© 1998 International Monetary Fund

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Hedge funds and financial market dynamics/by a staff team led by Barry Eichengreen and Donald Mathieson with Bankim Chadha … [et al.]. — Washington DC : International Monetary Fund, 1998

p. cm. — (Occasional paper ; ISSN 0251–6365 ; 166)

Includes bibliographical references.

ISBN 1–55775-736–4

1. Hedge funds. 2. Hedge funds — Asia. I. Eichengreen, Barry J. II. Mathieson, Donald J. III. Chadha, Bankim. IV. International Monetary Fund. V. Occasional paper (International Monetary Fund) ; no. 166. HG4530.H33 1998

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Contents

• Preface

• I Overview

  • Barry Eichengreen and Donald Mathieson

• II Hedge Funds and Financial Markets: Implications for Policy

  • Barry Eichengreen and Donald Mathieson

  • Hedge Fund Operations

    • Hedge Funds and Market Moves

    • Policy Implications and Options

  • The Hedge Fund Industry

    • Diversity Within the Hedge Fund Industry

    • The Fuzzy Line Between Hedge Funds and Other Institutional Investors

    • A Look Back

    • Quantitiative Dimensions

    • Use of Leverage and Derivatives

    • A Look Forward

  • Hedge Funds and Market Dynamics

    • Investment Strategies

    • Herding and Market Dynamics

    • Feedback Trading

  • Supervision and Regulation

    • Investor Protection

    • Disclosure of Activities with Implications for Market Integrity

    • Systemic Risk Management

  • Hedge Funds and Recent Crises

    • The 1992 ERM Crisis

    • Bond Market Turbulence in 1994

    • The 1994–95 Mexican Crisis

    • Interim Summary

    • The 1997 Crisis in Emerging Markets

  • An Appraisal

    • Implications of the Crisis

    • Policy Options

  • Appendix. Hedge Funds and Financial Markets: Theoretical Perspectives

  • References

• III The Hedge Fund Industry: Structure, Size, and Performance

  • Bankim Chadha and Anne Jansen

  • Evolution of Hedge Funds

  • Characteristics of the Industry

    • The Data

    • Investment Styles

    • Number, Size, and Location of Funds

    • Survival Rate

    • Manager Compensation and Incentives for Risk Taking

    • Redemption Policies and Implications for Market Dynamics

    • Decision-Making Process

    • The Investor Base

    • Leverage

  • Performance: Return, Risk, and Diversification Comparisons

  • Macroeconomic Events and the Performance of Macro Hedge Funds

  • Conclusions

  • References

• IV Hedge Fund Investment Strategies

  • Laura Kodres

  • Strategies Used by Arbitrage-Type Hedge Funds

    • Analytics Behind the Strategies

    • Strategy Determinants

    • Examples of Strategies

  • Strategies Used by Macro Funds

    • Strategy Determinants

    • Examples of Strategies

  • Strategies Used by Emerging Market Hedge Funds

    • Combination Macro Funds and Arbitrage Funds

    • Special Considerations

  • Other Types of Hedge Fund Strategies

    • Event-Related Funds

    • Value Investing

    • Short-Selling Funds

    • Sector Funds

  • Appendix. Characteristics of Hedge Fund Strategies

  • References

• V Effects of Hedge Funds’ Strategies on Price Dynamics

  • Laura Kodres

  • Stabilizing Strategies

  • Destabilizing Strategies

  • Empirical Evidence

  • References

• VI Regulation of Hedge Funds

  • Sunil Sharma

  • Regulation of Hedge Funds in the United States

    • Investor Protection Rules

    • Regulation to Protect Market Integrity

    • Reducing Systemic Risk

  • Regulation of Hedge Funds in the United Kingdom

  • Regulation of Hedge Funds in the European Union

  • Views of Regulators

  • References

• Glossary

• Boxes

  • 2.1. The Asian Carry Trade

  • 6.1. Differences Between Mutual Funds and Hedge Funds in the United States

• Tables

  • 2.1. Hedge Funds: Number of Funds by Investment Style

  • 2.2. Hedge Funds: Assets Under Management by Investment Style

  • 2.3. Returns, Volatility, and Risk-Adjusted Returns by Investment Style

  • 3.1. Hedge Funds: Number of Funds by Investment Style

  • 3.2. Hedge Funds: Number of Funds by Domicile, 1997

  • 3.3. Hedge Funds: Assets Under Management by Domicile, 1997

  • 3.4. Hedge Funds: Assets Under Management by Investment Style

  • 3.5. Leverage by Investment Style, December 1997

  • 3.6. Returns, Volatility, and Risk-Adjusted Returns by Investment Style

  • 3.7. Correlations of Hedge Fund Returns with Benchmark Indices, January 1990–December 1997

  • 3.8. Correlation of Returns Among Large Macro Hedge Funds, September 1993–November 1997

  • 4.1. Proportion of Hedge Funds Using Various Instruments Ranked by Quintile of Asset Size

  • 5.1. Contemporaneous Herding by Selected Institutional Groups with Hedge Funds

  • 5.2. Herding by Selected Institutional Groups Following Hedge Funds by One Day

• Figures

  • 2.1. Annualized Yield on U.S. Dollar Carry Trades in the Thai Baht

  • 2.2. Annualized Yield on Japanese Carry Trades in the Thai Baht

  • 3.1. Hedge Funds: Assets Under Management by Investment Style

  • 3.2. Monthly Total Returns by Investment Style

  • 3.3. Large Macro Hedge Fund Returns and Macroeconomic Events

Preface

This occasional paper comprises a set of studies focusing on the role of hedge funds in financial market dynamics, with particular but by no means exclusive attention to the foreign exchange market. While the project was undertaken at the request of IMF management in the wake of the 1997 turbulence in Asian currency markets, its remit is broader: it considers not just “macro” hedge funds that take positions in currency markets on the basis of their assessment of current and prospective macro-economic and financial fundamentals, but the entire constellation of hedge funds, including global funds and emerging market funds and also sector funds, merger-arbitrage funds, market-neutral funds, and funds of funds. It seeks to place the hedge fund industry in context by analyzing the relationships of hedge funds to their institutional-investor counterparties and competitors. While much of the focus is necessarily on the role of hedge funds in the recent Asian currency and financial crisis, the paper considers also the role of other international investors in 1997 and in previous episodes of financial market turbulence.

In addition to the authors listed here, the paper benefited from the contributions of Subir Lall and Michael Spencer. Helpful comments were provided by Stanley Fischer, Michael Mussa, and other members of IMF management and staff. The authors are also grateful for conversations with hedge fund managers and other practioners in New York and London (to which Mr. Eichengreen led a mission in late October 1997) and Kuala Lumpur, Hong Kong Special Administrative Region (SAR), and Singapore (to which Mr. Chadha led a mission in early November 1997). Valuable input was provided by staff members of the Securities and Exchange Commission (United States), the Commodity Futures Trading Commission (United States), the Bank of England, the Financial Services Authority (United Kingdom), and the European Commission. Esha Ray of the External Relations Department edited the paper and coordinated production. Last but not least, the authors would like to thank Rosalind Oliver for her exceptionally able secretarial assistance.

The views expressed here are those of the authors and do not necessarily reflect the opinions of other members of IMF staff or its Executive Directors.