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Hedge Funds, Highly Leveraged Investment Strategies and Financial Markets* I. Introduction This note provides general background information on current market practices of hedge funds and other highly leveraged institutions, their creditors and other counterparties and discusses the impact their activities may have on the functioning of financial markets. In relation to other sectors of OECD financial markets (banks, pension funds, mutual funds, life insurance companies, etc.), most hedge funds are small, measured at least in terms of their capital bases. In fact, most are quite small compared with other types of managed funds, including mutual funds, pension plans, and trust accounts. However, some hedge funds are fairly large and are willing to establish and maintain large positions (often magnified via leverage) on one side of a market, and, therefore, can have important effects on market dynamics. The central public policy concern follows from the consideration that some hedge funds, like other highly leveraged financial institutions, have the potential to disrupt the functioning of financial markets, raising issues concerning systemic risk and/or market integrity. The key to the understanding of the impact of hedge funds on the functioning of financial markets is an analysis of their trading practices. Many hedge funds attempt to exploit temporary valuation differences between similar types of securities. Bond and equity arbitrage strategies and currency trades may be employed, and these trading strategies may or may not involve leveraging and other higher risk investment techniques. Still, not all hedge funds engage in all of these activities; those that do might not do so all the time; and other financial institutions (e.g. investment banks and commercial banks) engage in many of the same activities and sometimes emulate hedge fund trading strategies. * This article has been prepared by Senior Economist Stephen Lumpkin and Head of Division Hans J. Blommestein, Financial Affairs Division. 27

Financial Market Trends, No. 73, June 1999 II. Nature of hedge fund activities: general business practices and other characteristics Analysts credit Alfred Winslow Jones with the founding of the first hedge fund in 1949. Jones sought to shield his portfolio’s return from market volatility by balancing his long and short positions through careful selection of a so-called “market-neutral” basket of stocks. The strategy was designed “to generate above-average returns without taking on more risk than was embedded in the market, or achieve market returns while actually reducing risk”. Most of the early hedge funds were similar vehicles, but today’s hedge funds are a far more eclectic group and there is no formal consensus definition of a “hedge fund”. Some participants contend that for a financial entity to be considered a hedge fund it must engage in one or more of the following activities: invest in multiple asset classes, use leverage, or employ dynamic hedging techniques. A very broad definition encompasses any pooled investment vehicle that is privately organised (commonly as limited partnerships or limited liability companies), administered by professional investment managers compensated on the basis of performance, and predominantly targeting wealthy individuals and institutional investors such as insurance companies and pension funds. 1 Others argue for a stricter definition, suggesting that a “true” hedge fund has at least 25 per cent of its portfolio held in a hedged structure at all times. Other definitions exist as well, but none has gained universal appeal and, for want of a common definition, the term has been applied to many types of entities with widely differing investment operations and strategies. Hence, the term “hedge fund” in this note will be used to refer to a broad range of entities employing a wide variety of investment styles.2 A. 28 Number and size of hedge funds Owing in part to the lack of a consensus view of what constitutes a hedge fund, coupled with the fact that many hedge funds have adopted a low profile, the exact number of hedge funds in existence is not known with certainty. Most estimates range upward from around 2 500 or so funds. At the high-end of published figures are estimates by one United States-based hedge fund consulting group, which placed the number of funds operating worldwide at 5 500 as of mid-year 1998, with just under 300 billion in assets under management (see Table 1). Most hedge funds are small, with less than 100 million in invested capital. A few dozen hedge funds have a capital base larger than 1 billion, with a handful holding capital in the range of 5-12 billion.3 About 3 800 of these funds were reported as being based in the United States. However, estimates regarding the number of independent funds in existence are clouded somewhat by the fact that many of the largest of these funds establish parallel operations in offshore locations to accommodate foreign investors who are precluded from investing in hedge funds in their domestic markets.

