Importance of hedge funds

The role that hedge funds are playing in capital markets cannot be quantified with any precision. A fundamental problem is that the definition of a hedge fund is imprecise, and distinctions between hedge funds and other types of funds are increasingly arbitrary. Hedge funds often are characterized as unregulated private funds that can take on significant leverage and employ complex trading strategies using derivatives or other new financial instruments. Private equity funds are usually not considered hedge funds, yet they are typically unregulated and often leverage significantly the companies in which they invest. Likewise, traditional asset managers more and more are using derivatives or are investing in structured securities that allow them to take on leverage or establish short positions.

Although several databases on hedge funds are compiled by private vendors, they cover only the hedge funds that voluntarily provide data.1 Consequently, the data are not comprehensive. Furthermore, because the funds that choose to report may not be representative of the total population of hedge funds, generalizations based on these databases may be misleading. Data collected by the Securities and Exchange Commission (SEC) from registered advisers to hedge funds are not comprehensive either. The primary purpose of registration is to protect investors by discouraging hedge fund fraud. The SEC does not require an adviser to a hedge fund, regardless of how large it is, to register if the fund does not permit investors to redeem their interests within two years of purchasing them.2 While registration of advisers of such funds may well be unnecessary to discourage fraud, the exclusion from the database of funds with long lock-up periods makes the data less useful for quantifying the role that hedge funds are playing in the capital markets.

Even if a fund is included in a private database or its adviser is registered with the SEC, the information available is quite limited. The only quantitative information that the SEC currently collects is total assets under management. Private databases typically provide assets under management as well as some limited information on how the assets are allocated among investment strategies, but they do not provide detailed balance sheets. Some databases provide information on funds’ use of leverage, but their definition of leverage is often unclear. As hedge funds and other market participants increasingly use financial products such as derivatives and securitized assets that embed leverage, conventional measures of leverage have become much less useful. More meaningful economic measures of leverage are complex and highly sensitive to assumptions about the liquidity of the markets in which financial instruments can be sold or hedged.3

Although the role of hedge funds in the capital markets cannot be precisely quantified, the growing importance of that role is clear. Total assets under management are usually reported to exceed $1 trillion.4 Furthermore, hedge funds can leverage those assets through borrowing money and through their use of derivatives, short positions, and structured securities. Their market impact is further magnified by the extremely active trading of some hedge funds. The trading volumes of these funds reportedly account for significant shares of total trading volumes in some segments of fixed income, equity, and derivatives markets.5

In various capital markets, hedge funds clearly are increasingly consequential as providers of liquidity and absorbers of risk. For example, a study of the markets in U.S. dollar interest rate options indicated that participants viewed hedge funds as a significant stabilizing force. In particular, when the options and other fixed income markets were under stress in the summer of 2003, the willingness of hedge funds to sell options following a spike in options prices helped restore market liquidity and limit losses to derivatives dealers and investors in fixed-rate mortgages and mortgage-backed securities.6 Hedge funds reportedly are significant buyers of the riskier equity and subordinated tranches of collateralized debt obligations (CDOs) and of asset-backed securities, including securities backed by nonconforming residential mortgages

0 replies

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published. Required fields are marked *