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Hedge funds: The new kings of capital?

September 20, 2010

Hedge fund moguls, are described as “wealthy, powerful and potentially dangerous”. Their “eclectic investment pools” are run in form of private partnerships, located offshore for tax regulatory reasons. Tax-friendly locations are a lodestone.  Their funds are domiciled outside main financial markets and thus less regulated. Investors are strictly high net-worth individuals and institutions. These are assumed to be savvy about the risks being taken.

The first hedge fund was established by A W Jones in 1949 in the US. He reduced the risk of his investments by borrowing a security and selling it with the hope of buying it back at a lower price, when or before repayment is due.

Jones’ genius was to combine two risky investment strategies: short selling and leverage by separating the risk of a drop either by an individual stock or the general market. Jones hedged against a drop in the general market by shorting on a basket of stocks. He then picked individual stocks, borrowing heavily. He went long on “undervalued” stocks and short on those he considered “overvalued”.

Jones’ fee to his managers was a function of profits. He also invested his capital in the fund, to align his incentives and that of investors. Hedge funds proliferated in the “go-go” 60s.

Hedge funds have a survival streak. This explains why the villains in Oliver Stone’s Wall Street: Money Never Sleeps were not hedge fund-types. The script was re-written and investment banks and their proprietary trading desks were blamed for the financial crisis. The movie whacks Goldman SachsGreed is still good.

Hedge funds leverage their capital by buying securities on margin (accounts with brokers that allow them to buy securities on credit. They pay for a fraction of the securities and balance is paid by the broker. The broker’s collateral is the value of the securities.)

Though the capital of hedge funds pales in comparison to that of other institutional investors (pension funds, insurance companies, mutual funds), they are thought to egg herds.  Still, hedge fund managers’ moves are likely to be copied by institutional investors, with their larger financial firepower. Evidence suggests no.

Astute and quick off the mark hedge funds “often act as contrarians, leaning against the wind, and therefore often serve as stabilising speculators.” This contrariness is regarded as a virtue hedge funds bring to the market. Hence, an IMF paper reckoned that

[S]trong limits on position taking could prevent hedge funds and other international investors from acting as contrarians. In addition, attempts to impose position limits or margin requirements will provide incentives for financial market participants to arrange transactions in unregulated or offshore jurisdictions, neutralizing efforts to constrain their activities.

Hmm.

The secret of hedge funds

Investments vehicles are regulated to protect investors, ensure the integrity of markets and to promote stability. Earlier, the case for not intensifying regulation of hedge funds was three-pronged: investors can fend for themselves, regulators, in the US and UK, can step in if the integrity of the market is at stake, say, at the risk of being manipulated or dominated. And in other countries, to limit money laundering and to avert systemic risk, regulatory requirements can be applied on margin loans, credit lines and exposure of financial intermediaries to individual customers.

Yet one of the pitfalls of the financial crisis was inadequate risk management, by banks not hedge funds. The stock-in-trade of hedge funds, regulatory arbitrage, because of competition among exchanges, was another snag. Money moves to where requirements are least, most often to offshore financial centres.

Hedge funds revel in secrecy. They loathe reporting their large positions/transactions, onerous reporting requirements to provide useful information on their borrowings (their oxygen.) Therefore they relocate their legal domicile offshore – where no questions, if any, are asked.

Financial reform should change all that. Recommendations of the G30 framework for financial stability, chaired by Paul Volcker, are being adopted. One recommendation called for restricting the high risk and interest-conflicting proprietary activities of systemically important banking institutions, limiting banks’ capital in hedge and private equity funds.

It was also suggested that hedge fund managers register with regulators, submit periodic reports and “public disclosures of appropriate information regarding the size, investment style, borrowing and performance of the funds under management.” Because, as the IMF noted, hedge funds tend to be highly leveraged, hence “When things go wrong, they go very wrong.”

A requirement that hedge funds be regulated by authorities in their primary business location “regardless of the legal domicile of the funds themselves” was also proposed.

Caveat: They cast a shadow wherever they stand

An international and consistent regulatory framework is key, given the global nature of markets. Levered nonbank institutions eg, investment banks, conduits, structured investment vehicles, hedge funds etc operated legally but outside the confines of bank regulation.

These “shadow banks” needed a seal of approval to convince those who funded them with short-term loans. Rating agencies stood ready to give favourable ratings without any historic record about the performance of such financial instruments.

There’s also a worrying assumption. Curbing the contrarian position taking by hedge funds, their penchant for flexibility, minimum transaction cost for liquidating positions (ie, hot money) can retard economic growth.

Boosters of hedge funds say it still is far from clear, that hedge funds, on the balance, cause harm when they precipitate the fall of asset prices. Other investors, with more capital, take their cue from hedge fund activity. The good they do, curbing the free fall of oversold markets, outweighs the harm they inadvertently cause.

Regulators have their work cut out. They have to work out a regulatory structure that eliminates “overlaps and gaps in coverage and complexity, removing the potential for regulatory arbitrage”. That the G30 recommended the need to raise “standards, where needed, with respect to offshore banking centres” lends credence to how hedge funds can use them to cause turmoil.

Offshore financial centres must be rightly understood. John Christensen of Tax Justice Network describes them as:

accountants, lawyers, bankers, plus their associated trust companies and financial intermediaries who sell services to those who wish to exploit the mechanisms the tax haven has created.

If regulation is unfavourable in one haven, they fly to another. They had threatened to leave the City of London, itself a tax haven. That they did not points to another G30 recommendation: insulation of national regulatory authorities from political and market pressures.

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