Hedge Funds, Highly Leveraged Investment Strategies and Financial Markets Table 1. Hedge Funds: Number of Funds and Assets under Management 1988-97 Global Hedge Fund Universe Number of Funds Assets under management ( billions) Source: 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1 373 42 1 648 58 1 977 67 2 373 94 2 848 120 3 417 172 4 100 189 4 700 217 5 100 261 5 500 295 Van Hedge Fund Advisors. Within the global hedge fund universe are funds that are active across a wide variety of markets, products and currencies, but there are others that tend to specialise in specific market categories or instruments. As noted in the introduction, any given hedge fund might not engage in all the activities attributed to the hedge fund universe, and other financial institutions also pursue many of the same strategies. In fact, in terms of their market activities, most hedge funds are not fundamentally different from other sophisticated financial institutions, such as internationally active commercial banks or proprietary trading desks of investment banks. There are, however, important differences between hedge funds and other financial institutions, associated mainly with the fact that the latter tend to be regulated while hedge funds are subject to minimal regulatory oversight. Hedge funds are often resident off-shore for tax and regulatory purposes. Their legal status and investment mandate place few restrictions on their portfolios and trading practices. This is perhaps most clearly evident in a comparison of hedge funds with other investment vehicles such as mutual funds, which serve a similar function, albeit for a different investor clientele. Take, for example, the case of the United States, where most hedge funds are based. Generally speaking, hedge funds are unregistered, private investment partnerships/pools bound for the most part only by an investment contract investors sign with the sponsors of the fund. Most hedge funds are structured in such a way as to minimise regulatory and tax impediments to their chosen operating strategy. 4 Thus, with the exception of antifraud standards, hedge funds in the United States are exempt from direct regulation by the Securities and Exchange Commission under the federal securities laws. 5 Accordingly, unlike mutual funds, which are subject to strict regulations concerning the extent to which they may invest in certain types of securities, hedge fund managers face no restrictions on the composition of their portfolios. Indeed, under United States federal law, hedge fund sponsors generally are free from any limitations on their management of the fund, and are not required to disclose 29

Financial Market Trends, No. 73, June 1999 information about the fund’s holdings and performance, apart from what they agree to provide to investors.6 Another distinguishing feature of hedge funds is that hedge fund managers frequently have a stake in the funds they manage. This is again in contrast to mutual funds, where managers hold no stakes in the funds they manage. B. Fee structure and investment behaviour A major difference between hedge funds and mutual funds are the fees charged to investors. In the United States, mutual fund sales charges and other distribution fees are subject to regulatory limits under rules promulgated by the National Association of Securities Dealers and also federal law, which imposes a fiduciary duty on a mutual fund’s investment adviser regarding the compensation it receives from the fund. In contrast, there are no legal limits on the fees a hedge fund can charge its investors. Typically, hedge fund managers take a fee of 1 or 2 per cent of net assets, plus around 20 per cent of the fund’s annual return. Some have up-front sales charges as well. Most contracts also include a “lock-up” period during which investors cannot withdraw their money. Additional allocations or sales fees also might be charged. Usually a “high-water mark” provision is in place that denies the manager his incentive fee until any previous losses have been recovered. Both of these distinguishing characteristics have important implications for the investment behaviour of the management of hedge funds in the form of investment style, return targets and risk profile. Since hedge fund managers get paid on the basis of the absolute size of realised earnings, they tend to pursue short-term investment strategies focused on achieving the highest absolute returns, given the adopted risk profile. In contrast, the money managers of mutual funds and other institutional saving institutions tend to use relative performance measures based on benchmarks that reflect industry averages. C. 30 Investment strategies As noted previously, the managing partner of a hedge fund is given a broad investment mandate in order to achieve the fund’s absolute return target. Consistent with this objective, hedge fund managers are given the flexibility to choose among a variety of asset classes and to employ dynamic trading strategies that may involve short sales, leverage, and derivatives. 7 Although hedge funds as a group often use leverage aggressively, analysts familiar with the hedge fund sector suggest that most hedge funds use derivatives only for hedging or do not use derivatives at all, and many hedge funds use little or no leverage.

