to more information and receive greater transparency than most investors. The vast majority of industry participants agree that in general hedge fund counterparties have much better transparency today, including data with reasonably granular detail (e.g., many credit institutions measure particular exposures across the entire institution, broken down by asset class or sometimes by fund strategy). As such, some market participants believe industry-wide or strategy aggregation of certain risk parameters is feasible. However, many hedge funds avoid allowing any counterparty to obtain full transparency to its trading and investment strategies, based largely on a desire to protect proprietary information and avoid front-running by trading desks within these institutions. Therefore, while better information and transparency appear available, a degree of coordination would be required to compile a reasonable risk profile of particular strategies or market activities.
Market Discipline
Earlier studies identified market discipline as the principal means by which risk-taking is controlled in a market-based economy.22 A key requirement for effective market discipline is the availability of relevant information. The improvements in risk management and counterparty practices discussed earlier must be complemented with greater transparency for market discipline to be effective. Moreover, such studies also recognized that as the demand for hedge funds grew, the desire to diversify across many hedge funds would bolster the role of FOFs and weaken the incentive or ability of investors to perform sufficient due diligence, placing more of the responsibility on FOF managers.23
Industry participants expressed skepticism about the ability of investors and other market forces to exert material discipline on hedge funds. Most simply, market participants believe the strong demand from investors for hedge fund capacity and increasing competition among regulated counterparties may undermine these sources of market discipline. Many market participants noted that the current strong demand to place capital with hedge funds by institutional investors (including FOFs) may limit their ability to gain greater transparency or to monitor hedge fund activities in a comprehensive manner.24
Banks and prime brokers also have been viewed as sources of market discipline. Many of these institutions actively monitor hedge fund activity and receive much better transparency than in the 1990s. However, this effort is, by its nature, focused on the hedge funds they service and is intended to manage their own exposures, which the largest banks and brokers seem to do well. Nevertheless, the picture obtained from the improved bilateral transparency and monitoring is unlikely to fully address financial stability issues (e.g., it does not evaluate broader aggregate market, credit, and liquidity risks, as well as concentrations, amplified by the use of leverage, across particular strategies or asset classes, or the potential for disruptive market dynamics). Moreover, with significant competition among banks and brokers for hedge fund business, there is potential for this form of discipline to disappoint. Therefore, at least at present, it would seem inappropriate to rely on market discipline as the primary source of surveillance and monitoring of hedge fund activities, particularly regarding potential systemic risks.
Hedge Fund Impact on Smaller and Developing Markets
Market participants, including hedge fund managers, agree that hedge fund activity can produce adverse market volatility in smaller and less liquid markets. There is broad agreement in the market that hedge funds, like other large investors, may be disruptive in smaller and developing markets. However, there is little empirical evidence that hedge funds have been a primary source of disruption during periods of emerging market turbulence, such as the Mexican or Asian currency crises of 1994 and 1998.25
Market participants emphasized that hedge fund impact on market volatility should not be solely assessed according to national or regional markets. While hedge fund managers agreed that active trading in relatively smaller markets may be disruptive, many managers also emphasized that the diversity of investors in a given market (or asset class or strategy) is a more significant determinant of market dynamics. For example, convertible arbitrage and many fixed-income strategies are dominated by hedge funds (often estimated to represent 80-90 percent of market activity), which are likely to behave in a broadly similar fashion in response to market developments. As such, these markets are likely to experience significantly greater volatility than a market populated by a more diverse investor group (e.g., insurance companies, mutual funds, and pension funds). In recent years, traditional emerging markets have benefited from a more dedicated and diverse investor base. As smaller markets develop and become more liquid, and thereby more attractive to hedge funds, efforts to further diversify and broaden the investor base should enhance financial stability in those markets. Most hedge fund managers cited particular asset classes and strategies (as above), not national or regional markets, as those markets most likely to suffer from significant hedge fund concentration. For policymakers, this implies that financial market surveillance could benefit from an operational metric to gauge the diversity of players in a particular market, in addition to those for depth and liquidity.
Preliminary Conclusions
The demand by institutional investors to place capital with hedge funds continues to grow, and is likely to continue for some time. This trend is fueled by investors’ desire to enhance returns from active asset management, and to seek greater portfolio diversification. Institutional investors should be encouraged to press for more information from hedge funds and FOFs (e.g., as a product of fiduciary duties to their underlying investors), to ensure that they understand the factors contributing to investment returns and portfolio risks.
Since 1998, banks and prime brokers have improved their management of hedge fund exposures, as well as their credit and risk management practices. Best practices have emerged and are more broadly adopted. Consistent with Basel II implementation, we find the established brokers and larger banks (and hedge funds) are using sophisticated credit and market metrics to measure and monitor counterparty exposures, including hedge fund exposure. However, it is doubtful whether regulated counterparties have sufficient transparency to allow them to fully assess risks across all of a large hedge fund’s activities (particularly potential systemic risks) or across a particular trading strategy (e.g., fixed-income or convertible arbitrage).
Despite the relatively moderate use of leverage by hedge funds today, there is the potential for leverage to rise. In an attempt to maintain performance, funds may pursue more risky strategies, supported by more leveraged positions. Moreover, with new entrants and strong competition among brokers, credit is more readily available to hedge funds today. In addition, FOFs have begun to employ leverage to enhance returns. This layering of leverage may significantly increase the potential for amplifying volatility and market disruptions.
