Hedge funds and their impact on financial stability. Implications for systemic risk and how to control for it

TABLE OF CONTENTS

LIST OF TABLES

LIST OF FIGURES

LIST OF ABBREVIATIONS

1. INTRODUCTION

2. LIMITATIONS OF APPLIED DATA

3. DEVELOPMENT OF THE HEDGE FUND INDUSTRY
4. DISTINGUISHING HEDGE FUNDS FROM OTHER INVESTMENT VEHICLES
4.1 REGULATION AND SUBSCRIPTION
4.2 INVESTMENT TECHNIQUES AND LEVERAGE
4.3 OPACITY
4.4 COMPENSATION STRUCTURE

5. HEDGE FUND STRATEGIES
5.1 DIRECTIONAL
5.2 MARKET NEUTRAL
5.3 EVENT DRIVEN
5.4 MULTI STRATEGY

6. POTENTIAL BENEFITS FOR THE FINANCIAL SYSTEM
6.1 RISK DIVERSIFICATION
6.2 RISK SHARING
6.3 PROVIDERS OF MARKET LIQUIDITY AND EFFICIENCY
6.3.1 H EDGE F UNDS ’ R OLE IN R ISING M ARKETS 24
6.3.2 H EDGE F UNDS ’ R OLE IN F ALLING M ARKETS 25

7. POTENTIAL RISKS FOR THE FINANCIAL SYSTEM
7.1 MICRO-PRUDENTIAL RISK
7.1.1 O PERATIONAL P ROCESSES 28
7.1.1.1 Operational Infrastructure
7.1.1.2 Fraudulent Behavior
7.1.2 I NVESTOR P ROTECTION 32
7.2 MACRO-PRUDENTIAL RISK
7.2.1 D IRECT T RANSMISSION C HANNEL 33
7.2.1.1 Implications of Leverage
7.2.1.1.1 Funding and Instrument Leverage
7.2.1.1.2 Leverage and LTCM
7.2.1.1.3 Development of Leverage from the Russian Default until 2011
7.2.1.1.4 Systemic Relevance of Leverage
7.2.1.2 Implications of Counterparty Credit Risk
7.2.1.2.1 Counterparty Credit Risk Management
7.2.1.2.2 Limitations of Counterparty Credit Risk Management
7.2.1.2.3 Systemic Relevance of Counterparty Credit Risk
7.2.2 I NDIRECT T RANSMISSION C HANNEL 48
7.2.2.1 Implications of Liquidity Risk
7.2.2.1.1 Illiquidity Exposure
7.2.2.1.2 Funding Liquidity Risk from Investor Redemptions
7.2.2.1.3 Funding Liquidity Risk from Financiers
7.2.2.1.4 Systemic Relevance of Liquidity Risk
7.2.2.2 Implications of Connectedness Risk
7.2.2.2.1 Empirical Evidence of Connectedness
7.2.2.2.2 Systemic Relevance of Connectedness Risk
7.3 SYSTEMICALLY IMPORTANT MARKETS

8. APPROACHES FOR REGULATION
8.1 DIRECT REGULATION
8.2 INDIRECT REGULATION
8.3 CAPITAL MARKETS SAFETY BOARD

9. CONCLUSIVE STATEMENT

BIBLIOGRAPHY

LIST OF TABLES

TABLE 1: DEVELOPING PROPORTION OF FINANCIAL ASSETS; HEDGE FUNDS’ ASSETS UNDER MANAGEMENT RELATIVE TO TOTAL GLOBAL ASSETS OF THE LARGEST 1,000 BANKS FROM 1998 - 2007

TABLE 2: OFFSHORE LOCATION OF HEDGE FUNDS IN PERCENT

TABLE 3: CORRELATION MATRIX OF VARIOUS HEDGE FUND STRATEGIES AND BOND & STOCK MARKET INDICES

TABLE 4: MAXIMUM DRAWDOWN OF HEDGE FUNDS VS. MUTUAL FUNDS FROM 1999 - 2005

TABLE 5: PROPORTIONAL SHARE IN PRIME BROKERAGE SERVICE (TOP 5 MAKE UP 62 PERCENT, TOP 10 MAKE UP 80 PERCENT)

LIST OF FIGURES

FIGURE 1: ACCUMULATED RETURNS OF THE DOW JONES CREDIT SUISSE BROAD HEDGE FUND INDEX AND S&P500

FIGURE 2: NUMBER OF HEDGE FUNDS VS. ASSETS UNDER MANAGEMENT FROM 1990 - 2011

FIGURE 3: FREQUENCY OF HEDGE FUNDS RELATIVE TO THE ASSETS UNDER MANAGEMENT

FIGURE 4: OVERVIEW OF HEDGE FUND STYLES WITH RESPECTIVE BELOW LISTED STRATEGIES

FIGURE 5: OVERVIEW OF THE PROPORTION OF MOST COMMON STRATEGIES

FIGURE 6: RATIO OF THE ANNUAL COMPOUNDED RATE OF RETURNS DIVIDED BY ANNUALIZED VOLATILITY OF MONTHLY RETURNS FROM 1994 - 2004