Hedge Funds, Highly Leveraged Investment Strategies and Financial Markets Table 2. Selected Hedge Fund Styles Hedge Fund Style Sub-Category Description Global International Manager focuses on economic developments in non-U.S. countries, investing in stocks in markets believed to be favourable. Established Manager focuses on opportunities in established markets such as Europe and Japan. Emerging Manager invests in less mature financial markets. Because shorting is not permitted in many emerging markets, managers must go to cash or other markets when valuations make being long unattractive. Focus on specific regions. Global Macro Opportunistic; manager invests wherever he finds value. Use leverage and derivatives to enhance positions, which will have varying time frames ranging from short (under 1 month) to long (more than 12 months). Event-Driven Investment theme is dominated by events that are seen as special situations or opportunities to capitalise from price fluctuations. Distressed Securities Manager focuses on securities of companies in reorganisation and/or bankruptcy, ranging from senior secured debt (low-risk) to common stock (high risk). Risk Arbitrage Manager simultaneously buys stock in a company being acquired and sells stock in its acquirers. If the take-over falls through, traders can be left with large losses. Diversified Manager allocates capital to a variety of fund types. Niche Manager allocates capital to a specific type of fund Fund of Funds Capital is allocated among groups of funds. Market Neutral Manager attempts to lock out or neutralise market risk. In theory, market risk is greatly reduced, but it is difficult to make a profit on a large, diversified portfolio, so stock picking is critical. Long/Short Net exposure to market risk is believed to be reduced by having equal allocations on the long and short sides of the market. Arbitrage-Conver One of the more conservative styles. Manager takes long position in convertible tible securities and shorts underlying equities, profiting from mispricing in the relationship between the two. Opportunistic Arbitrage-Fixed income Manager buys bonds – often Treasury bonds, but also sovereign and corporate bonds – and shorts other securities that replicate the owned bond; manager aims to profit from mis-pricing of the relationship between the long and short sides. Industry Manager follows specific industry; managers can use a wide range of methodologies (e.g. bottom-up, top-down, discretionary, technical) and primary focus (e.g. large-cap, mid-cap, small-cap, micro-cap, value growth, opportunistic). Sector Manager follows specific economic sectors. Short Sellers Manager takes a position that stock prices will fall. A hedge fund borrows stock and sells it, hoping to buy it back at a lower price. Manager shorts only overvalued securities. A hedge for long-only portfolios and those who feel market is approaching a bearish trend. Long-only Leveraged Traditional equity fund structured like a hedge fund; i.e. uses leverage and permits manager to collect an incentive fee. Source: Managed Account Reports, Inc. 31

Financial Market Trends, No. 73, June 1999 Hedge fund strategies or styles generally tend to be descriptive of the market or markets in which the manager is active. 8 Investment styles vary in terms of selectivity – the ability to select overvalued (if short) or undervalued securities – and market timing, which refers to the fund manager’s ability to predict market trends and reversals. The categories listed in Table 2 are generic classifications and a manager of a given hedge fund might not always conform to any set strategy among them. Hedge fund managers tend to vary their strategies over time and thus, under certain market conditions, the distinction between, for example, market-neutral hedge funds and investment pools that take leveraged, directional bets can blur. Furthermore, there are a variety of mixed or hybrid investment strategies in use, characterised by a combination of various, specific, pre-determined strategies in order to provide a diversified approach. There are also funds of funds, which are akin to portfolios of hedge funds in the sense that funds invested in them can flow into a number of different types of hedge funds. Thus, the list of hedge fund strategies is representative of the hedge fund universe but is not exhaustive. Moreover individual hedge funds may employ different investment strategies. Hedge funds change investments frequently, so as to benefit from changes in market prices and/or to maintain the preferred risk profile. Active trading and the associated short-term investment horizon are features that hedge funds have in common with the proprietary trading desks of financial institutions and the treasuries of large non-financial companies. D. Performance The empirical evidence regarding hedge fund performance tends to be mixed, depending on the hedge fund segment. Moreover, performance is affected by the choice of time period. Data for the United States show that in the period 1991-1998, the global macro funds outperformed the S&P500 but they also took on greater risks; the market neutral funds and funds of funds under-performed the S&P500 but with lower risk levels; the other hedge fund segments performed poorly relative to the S&P500 and did so with higher volatility. For all hedge fund segments risk was lower than all other benchmarks except the bond benchmark, and returns higher (except for funds of funds) than all the other benchmarks.9 32 In the period 1994-1997 global funds performed better than the S&P500 albeit with higher risk levels. In contrast, the market neutral funds and other funds had a lower performance relative to the S&P500 but the average volatilities of these classes of funds were lower than the S&P500.10

