Hedge Funds (Samples Essay)

Hedge Funds (Samples Essay)

I. The role of hedge funds in the financial markets

Hedge Funds (Samples Essay)

The world financial markets include many participants, such as banks, mutual funds, pension funds, private equity funds, hedge funds and investment banks. Hedge funds currently occupy a good share among these participants. It is estimated that presently the hedge funds have about $1 trillion under management around the world, with about 8300 actively operating hedge funds.

Even more important is probably the fact that hedge fund industry is growing quite fast, posting a double digit growth, which according to some estimates reaches 20% per year. The global hedge fund industry has substantially changed since 2003. While in the beginning hedge funds was a domain of very rich individuals and had some quite of exclusivity, it has been opening to other investors that started looking at hedge funds when returns from traditional investment, such as mutual funds or pension funds, were becoming lower. As a result, even insurance and pension funds themselves started investing into hedge funds (Singh 2005, p.3).

The UK is quite prominent with regard to hosting hedge funds. According to the information recently published in the Financial Times, the London’s share of world hedge funds assets more than doubled in the last 5 years. The more precise figures were available in the recently issued London’s annual report on hedge funds (International Financial Services), which stated that in 2006 about 20% of the global funds assets were managed from London, versus only 10% in 2002. For comparison, the share of New York that used to be a leader in hedge funds assets has been steadily decreasing (Willman 2007).

Presently hedge funds that are based in the United Kingdom account for about 30% of the whole trading on the London Stock Exchange, the biggest stock market in Europe. This fact again delineate how substantial is the present share of the hedge funds in the financial markets.

To summarize, hedge funds play quite an important role in the global financial markets, adding liquidity to the whole system, possibility for additional diversification and lower risks.

II. The criticism of the hedge funds

Despite a significant role that the hedge funds play in the financial markets, there is also a lot of critique directed at them. There are several major points of critique that I found plausible and that I summarized below:

1) Hedge funds are not obliged to reveal any information about their activities to the public, as a result they can do operations can actually make the financial markets more risky or practice some methods potentially hurting other financial market participants. It was identified in several sources that some hedge funds rejected IPOs because of the requirement to bring to public some of the fund information in the course of issuing an IPO. And this is done despite many benefits that an IPO can bring, such as additional funds to manage or possibility to get some additional cash for the fund shareholders (White & Mackintosh, 2007).

2) Hedge funds are presently not regulated, unlike almost all the rest of the financial markets participants, such as mutual funds, insurance companies and banks. This may pose some risks to the global financial system, the stability of which depends a lot on its transparency and fair rules of the game for all participants. John Sunderland, the President of Confederation of British Industry, has recently criticized hedge funds “for their short-term investment strategies and lack of transparency and accountability” (Singh 2005, p.4). Also, for the first time the Financial Services Authority (FSA), UK financial regulatory authority, got concerned about the hedge funds. In its recent discussion paper, Financial Services Authority the FSA cautioned that “some hedge funds are testing the boundaries of acceptable practice concerning insider trading and market manipulation”. Going further, the FSA has also announced that its plan to establish a new unit that shall monitor and supervise the trading activities of hedge funds (Singh 2005, p.4).

3) Additional volatility that hedge funds bring to the financial markets. Quite often hedge funds are using a lot of leverage and practice speculative trading. This point of criticism has some validity especially due to a well-known collapse of a hedge fund called Long-Term Capital Management (LTCM) in 1998. After Russia defaulted on its debt in 1998, Long Term Capital Management was greatly injured, when five-year swap spreads nearly doubled from 0.5 percent to 0.8 percent (Brealey & Myers 2003, p.761). Additionally, due to the fact that hedge funds are the clients of other financial institutions, the collapse of a big enough hedge fund can lead to a domino effect and a broader crisis in the whole financial market. At a present era of globalised financial markets, such domino effect can even spread around the world.

The counterargument for this criticism is given by Dion Friedland, Chairman of Magnum Fund, in the statement that “In reality, less than 5% of hedge funds are global macro funds (which means that can be highly volatile). Most hedge funds use derivatives only for hedging or don’t use derivatives at all, and many use no leverage” (2007). However, due to potential bias of Dion Friedland, it needs probably additional arguments and research to make it clear whether hedge funds at present time add more volatility to the market or not.

4) Adverse influence that hedge funds can have outside of the purely financial markets in the business world. Such possibility for influence of business decisions may be misused by some interested parties, especially taking into account lack of regulation of hedge funds and absence of public disclosure requirements for hedge funds. The best example of this point of criticism can be probably provided from the recent attempt bid of Deutsche Borse for a London Stock Exchange. The UK based hedge fund, the Children’s Investment Fund, holding only about 8% of the equity of Deutsche Borse, played a critical role in firing the CEO of Deutsche Borse and blocking its bid for the London Stock Exchange (Singh 2005, p.3).

III. Importance of hedge funds as clients of investment banks

Currently hedge funds play quite an important role for investment banks, as one of their major clients. A significant share of the profits of investment banks come from the services that they provide to the hedge funds from such highly profitable businesses as prime brokerage, credit default swaps, mortgage-backed securities, etc.

Many big investment banks have prime brokerage operations that they do for hedge funds. Prime brokerage means that the investment bank executes daily trading activities for hedge funds, hold their securities, evaluate the losses and gains achieved by the hedge funds as a result of trading, lend funds to the hedge funds, etc. When taking into account that hedge funds manage billion of dollars, the profit of investment banks from fees for such services is also substantial.

Another additional relationship between investment banks and hedge funds stems from investment banks actually owing stakes in the hedge funds. As was mentioned before, hedge funds sometimes are reluctant to issue IPOs to inject additional capital to the hedge funds. As an alternative to the IPO, hedge funds sometimes sell some of their equity stakes to the investment banks.