FIGURE 7: SOURCES OF HEDGE FUND FAILURES

FIGURE 8: DEVELOPMENT OF INVESTOR ALLOCATION FROM 1997 - 2005

FIGURE 9: ESTIMATED LEVERAGE RATIOS BASED ON A 24 MONTH ROLLING REGRESSION WINDOW FROM 1997 - 2003

FIGURE 10: WEIGHTED AVERAGE LEVERAGE RATIOS FROM 2006 - 2011

FIGURE 11: ASSET WEIGHTED AUTOCORRELATION OF HEDGE FUND RETURNS FROM 1980 - 2008

FIGURE 12: TIME SERIES DATA OF MARGIN RATES FROM 1982 - 2008

FIGURE 13: PROCESS OF A LIQUIDITY SPIRAL

FIGURE 14: TIME SERIES OF AGGREGATED CORRELATION OF HEDGE FUND RETURNS FROM 1994 -2006

FIGURE 15: TIME SERIES OF AGGREGATED COVARIANCE OF HEDGE FUND RETURNS FROM 1994 - 2006

FIGURE 16: TIME SERIES OF AGGREGATED VOLATILITY OF HEDGE FUND RETURNS FROM 1994 - 2006

List of Abbreviations

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1. Introduction

Over the past decades the architecture of the financial system has undergone a significant change, whereby the alternative investment industry has claimed an ever increasing importance and popularity. Hedge funds have taken the leading role in this development. From a handful of hedge fund managers in the United States (U.S.), hedge funds have been growing to a worldwide business at the forefront of sophisticated financial innovation.¹

Despite their rising success in the alternative investment industry, only a few subjects in the financial world appear to create such diverse opinions as hedge funds do. On the one hand, there are policy makers and academics, which appreciate and highlight hedge funds’ main role in increasing profits and effectively diversifying risks in traditional portfolios. Moreover, Alan Greenspan, the former chairman of the Federal Reserve System (Fed), stated that hedge funds “have become major contributors to the flexibility of the financial system.”² Provided with flexibility and light regulatory oversight, their participation in various markets has been proven important. Especially, due to the provision of liquidity, financial markets have become more efficient but also resilient by absorbing many financial shocks in past years, including the most recent financial crisis. On the other hand, there are also policy makers and academics, who claim that hedge funds are large enough to destabilize markets or even trigger financial crises. A common concern following the near failure of Long Term Capital Management (LTCM) in 1998 is that one single hedge fund, as a highly leveraged investment pool, can create systemic risk to the worldwide financial system. Such ongoing concern about the vulnerability paired with the tremendous development and opaque nature of hedge funds, emphasize their potential threat to financial stability. Despite the fact that only little is known about these loosely regulated private investment pools, an unstudied reaction to 1998 is to regulate them.

Against this background, the aim of this paper is to give the reader a better oversight and understanding of the hedge fund industry by deeply analyzing and discussing their beneficial characteristics but more importantly the issue of how they may be an essential threat to the financial system. Therefore, the paper is split into four main parts. The first part provides the reader with an overall picture of the unfolding of the hedge fund industry from the beginnings until today. Following that, hedge funds are defined more precisely by making a clear distinction to other private investment pools, in particular to mutual funds. Ultimately, an introduction to hedge fund styles and respective investment strategies gives a defined overview of how hedge funds may use their flexibility to generate profits during phases of varying market conditions.

The second part concentrates on potential benefits, which hedge funds can provide to market participants and the overall financial system. Herein, the objective is to exhibit their contribution to risk diversification and risk sharing. Build upon evidence, the issue of hedge funds as being providers of market liquidity and efficiency is also addressed.

The third part forms the main body of this paper and contains a careful analysis of potential systemic risks that hedge funds may pose to the financial system. To this end, the analysis distinguishes between micro-prudential and macro-prudential risks. In order to identify risks, which are specific to hedge funds themselves, the author first examines concerns of financial stability that arise on a micro-prudential level. Herein, the aim is to detect flaws of operational processes within hedge funds but also in investor protection that is of particular interest, as hedge funds become increasingly accessible to various investors. After that, the author shifts the focus to potential macro-prudential risks. To properly assess the risk contribution of hedge funds to the financial system, it is strictly differentiated between a direct and an indirect transmission channel. While the former allows evaluating the risk, arising from strong connections between hedge funds and systemically important financial institutions, the latter aims to detect market related hedge fund vulnerabilities, causing them indirectly to threaten the financial system. Having assessed different systemic risk sources, the author looks at the systemic importance of markets in which hedge funds operate, to determine the potential impact of their dynamic investment activities.