Hedge Funds, Highly Leveraged Investment Strategies and Financial Markets A few empirical studies have shown that – unlike mutual fund returns, which have high and positive correlation with the returns on broad asset classes (consistent with a buy-and-hold strategy) – hedge fund returns have low and sometimes negative correlation with asset class returns, presumably reflecting the use of arbitrage and hedging strategies.11 There is evidence that the inclusion of hedge funds in the portfolios of investors increases expected portfolio returns, without an increase in risk.12 This result can be explained by the low correlations between the return on hedge funds and major benchmarks (see Table 3). However, the extent to which hedge funds’ returns are uncorrelated with measures of broad market performance varies across funds and over time, depending on the investment strategy. Another attractive performance feature is that hedge funds tend to outperform the market during periods of poor market returns.13 Table 3. Average Hedge Fund S&P500 Russell 2000 MSCI EAFE MSCI Emerging Markets Index Lehman US Bond Index Source: Correlations between Hedge Funds and Major Benchmarks Average hedge fund S&P500 Russell 2000 MSCI EAFE MSCI Emerging Markets Index Lehman US Bond Index 1.00 0.29 0.13 0.03 –0.08 –0.01 0.29 1.00 0.24 0.54 0.59 0.06 0.13 0.24 1.00 0.21 0.36 0.21 0.03 0.54 0.21 1.00 0.47 0.11 –0.08 0.59 0.36 0.47 1.00 0.09 –0.01 0.06 0.21 0.11 0.09 1.00 Warburg Dillon Read, “The Reality of Hedge Funds”, 30th October, 1998. Although a few hedge funds have generated above-average returns for nearly a decade, an investment in the hedge fund sector does not guarantee yield enhancement, or even success. Indeed, available data indicate that about one in five hedge funds goes bust in its first seven years, which is roughly the same survival rate as for other investment funds. One development that has some bearing on the ability of hedge fund managers to generate outsized returns is the fact that markets are becoming more efficient, owing in some cases to the activities of the funds themselves. In many markets, especially the most liquid markets, many pricing anomalies are now remedied rather quickly, so arbitrage opportunities are harder to come by. This development has particular implications for market-neutral funds. Increased market efficiency suggests that, without leveraging, a true market-neutral manager will earn the riskless rate of return, more or less. In theory, market-neutral funds do not 33