Therefore, the direct result of the growth of hedge funds in recent years was also the increase of profits for investment banks and their increased dependency on hedge funds. Of course, such dependency is not very high at a present time. But as hedge funds gain more and more popularity around the world, their influence on performance of investment banks can also grow.

IV. Hedge funds investment styles

With respect to investment styles, hedge funds are not homogenous at all. There are many investment approaches and strategies currently utilized by the hedge funds. Those strategies can differ a lot in terms of return, risk and volatility that they bring. Taking this into account, I think it may be wrong to tell that all hedge funds, as a category of financial markets participants, and safer or riskier than other financial players. Depending on the strategies used, the hedge funds can substantially differ from one another.

According to Dion Friedland from Magnum Funds, there are 14 distinct investment strategies applied by the hedge funds, each associated with a certain risk and return. In this paper, I would like to describe four selected investment styles used by the hedge funds, namely, global macro, event-driven, market neutral arbitrage and opportunistic investment styles.

1) Global macro is the investment style, using which hedge funds invest globally in debt and equity, currency and commodities trying to profit from the changes in the national policies or actions, which in turn would affect those securities. The example of such change can be change of the interest rate, which in turn would affect currency and debt markets. When using global macro approach, in most cases hedge funds also resort to high leverage and hedging through derivatives in order to enhance the impact of market changes. Owing to its nature, global macro hedge fund can be quite dynamically growing, but also riskier and more volatile that the other hedge funds applying different and more cautious strategies.

Macro hedge funds are also probably one of the most famous hedge funds and receiving most of publicity. For example, macro investment style was the one used by George Soros in his bet against the British pound in 1992. At that time he put a bet of $10 billion, big part of which was borrowed, on the devaluation of the pound sterling. As a result of a successful bid, his fund realized $2 billion in profits (Friedland, 2007). However, there are also many examples of negative bids and a lot of money lost as a result of applying macro investment style.

2) Event-driven is the investment style, using which hedge funds try to profit from some specific types of event promising to bring above-market returns. For example, hedge funds can invest into distressed securities. Following this investment strategies, hedge funds can buy equity, debt or some other obligations from the companies who are in a poor financial conditions, are under re-organization or on the verge of bankruptcy.

Due to the fact that many institutional investors are not allowed to hold securities with such risks, hedge funds have the opportunity to receive above-market profits from such transaction, especially taking into account that distressed securities are often very grossly under-valued (i.e. the current investors of distressed securities want to sell them, while there are not so many financial investors who would like to buy them, therefore, much lower liquidity and much higher transaction settlement price). Additional benefit from this strategy is that the results generally do not depend on the overall tendencies in the equity/bond markets. The risk associated with this strategy is moderate.

3) Market neutral arbitrage is the investment style, using which hedge funds try to make profit through finding arbitrage opportunities in some specific securities, while keeping a neutral position with regard to specific sector, country of the market as a whole. The strategy is based on taking opposite positions in different financial securities, offered in the same sector or even by the same company.

A good example of market neutral arbitrage can be a hedge fund that buys short equity of a certain company, while selling long convertible bonds issued by the same company. The choice whether the long positions are hedged with the short positions or vice versa depends on the bet that the hedge fund is doing, whether long-term or short-term performance will be better in the sector. Therefore, such investment style attempts to become a hedge fund independent of the strength of a specific sector or sector-wide events. As a result of such a cautious strategy, hedge fund applying this investment style is exposed to relatively low risks, but also is not probable to realize very high returns and experience dynamic growth.

4) Opportunistic is the investment style, using which hedge funds are trying to realize gains by taking advantage of any special events or unique opportunities for investments they can come across. For example, opportunistic hedge funds can invest into distressed securities, if they find such an opportunity probable to yield extraordinary results, IPOs, the equity of companies that is to be acquired or the equity of acquirer, the equity of the companies that are threatened by a hostile takeover or the one with disappointing results. All of such events can devaluate the stock price for a certain period of time – the opportunity from which hedge funds strive to profit using opportunistic investment style.

There are no specific boundaries for the opportunistic investment style. It can be a blend of different approaches being in a state of flux. Due to such uncertainty with regard to specifics of possible investments, the risk and return associated with this investment style can greatly vary from time to time, changing from low to high and bounding back.

V. Conclusions

To summarize, hedge funds are important players of the modern global financial markets. They play an important role, adding liquidity and diversification to the market. There are also drawbacks associated with the hedge funds, with the present lack of their regulation and potentially added volatility to the market as most loudly pronounced arguments of criticisms. Hedge funds do not form a homogenous category. They can substantially differ in terms of risk and return as a result of the investment style applied. Many investment styles currently utilized by the hedge funds are sometimes blended together and are often themselves in a state of flux.

References:

Brealey, R., Myers, S. (2003). Corporate Finance. New York: McGrew-Hill/Irwin.

Friedland, D. 2007 ‘About Hedge Funds’. Magnum Funds. Available at:

http://www.magnum.com/hedgefunds/abouthedgefunds.asp#strategies

Friedland, D. 2007 ‘Global Macro Investing’. Magnum Funds. Available at:

http://www.magnum.com/hedgefunds/globalmacroinvesting.asp

Singh, K. ‘Globalization of Locusts”. July 09, 2005. Available at:

http://www.zmag.org/content/showarticle.cfm?ItemID=8264

White, B., Mackintosh, J. ‘Hedge fund AQR considering flotation’. Financial Times. April 20, 2007.

Willman, J. ‘London doubles share of hedge fund assets’. Financial Times. April 17, 2007.

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