The fourth and final part exclusively contains proposals for hedge fund regulation. Herein, the reader will be introduced to the common approaches of direct and indirect regulation, followed by the alternative approach of a ‘Capital Markets Safety Board’ as suggested by Lo (2008).

2. Limitations of Applied Data

The author acknowledges that there are no reliable estimates concerning hedge fund statistics. Thus, the data that is used throughout the paper might deviate from other data sources. Commercial data providers that report on hedge funds depend on information issued by those funds. The reason for this less satisfying state of affair is that hedge funds do not have the same disclosure requirements as other investment funds, which are accessible to retail investors.³ As a result, the voluntarily provided data by hedge funds are open to a natural survivor bias across all hedge fund databases, as many new established or poorly performing hedge funds are less likely to provide any information. Consequently, only successful funds may choose to report in order to attract potential investors.⁴ Even after the U.S. Securities and Exchange Commission (SEC) Rule 203 (b) (3) -2 was passed and a large number of hedge fund managers became registered investment advisors, this data insufficiency could not be solved. The rule still did not include any information regarding leverage ratios or the liquidity of investments or counterparties of hedge funds (note that this rule has been overturned by the U.S. Court Appeals for the District of Columbia Circuit in June 2006).⁵ Thus, the quantitative information shown in this paper shall solely help understanding the recent development as well as the role of hedge funds in the financial industry. However, one must bear in mind that it is impossible to provide unbiased measures in order to determine what their definite contribution to financial benefits but more importantly to systemic risk is.

3. Development of the Hedge Fund Industry

Investment partnerships exist as long as financial markets. Yet, partnerships known as hedge funds have started out in 1949, when the sociologist and financial journalist Alfred Winslow Jones established his Jones Hedge Fund in the U.S. To attract new investors, Jones used the complementary nature of leverage and short selling. Leverage increases the debt to equity ratio of a firm and invests the borrowed capital to magnify the return on equity. Short selling refers to borrowed securities, which are sold in anticipation to repurchase them at a lower market price at or before the time they have to be handed back to the lender. If both, short selling and leverage are viewed in isolation, these disciplines generally increase the risk exposure. However, Jones was credited by showing how these two disciplines in combination can develop a strategy that limits the market risk, while producing attractive returns at the same time. Jones’ understanding was that coupling the equity long exposure with short selling of other equities issued by companies in the same sector, would hedge the profit of a portfolio from market movements. In this way, the investment performance within the hedge strategy would rely on chosen equities rather than on market volatilities.⁶ Hence, Jones kept a basket of shorted equity positions he assumed to be overvalued to control for market risk and a basket of long positions he assumed to be undervalued (This strategy will be further discussed in chapter 5.1). This allowed the investor to participate in hedged profit opportunities to the extent that the portfolio was split into long equity positions that would gain in value in raising markets and short equity positions that profit in falling markets.⁷

When Jones resigned from his hedge fund management in the early 1980s, his record of accomplishments showed only three years of negative returns compared to nine years of losses of the S&P 500 stock index. Especially noteworthy was the funds’ outperformance of the market during the bull period from 1962 until 1968.⁸ During this time, the hedge fund industry experienced its first growth as the stock market increased and Jones’ hedge fund gathered positive publicity. By the end of the bull market in 1968 a survey by the SEC ascertained 140 hedge funds out of 215 overall counted investment partnerships, constituting a market share of 65 percent. While the market was upward trending, hedge funds invested primarily in corporate equities by using leverage rather than short selling techniques. This made them highly vulnerable to the sustained market downtown in 1968, whereupon five of 28 large hedge funds and many smaller funds had to close down their business, causing deterioration in assets under management (AUM) by 70 percent by the end of 1970.

Hedge funds gradually began to resurge in the 1980s. This was partly associated with the end of the Bretton Woods System when new investment opportunities opened up, which allowed hedge funds to create international diversified portfolios, containing government bonds, currencies, and many other types of assets.⁹ In the subsequent periods, hedge funds became particularly fashionable following a variety of investment strategies, most of which applied instruments such as short selling, leverage and derivatives. Eventually, the real boom set in with the burst of the dotcom bubble and its subsequent stock market collapse in 2000. Investors were overwhelmed by the fact that hedge funds were able to preserve capital as opposed to pure equity investments, particularly when markets were highly volatile in the period from 2000 to 2003 as one can see in figure 1.