Financial Market Trends, No. 73, June 1999 engage in directional trades, but in practice, many do. As markets become more efficient, market-neutral managers may be forced to make more directional bets in order to increase their absolute returns. III. Characteristics of hedge fund investors, investment services and financial instruments A. Investors As noted previously, one of the means by which hedge funds avoid regulation as investment companies is by limiting the number and type of investors they accept. Generally, the restrictions take the form of minimum net worth requirements, which satisfy legal limits intended to restrict participation in hedge funds and other types of unregulated pools to highly sophisticated investors.14 Typically, a minimum net worth of 1 million is required for each individual investor, but some funds admit investors with lower net worth, provided the investors have total investment portfolios above some statutory minimum. In the United States, for example, the National Securities Markets Improvement Act of 1996 enables hedge funds to accept investments from individuals with total investment holdings of at least 5 million, regardless of their net worth, although limits still apply regarding the total number of investors permitted. While hedge funds have historically been targeted to sophisticated individual investors (80 per cent of hedge fund assets according to some estimates), in recent years a variety of institutional investors have begun to invest in these entities. In the United States, for instance, institutional investors are said to have accounted for nearly 30 per cent of new money flowing into hedge funds in the past few years. University foundations and endowments are reported to be among the more aggressive institutional investors. In 1997, eighty-seven college and university endowments are reported to have invested in hedge funds, up from seventy-four in 1996. In addition to endowments, pension funds are also starting to allocate capital to hedge funds, with both private pension schemes and their public sector counterparts getting involved. A few of these institutional investors have pursued fairly aggressive strategies, but most have opted for a broadly diversified hedge fund portfolio, and have allocated only a small fraction of their total investment capital to the hedge fund sector. 34 Analysts state that conventional institutional investors, such as pension funds, insurance companies, foundations, etc., are accustomed to investments that track broad market benchmarks, such as stock or bond indices. Most hedge funds, however, pursue absolute return targets, and thus, tend to eschew benchmarks. This fact has not proved to be a major stumbling block as institutional investors appear

Hedge Funds, Highly Leveraged Investment Strategies and Financial Markets to be increasing their hedge fund investments. Trade reports suggest that institutional investors tend to invest with a small number of well-known hedge funds. For instance, thirteen of the eighty-seven university endowments that made allocations to hedge funds in 1997 were reported to have invested in Tiger Management; nine others chose Dawson-Sandberg Capital Management. Market-neutral funds, which are considered to be less volatile than the global macro funds and are thus seen as a more conservative way to diversify, have also benefited from the inflow of institutional money. Given the increasing attractiveness of the hedge fund concept to institutional investors, traditional managers of institutional money have begun to add hedge funds to their product lines. A growing number of banks and investment banks are now either running in-house funds or managing funds of funds with linkages to hedge funds. Moreover, a large number of traders and analysts have departed from traditional investment houses and asset-management firms to start their own hedge funds. Some of these fund managers have also developed investment products that are targeted to institutional investors. Due diligence, transparency and disclosure Institutional investors have clearly been attracted to the higher returns that a few hedge funds have generated. As the experience of the past year indicates, however, these higher returns do not come completely free of risk, and it is important for hedge fund investors to take extra steps to reduce the chance that their investment becomes overly exposed to market outcomes. Pension fund trustees and other fiduciaries are legally required to exercise a certain amount of care in executing investments on behalf of their institutional investor clients. Hedge funds generally require more due diligence than most investment funds, and this is particularly true of hedge funds run by managers using dynamic trading strategies. Investors in such funds should make sure they have adequate information to make prudent decisions on an ongoing basis. This calls for greater efforts in due diligence up-front and proper risk monitoring on a case-by-case basis. Monitoring, in turn, requires transparency and disclosure. The degree of transparency and disclosure that institutional investors are accustomed to is perhaps antithetical to the nature of hedge funds, especially those funds that invest in illiquid markets. In reality, hedge funds are subject to less strict disclosure requirements than many other financial institutions.15 Hedge fund managers with a more conservative investment approach may be more willing to keep investors apprised of their fund’s performance and risk, but even these managers are unlikely to provide daily reports, and it is unclear how much information value is contained in less frequent updates, or more generally in balance-sheet reports. As 35