Disclosure and transparency are core issues, and without better transparency it is doubtful market discipline can be relied upon to effectively monitor hedge fund activity. Improving disclosure and transparency on a broader basis would support the effectiveness of market discipline.26 Banks and brokers generally receive much better transparency today from their hedge fund counterparties, which helps to manage bilateral exposures, but not necessarily systemic risk. The largest hedge funds utilize multiple counterparties, and remain uncomfortable with broad transparency. In part, this may be justified, as many counterparties are also competitors through their proprietary trading desks. Likewise, there is a large variance in investor disclosure, and given the current strong demand for hedge fund investments we question investors’ ability to impose market discipline. In short, the hedge fund industry has not embraced earlier recommendations to develop improved standards for disclosure and reporting. Consequently, many in the official sector have questioned whether hedge fund regulation, or monitoring of their activities through regulated financial institutions, may be needed to provide adequate financial surveillance.
The primary goal of most official bodies is to better understand hedge fund operations and their potential impact on systemic risk, not necessarily to regulate these funds. Gaining a greater knowledge of hedge fund activities seems a logical ambition, particularly since hedge funds represent a significant counterparty to systemically important financial institutions. As such, it seems appropriate to monitor their market activities. Similarly, we believe it would be in the best interest of the hedge fund industry to more broadly and proactively encourage increased transparency, particularly as it grows and matures. In those cases where wholesale regulation of even institutional hedge fund activity is advocated, we question such an approach at this time, and whether the appropriate resources will be applied.
Despite the challenges, we believe hedge fund activities and potential systemic risks can be monitored in the main financial centers.27 A monitoring exercise could occur in two ways. First, as the hedge fund industry becomes more mature, with many managers institutionalizing their investment management businesses, we found managers of some of the largest hedge funds willing to provide risk information to national authorities on a voluntary basis. If many of the hedge funds with $2 billion or more in assets under management provided such information (covering approximately 70 hedge fund groups, representing approximately 40 percent of industry assets, and located primarily in New York and London), a substantial picture of the risk profile of hedge fund activity (by strategy and other criteria) would be available to better monitor systemic risks. Second, and independently, while perhaps challenging to implement, we believe the major prime brokers and banks may be able to provide supervisors with sufficient disaggregated information to allow officials to obtain a more complete assessment of particular risk profiles, potentially at the level of particular hedge fund strategies and financial instruments. Supervisors have always focused on various industry exposures and market risks that they believed required special review. As such, the supervisory structure already exists to monitor hedge fund exposure and activity. Of course, hedge funds operate across national and legal jurisdictions, so a reasonable level of cross-border cooperation would be required among financial supervisors. It is not clear that sufficient cooperation and coordination exists today. In either case, agreement about a common matrix of information, which would include qualitative observations and assessments as well as quantitative data, to properly aggregate and analyze available information would be a significant step forward.28 Given the improvement in risk management techniques by the largest hedge funds and their regulated bank and broker counterparties, we believe the opportunity exists to improve our understanding of hedge fund activities and potential systemic risks.
Some argue that to regulate or to monitor hedge funds would create moral hazard. The regulation or monitoring of hedge fund activities may be perceived as providing an implicit safeguard for investors, and regulated banks and brokers, possibly leading to more risk taking. Some authorities also worry that monitoring may be more problematic than regulation, particularly concerning how a regulator should act upon information or data obtained. We understand these concerns; however, we do not believe they differ in this context from the general supervisory process, or outweigh the benefits of better understanding hedge fund activities. Moreover, reacting to concerns through regulated entities may also prove the most effective means to influence hedge fund behavior and practices, including immediate risk positions and longer-term transparency issues.
Looking forward, as the hedge fund industry continues to grow and mature, we observe several themes likely to emerge in relation to our work. In particular, given the current and expected capital flows from traditional institutional investors into hedge funds, the largest banks and brokers are increasingly organizing themselves to attract this capital and participate in the “institutionalization” of the hedge fund industry. It is estimated that many of the largest banks and brokers will each manage $20 billion to $30 billion of hedge fund capital within five years. As such, the regulation or monitoring of such activities would become subsumed within existing supervisory mechanisms of the parent institutions. Moreover, some of these institutions also anticipate stronger retail demand for hedge fund products, which may contribute to the U.S. SEC’s recent initiative. Among the larger and more established hedge funds, we observe a similar institutionalization of activities, and they broadly anticipate a period in which lower returns produce a shakeout in the industry. While we share much of this view of future industry developments, we remain focused on the potentially sloppy and volatile transition process, and related financial stability issues.
We support efforts to develop a broader understanding of hedge fund activities, which we believe will enhance financial stability. Hedge funds are an established investor group in international capital markets, and a constructive influence on efficient market behavior. Nevertheless, they are a leveraged and active counterparty to systemically important financial institutions, and efforts by authorities to better monitor and influence their activities, including through regulated financial institutions, should be encouraged. Hedge funds, like other institutional investors, can contribute to or may adversely impact financial stability. As such, we still do not know what we do not know about hedge funds, and efforts to improve our surveillance and understanding of their market activities should be supported.