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Figure 1: Accumulated returns of the Dow Jones Credit Suisse Broad Hedge Fund Index and S&P500 (Source: Own illustration based on Standard & Poors (2011) and Credit Suisse (2011))

Therefore, it may not be surprising that the number of hedge funds and net asset flows multiplied in the following years.¹⁰ Although the hedge fund industry was severely hit during the financial crisis from 2008 to 2009, where the estimated asset size as well as the number of hedge funds significantly fell, returns generated by hedge funds have decreased less than in the equity market. Moreover, the effective overall growth of the size of the hedge fund industry has been positive over the last decade. According to estimates from 1990 until the first quarter of 2011, hedge funds’ AUM grew from USD 38 billion to more than USD 2 trillion globally and thus with a compounded annual growth rate (CAGR)¹¹ of 19.7 percent over the past two decades (see figure 2).

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Figure 2: Number of hedge funds vs. assets under management from 1990 - 2011 (Source: Own illustration based on Hedge Fund Research (2011), pp. 18-24)

The U.S. with 70 percent and the United Kingdom (UK) with 15 to 20 percent market share of total AUM by hedge fund managers, depict the leading centers for the hedge fund management worldwide.¹² By March 2011 Hedge Fund Research (2011) estimated 7,300 active hedge funds, whereby the AUM has a skewed distribution towards smaller funds as shown in figure 3.

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Figure 3: Frequency of hedge funds relative to the assets under management (Source: Own illustration based on Lhabitant, F. S. (2006), p. 21)

While the hedge fund industry has increased by a multifold, table 1 shows that the total AUM of hedge funds remains with 1.3 percent comparatively small relative to assets of leading global investment pools and banks.¹³

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Table 1: Developing proportion of financial assets; Hedge funds’ assets under management relative to total global assets of the largest 1,000 banks from 1998 - 2007

(Source: Own illustration based on King, M. R./Maier, P. (2009), p. 285)

Nevertheless, hedge funds depict key players in many financial markets and account for an essential proportion of trading activity. They account for more than 40 percent of the trading volume in the leveraged loan market, nearly 50 percent of some structured credit markets, 80 percent of some kind of credit derivative markets and more than 85 percent of the distressed debt market, thus making them indispensable liquidity providers in these markets.¹⁴

4. Distinguishing Hedge Funds from other Investment Vehicles

As mentioned previously, hedge funds initially started out as U.S. investment partnerships using the Long/Short Equity strategy to eliminate risk.¹⁵ Over time, they have evolved into a multifaceted fund structure that defies a simple definition. In fact, nowadays the term hedge fund often rises confusion and the word ‘hedge’ can be rather misleading as giving definitional value to it. That is, many hedge funds do not hedge in the strict sense of the term. Furthermore, a general problem is that hedge funds and other investment funds are becoming increasingly arbitrary.¹⁶ Nonetheless, some characteristics can be identified that distinguish hedge funds from other private pooled investment vehicles and are discussed in the following.

4.1 Regulation and Subscription

In contrary to mutual funds and other regulated private investment pools, the management of hedge funds is generally located onshore (note, since the U.S. and the UK are the most relevant onshore markets for hedge funds, their regulation policy shall solely be discussed). However, the funds themselves are often registered in offshore jurisdictions such as the Bahamas, Cayman Islands or Luxemburg, which enables them to simplify tax implications as a result of their liberal trading strategies (see table 2).¹⁷

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Table 2: Offshore location of hedge funds in percent

(Source: Own illustration based on Lhabitant, F. S. (2006), p. 28)

Furthermore, it is a general thought that hedge funds are fully unregulated. Instead, a more accurate way of saying is that hedge funds have modeled themselves to fit all of the U.S. exemptions to regulations under the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Company Act of 1940, which allows hedge funds to operate with little U.S. regulatory oversight.¹⁸ The reason for the exemptions results from the fact that these regulations are intended to protect the general public and thus apply for retail investors only.¹⁹ Efforts to bring hedge funds under SEC oversight have constantly failed, such as the most recently rejected Rule 203 (b) (3)-2 in June 2006.²⁰

Nevertheless, in course of the past financial crisis radical changes in the regulatory framework have taken place not only in the U.S. but also in the UK. In the U.S. as the largest center for hedge fund management, the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) has been passed in 2010. This now officially requires extensive registration of hedge fund managers with the SEC. Further, before the DFA made registration, the SEC allowed hedge funds to make their investments in private placements accessible to fewer than 100 accredited investors or qualified purchasers, such as high net worth individuals and institutional investors.²¹ According to Kaiser (2009), gradually relaxed conditions by the SEC do not restrict the number of hedge fund investors anymore but they must be accredited.²² Referring to the former Rule 501 of Regulation D of the Securities Act 1933, investors, who either had an individual net worth in excess of USD 1 million or an annual income of USD 200 thousand, were deemed accredited. Under the current SEC rule, the DFA requires investors to have a net worth in excess of USD 1 million that excludes primary residence. Consequently, many U.S. investors, who do not have the required minimum annual income but possessing high valued property, will fall out of the accredited investor category.²³