Financial Market Trends, No. 73, June 1999 noted above, many hedge funds are engaged in active trading practices in which investment positions and related risk profiles are frequently changed. These considerations make the transparency and disclosure of hedge fund behaviour a non-trivial policy issue. The issue of transparency and disclosure has been addressed in some detail by the Basle Committee on Banking Supervision, which looked into the interactions between banks and highly leveraged institutions in the aftermath of the well-publicised, near-collapse of United States-based hedge fund Long Term Capital Management (LTCM). In so doing, the Committee identified a number of weaknesses in banks’ credit risk management. The Committee’s findings are discussed in detail in a later article in this publication. The main points are: 1) Banks received insufficient data from their counterparties, and often based credit decisions on qualitative information; 2) the information that was received was not reflective of the entities banks were lending to; and 3) competitive pressures acted to limit the degree to which banks required more complete disclosure from their hedge fund counterparties. After reviewing the findings of its investigation, the Committee issued a set of “sound practices” for banks to follow in managing their risk exposures. These guidelines included: 1) banks should establish clear policies and procedures for interactions with hedge funds; 2) banks should develop more accurate measures of their credit exposures resulting from trading and derivatives transactions with highly leveraged institutions; such measures need to be more forward-looking and not merely reflect current market prices; 3) there should be meaningful overall credit limits for highly leveraged institutions; 4) banks must develop appropriate credit enhancement tools that are linked to the specific characteristics of highly leveraged institutions; and 5) credit exposures need to be monitored on an ongoing basis, taking into account the trading activities, risk concentration, leverage and risk management processes of the counterparties. 36 The Basle Committee’s recommendations were intended for use by banks with respect to hedge fund clients and other highly leveraged counterparties, but they are applicable to investors and other entities as well. As to the type and quantity of information that is needed by investors/counterparties to reach a comfort level with hedge funds, it depends on the nature of the funds’ investment strategies. For example, information that is historical in nature would not be very helpful for understanding what is happening with active traders. It should be noted that the desire for information by hedge funds’ counterparties and providers of credit facilities is balanced against the desire of fund managers to protect trade secrets and proprietary information. Most fund managers, especially those employing dynamic trading strategies, would presumably be unwilling to disclose actual underlying positions. In practice, the level of information disclosure has

Hedge Funds, Highly Leveraged Investment Strategies and Financial Markets tended to ebb and flow, depending in part on market sentiment and the related balance-of-power between hedge fund managers on the one hand, and investors and creditors on the other. During times of heightened market volatility and general credit restraint, the volume of information provided to creditors and other counterparties has tended to increase, but the provision of information typically subsides as lenders relax and become more flexible. B. Investment services and financial instruments Some of the same features of hedge funds that have resulted in attractive returns for investors – participation in many asset classes, flexibility in use of leverage and short sales, and use of dynamic trading strategies – have also made hedge funds attractive clients for major banks and investment banks. 16 In fact, hedge funds have become an integral component of the new financial landscape and are considered by most observers to be a permanent feature. Depending on the investment style, hedge funds can be in and out of the markets in which they operate on a regular basis and, thus, have become a major source of liquidity, surpassing traditional investment funds in their transaction flow.17 The global-macro funds, in particular, tend to trade enormous volumes in order to maintain returns, and in so doing, are a key source of commission business for bankers.18 Given their often-innovative trading strategies, hedge funds are also outlets for complex, structured securities, and are important sources of pricing information. When properly positioned, bankers are sometimes, in principle, able to fully emulate hedge fund trading strategies, but the information gleaned from a trade with a hedge fund is often limited to knowing only the direction (long/short) in which the market is heading. Two distinct types of service are provided to hedge funds: prime brokerage and niche services. Prime brokerage services include custody, clearance, securities lending, financing, portfolio accounting, investment banking, trading, etc. The prime brokerage providers, typically only the very largest investment banks, may provide office space and access to technology (telecommunications and computers) as well fo

A. Number and size of hedge funds Owing in part to the lack of a consensus view of what constitutes a hedge fund, coupled with the fact that many hedge funds have adopted a low profile, the exact number of hedge funds in existence is not known with certainty. Most estimates range upward from around 2 500 or so funds.

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