The UK, as the worldwide second largest market and the largest for hedge fund managers in the European Union (EU), historically required managers to be registered by the Financial Services Authority (FSA), the national regulator in the UK. As far as investors are concerned, the FSA does not impose any investment criteria that must be met by individual investors such as minimum income or wealth and builds rather upon hedge funds’ own commercial decisions.²⁴ Yet, to aim for an EU- wide harmonized regulatory framework for enhanced monitoring and oversight, the European Commission has approved a directive on Alternative Investment Fund Managers (AIFM) at the end of 2010, including hedge funds.²⁵ The UK as well as any other EU member state will have to transpose this regulation into national law by July 2013.^{26 27}

As both regulations have been introduced recently, no judgment can be made regarding the impact on the hedge fund industry. In its current state, the DFA ultimately allows the SEC an open mandate to regulate and to define the extent of its own authority. The same applies to the directive on AIFM, as each EU member state has two years to implement this framework into national law. Thus, the sensibility and effect on the hedge fund industry fully depends on the individual rule that will be determined by the regulators in the U.S. as well as in the UK.²⁸ Given the significant fact that both acts have many important details left for the regulators, a judgment on both regulatory frameworks cannot be made yet. It may even need another few years after implementation until one can see how rules for the hedge fund industry have altered or whether hedge funds have once more circumvented themselves from regulatory efforts. Hence, the author will follow the current state of hedge funds’ transparency throughout the paper, knowing that new regulations are going to be implemented in the future.

4.2 Investment Techniques and Leverage

Another striking feature of many hedge funds is their objective to exploit market inefficiencies. This can be achieved by combining various investment strategies in assets that seem to deviate from their fundamental values or by making opinions about other forms of pricing abnormity. Based on their (still) unregulated nature, they can exploit these imperfections by choosing within a wide range of investment instruments and strategies. Thus, in contrast to mutual funds, hedge funds may employ derivatives and execute short selling to do so.²⁹ To intensify the power of their market views, many hedge funds apply financial engineering techniques by applying leverage through loans or derivatives (see chapter 7.2.1.1.1).³⁰ Also, this liberal use of leverage is not accessible to many other investment vehicles such as mutual funds, who are allowed to leverage up to a maximum of 50 percent of their net assets.³¹

4.3 Opacity

Hedge funds typically have little transparency with constrictive disclosure beyond their trading strategies to their investors as well as prime brokers and banks (henceforth financiers).³² Although their clients enforce some investment discipline, hedge funds’ intransparency undermines this discipline a priori. Yet, hedge funds do release some qualitative information about their investment type but the interpretation is complex. This degree of opacity is the basic principle for the success of hedge funds, creating an edge to foster financial innovation with the purpose to increase absolute returns. That is, returns that do not compare to any other measure or benchmark as relative returns of mutual funds do. On this account, their clients tolerate a specific amount of opacity, which is not seen in the mutual fund industry, hoping to be compensated by high returns.³³

4.4 Compensation Structure

The fee structure of hedge funds varies significantly from other investment vehicles. While mutual funds charge merely a management fee, hedge fund managers include a management fee as well as an incentive fee. Herein, management fees are typically described as a percentage of AUM and are mostly due on a quarterly or yearly basis, varying within 1 to 3 percent per annum.³⁴ Incentive fees encourage hedge fund managers to obtain the highest absolute returns possible and they range from 15 to 25 percent based upon the yearly fund performance.³⁵ To avoid principal-agent problems and excessive risk taking, hedge funds also add features in the form of hurdle rates (incentive fee is paid when returns exceed the hurdle rate) and high-water mark provisions (incentive fee only paid on new profits but only if past losses are recovered).³⁶ While hurdle rates and high-water mark provisions may under some conditions lead to excessive risk-taking and, therefore, making investors cautious to commit capital, countervailing forces may reduce such risk. Thus, hedge fund managers, as the general partner, invest a significant fraction of their own wealth in the fund to assimilate their incentives with potential investors.³⁷

5. Hedge Fund Strategies

The initial idea of hedge funds was to exploit price inefficiencies using Long/Short Equity and thus eliminating systematic market risks. However, along with the growing power of technology and financial theory in the past, hedge funds have evolved new investment strategies. According to Busack and Kaiser (2006), there exist sufficient documented opportunities in theory and praxis to classify hedge fund investment strategies i.e. into directionality, volatility, investment process, asset classes, geographical orientation or industry focus.³⁸ So far, the hedge fund industry as well as academic research has not agreed on a common standardized classification system.³⁹ One of the clearest classification systems of different hedge fund styles follows the investment process and can be divided into the four different main styles of directional, market neutral, event driven and multi strategy. An overview of the different investment styles with the respective strategies is given in figure 4. Moreover, it is worth noting that this classification may change in the process of time. Also, the author only uses a list of major strategies, which may therefore be slightly different from categories used by other authors. However, these differences are marginal, as fundamental strategies are categorized in a comparable way.

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Figure 4: Overview of hedge fund styles with respective below listed strategies (Source: Own illustration based on Garbaravicius, T./Dierick, F. (2005), pp. 8-10)

5.1 Directional

Hedge funds that make use of the directional style follow the top down approach, seeking macroeconomic trends to predict future market movements. Those hedge funds offer returns that usually commensurate with the high risk, fostered by leveraged positions.⁴⁰ On this occasion, hedge fund managers can avail of the following strategies Long/Short Equity, Global Macro, Managed Futures and Emerging Markets.

The classical Long/Short Equity strategy that A. W. Jones originally developed still claims the vast majority among the most common strategies as figure 5 shows.

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Figure 5: Overview of the proportion of most common strategies

(Source: Own illustration based on Ferguson, R./Laster, D. (2007), p. 47)

Nowadays, this strategy often makes use of derivatives to open equity positions in both ways long and short. Equity positions that are considered undervalued will be bought, while equity positions that are believed overvalued will be sold. In an event of a rising market, undervalued stocks will increase over-proportionately, while in a falling market overvalued stocks will decrease over-proportionately, thus generating profits mostly independent from market movements.⁴¹ Long/short portfolios are typically not entirely market neutral and show either a long or a short bias. Therefore, their market exposure is either negative or positive.⁴²

Referring to Global Macro hedge funds, based upon their views of the overall economic market conditions, the managers seek to identify occasions where macroeconomic fundamentals are far out of equilibrium. Changes in prices of asset positions and the associated earnings are substantial when they eventually emerge. To construct the eventual portfolio, hedge funds open long and short positions not only on stock markets but also on fixed income foreign exchange or commodity markets, using cash or derivatives.⁴³

The strategic approach of Managed Futures hedge funds aims to invest worldwide in listed financial and commodity future markets as well as foreign exchange markets. The trading principles of hedge fund managers can be distinguished in discretionary and systematic. To take trading decisions, discretionary traders often make use of a judgemental approach whilst systematic traders rely on price and in particular on market information.⁴⁴

As far as Dedicated Short Bias hedge funds are concerned, their original strategy of dedicated short was once a very popular investment approach in the hedge fund industry before the long lasting bull market in the 1990s made this strategy more challenging to apply. Thereupon the category dedicated short bias has emerged that carries equity and derivatives positions net short as in contrast to a pure short exposure.⁴⁵

Hedge funds using the Emerging Markets strategy are subject to more restrictions, as many emerging markets prohibit short selling and do not offer useful derivatives that allow fund managers to hedge their portfolios. Thus fund managers often follow a conservative strategy and only take long positions in equity and fixed income investments.⁴⁶

5.2 Market Neutral

Market neutral hedge funds seek to avoid market wide fluctuations by searching for arbitrage or relative value opportunities to take advantage of price differences. Although their strategies are associated to low volatilities, they can be paired with high levels of leverage in order to benefit from small price distortions.⁴⁷ The market neutral style implies the strategies of Equity Market Neutral, Fixed Income Arbitrage and Convertible Arbitrage to which the reader will be introduced in the following.

Hedge fund managers following the Equity Market Neutral strategy typically use long and short positions of stocks that share the same characteristics in order to take advantage of price differences in the equity market. Herein, the portfolio is designed to be beta neutral, currency neutral or both.⁴⁸ Today’s financial markets have become very efficient and price differences are seen to be seldom. Thus, this strategy involves also arbitrage between similar stocks such as common and preferred shares of the same company or stocks of two companies operating in the same industry.⁴⁹

Fixed Income Arbitrage hedge funds have the objective to profit from price anomalies of related interest rate securities. Herein, arbitrage strategies include interest rate swap arbitrage, U.S. and non-U.S. government bond arbitrage as well as forward yield curve arbitrage. Hedge fund managers also use mortgage backed securities arbitrage where the market is mainly based in the U.S. and over-the- counter (OTC).⁵⁰

Hedge funds applying the Convertible Arbitrage strategy make use of differences in the valuation of convertible bonds and stocks of the same company. Often, hedge fund managers may take short positions in stocks and long positions in assumed undervalued convertible bonds in order to generate profit.⁵¹

5.3 Event Driven

Event driven strategies aim to exploit a spotted mispricing of assets by assuming occasions such as corporate mergers or acquisitions or bankruptcies and their associated effects.⁵² The levels of applied leverage are comparatively small, while the asset volatility can be positioned in the middle of the volatility spectrum of all hedge fund styles.⁵³ Strategies that are used can be assigned to Risk (M&A) Arbitrage and Distressed Securities.

Risk (M&A) Arbitrage hedge funds try to participate in the course of mergers in order to exploit a perceived mispricing of securities. As long as a merger is incomplete, a substantial price inequality between the takeover bid price and the current price of the takeover candidate can often be observed. To profit from this constellation, hedge fund managers may purchase stocks of the takeover candidate and simultaneously short stocks of the buyer, expecting the price of both stocks to converge. However, this strategy implies a lot of risk in case the merger does not take place.⁵⁴

Hedge funds using the Distressed Securities strategy avail trading investment opportunities that are based upon firms in distressed or defaulted situations. Hedge funds speculate on a turnaround of firms by using investment instruments such as stocks, bonds or other liabilities associated to them.⁵⁵

5.4 Multi Strategy

Multi strategy hedge funds have become quite common within the hedge fund industry over the past years and are mainly characterized by dynamic capital reallocations. Based on current market conditions and profit occasions, these hedge funds independently use the wide range of the above listed strategies or even make use of other unique strategies. Therefore, multi strategy hedge funds can be partially characterized by each of the above listed strategies. However, due to their multiple strategy structure, it appears to be difficult to assign these funds to any of these traditional hedge funds disciplines.⁵⁶

6. Potential Benefits for the Financial System

Even though the role of hedge funds in capital markets cannot be quantified with any precision, the growing importance of this industry is clear and financial markets have profited from this growth. Loosely restricted from regulatory investment requirements and supported by a dynamic financial and technological development, hedge funds have become a substantial driver in the source of financial market innovation. Given their flexible investment choice in financial markets and their comprehensive use of innovative financial instruments, they provide many advantages to their investors and the financial system as a whole. To highlight the advantages that hedge funds perform, this chapter focuses on the various functions of risk diversification, risk sharing and market efficiency.

6.1 Risk Diversification

As previously outlined, hedge funds are not subject to investment restrictions such as mutual funds, which allows them to provide trading strategies that are otherwise often unobtainable.⁵⁷ Hence, they maintain a portfolio optimization purpose, where risk can be intermediated on a much higher scale, achieving attractive diversification benefits for investors.⁵⁸ Considerable evidence demonstrates that hedge funds provide returns that are slightly correlated or even uncorrelated to equity and fixed income markets. Based on empirical data from 1994 to 2004 the correlation coefficients within the family of hedge fund strategies to major stock as well as bond indices were constantly below 0.61 and often times even negative as seen in table 3.

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Table 3: Correlation matrix of various hedge fund strategies and bond & stock market indices (Source: Own illustration based on Garbaravicius, T./Dierick, F. (2005), p. 26)

In fact, the significance of hedge funds as suitable portfolio investments becomes even more distinguished when historical risk-adjusted returns are taken into consideration. Excluding certain directional strategic approaches, hedge funds strategies appear to outperform equity and fixed income markets on a risk adjusted-basis (see figure 6).⁵⁹

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Figure 6: Ratio of the annual compounded rate of returns divided by annualized volatility of monthly returns from 1994 - 2004

(Source: Own illustration based on Garbaravicius, T./Dierick, F. (2005), p. 28)

In addition, Mustier and Dubois (2007) demonstrate that even if hedge funds did not outperform, they were on an aggregated basis less risky than other investment vehicles such as (equity) mutual funds as shown in table 4.

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Table 4: Maximum drawdown of hedge funds vs. mutual funds from 1999 - 2005 (Source: Own illustration based on Mustier, J. P./Dubois, A. (2007), p. 91)

In the period from 1999 to 2005, the share of hedge funds experiencing losses was constantly smaller than the share of (equity) mutual funds. For instance, a maximum drawdown⁶⁰ exceeding 50 percent of value was realized by 73.7 percent of all mutual funds compared to merely 10.2 percent within the hedge fund industry. This result also holds for volatility or any other risk parameter.⁶¹

[...]

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¹ Lhabitant, F. S. (2006), p. 1

² Financial Times (2005)

³ Note that efforts for new regulation may change this lack of information in the future; a detailed discussion can be found in chapter 4.1.

⁴ Cp. Hildebrand, P. M. (2005), p. 45

⁵ Cp. Lo, A. W. (2010), p. 200

⁶ Cp. Eichengreen, B. J./Mathieson, D. J. (1998), p. 1944

⁷ Cp. Eichengreen, B. J./Mathieson, D. J. (1999)

⁸ Cp. Man Investments (2011), p. 3

⁹ Cp. Eichengreen, B. J. et al. (1998), p. 1944

¹⁰ Cp. Man Investments (2011), p. 3

¹¹ The CAGR can be seen as a smoothed annualized growth that has been obtained during the underlying time horizon.

¹² Cp. Waters, D. (2005)

¹³ Cp. King, M. R./Maier, P. (2009), p. 285

¹⁴ Cp. United States Government Accountability Office (2008)

¹⁵ Cp. Nyberg, L. (2006), p. 1

¹⁶ Cp. Heise, M. (2007), pp. 18-22

¹⁷ Cp. Crockett, A. (2007), p. 20

¹⁸ Cp. Eichengreen, B. J./Mathieson, D. J. (1998), p. 1943

¹⁹ Cp. Fung, W./Hsieh, D. A. (1999), p. 315

²⁰ Cp. Lo, A. W. (2010), p. 200

²¹ Cp. Turn Key Hedge Funds Inc. (2010)

²² Cp. King, M. R./Maier, P. (2009), p. 38

²³ Under the new Act, registration with the SEC must have been done before July 21 2011, entirely conformal with the requirements of the Investment Advisers Act of 1940. Hedge funds have become subject to extensive records about their investment and business practices. Exempted from registration are only funds with AUM below USD 150 million and family offices. Moreover, hedge funds registered offshore with more than 14 U.S. clients or investors; or managing assets of these clients or investors of more than USD 25 million must register with the SEC as well. Cp. Price Waterhouse Coopers (2010), pp. 1-5

²⁴ Cp. Hanson, T. (2011)

²⁵ Cp. Commission of the European Communities (2009), p. 5

²⁶ Cp. Waters, D. (2005)

²⁷ Excepted from this new regulatory framework will be funds with AUM of less than EUR 100 million. Also, for those hedge funds with no leverage and which do not grant investors redemption rights, will be excepted from this regulation, if their AUM is of less than EUR 500 million. Cp. Commission of the European Communities (2009), pp. 5-6

²⁸ Cp. Brown, S. et al. (2010)

²⁹ Cp. Crockett, A. (2007), p. 20

³⁰ Cp. Kambhu, J. et al. (2007), p. 2

³¹ Cp. Ackermann, C. et al. (1999), p. 835

³² Cp. King, M. R./Maier, P. (2009), p. 285

³³ Cp. Noyer, C. (2007), p. 106

³⁴ Mutual funds incentives rely on boosting the asset under management rather than the investment performance.

³⁵ Cp. Lavinio, S. (2000), p. 30

³⁶ Cp. Agarwal, V. et al. (2008), pp. 2-3

³⁷ Cp. Hildebrand, P. M. (2005), p. 44

³⁸ Cp. Busack, M./Kaiser, D. G. (2006), pp. 5-6

³⁹ Cp. Hilpold, C./Kaiser, D. G. (2005), p. 13

⁴⁰ Cp. Nyberg, L. (2006), p. 2

⁴¹ Cp. Garbaravicius, T./Dierick, F. (2005), p. 8

⁴² Cp. Connor, G./Woo, M. (2004), p. 24

⁴³ Cp. Garbaravicius, T./Dierick, F. (2005), p. 9

⁴⁴ Cp. Chan, T. N. et al. (2005), p. 99

⁴⁵ Cp. Garbaravicius, T./Dierick, F. (2005), p. 9

⁴⁶ Cp. Österreichische Finanzmarktaufsicht (2005), p. 13

⁴⁷ Cp. Garbaravicius, T./Dierick, F. (2005), p. 10

⁴⁸ Cp. Garbaravicius, T./Dierick, F. (2005), p. 10

⁴⁹ Cp. Österreichische Finanzmarktaufsicht (2005), p. 14

⁵⁰ Cp. Garbaravicius, T./Dierick, F. (2005), p. 10

⁵¹ Cp. Österreichische Finanzmarktaufsicht (2005), p. 14

⁵² Cp. Connor, G./Woo, M. (2004), p. 25

⁵³ Cp. Garbaravicius, T./Dierick, F. (2005), p. 10

⁵⁴ Cp. Connor, G./Woo, M. (2004), p. 25

⁵⁵ Cp. Österreichische Finanzmarktaufsicht (2005), p. 14

⁵⁶ Cp. Garbaravicius, T./Dierick, F. (2005), p. 10

⁵⁷ Cp. Daníelsson, J. et al. (2004), p. 17

⁵⁸ Cp. Hildebrand, P. M. (2007), p. 70

⁵⁹ Cp. Garbaravicius, T./Dierick, F. (2005), pp. 26-27

⁶⁰ A maximum drawdown is the percentage negative return of a fund. That is, the decline of the peak net asset value to the lowest in the given period of time. The maximum drawdown is commonly used as a measurement of the risk of an investment vehicle. Cp. Kaiser, D. G. (2009), p. 149

⁶¹ Cp. Mustier, J. P./Dubois, A. (2007), p. 91