Friday, March 28, 2008

Hedge funds - do they bring any value?

Just read Vito Tanzi' excellent paper on "Complexity and Systemic Failure" published in "Transition and Beyond. A Tribute to Mario Nuti" edited by Estrin, Kolodko, and Uralic. Tanzi was extremely prescient as to the upcoming financial sector crisis. He argued that the financial sector became so complex that no one could understand it any more let alone assess the risks of crisis. To quote him "Complexity makes it more difficult to anticipate crises, to predict how crises will evolve, what will be their consequences, and what policy tools the policymakers could use in such events". He implicitly calls for much stricter regulation of financial markets. I was most impressed with his note on hedge funds: do they bring any economic value? Are billion dollar payouts for hedge fund managers justified? Read below...

"The hedge fund industry has made it possible for some managers to get enormous incomes. Forbes’ 2006 Report on the 400 richest Americans includes 12 hedge fund managers among them. In 2005, James Simons, of Renaissance Technologies, and T. Boone Pickens Jr., of BP Capital Management, reported incomes of $1.5 billions and $1.4 billions respectively from their hedge fund activities. Each of the top ten hedge fund managers had salaries that exceeded $300 million in 2005. These are incredibly large incomes that raise legitimate questions about what these individuals were contributing to society that deserved such enormous compensation, especially when many economists continue to believe that capital markets are efficient. There are also questions as to whether these funds have not in fact increased the volatility of some markets. Apart from these important questions, there is the problem that the form of contracts used to make investments in hedge funds tend to encourage hedge funds’ managers to take excessive risks. Much of their compensation comes from being able to beat some market indexes. A single good year can make these managers rich for the rest of their life. Thus, the managers have incentives to take large risks. When they lose in these bets, they may close the hedge funds they had been guiding and may open new ones. At times, within days, they go from reporting large gains for a year to reporting enormous losses, and happened to “Amaranth Advisers” between August and September 2006. There are no firm data to indicate that as a group, including those that fail, hedge funds’ earnings systematically beat the market.
The risks associated with the growth of the hedge fund industry are several. Some are mentioned here without much elaboration.
First, as the number of hedge funds rises, it is not likely that there will be enough “market imperfections” in the pricing of financial instruments that can be exploited by them to support their activities. The mathematical models developed are based on the historical behavior of financial variables. This behavior may change suddenly. The models also do not reflect systemic risk. But, as Long Term Financial Management discovered in 1998, historical relationships for specific variables become irrelevant when whole systems fail.
Second, as mentioned above, the contracts that investors have with the managers of the hedge funds invite the taking of excessive risk: the managers gain when they beat the market while the investors in the hedge funds are the main losers when the funds do badly. The investors who lose money often complain that they had not received precise information on the operations of these hedge funds.
Third, as the number of hedge funds increases, and there is mobility of personnel among them, the mathematical models that they use inevitably tend to become more similar thus increasing the probability that herd instinct will guide behavior.
Fourth, the money that investors invest in the hedge funds supports contracts or positions that are a large multiple of that money. For example, by the spring of 1996, Long Term Capital Management had $140 billion in assets, or thirty times the capital that investors had placed with it. Lowenstein, 200, p. 80. This leveraged position forces them to borrow enormous amounts of money from banks which later may claim that they were not fully informed about the fund’s activities. Some reports have indicated that the total value of the derivative contracts entered by hedge funds is now (September 2006) more than 22 times the gross domestic product of the United States. This gives a clear idea of the role of the hedge funds in the financial market and the danger that a systemic crisis involving them could create for the financial system. It should be recalled that the Federal Reserve Bank of New York had to intervene in 1998 to prevent a financial meltdown, after Long Term Capital Management failed as a consequence of the Russian default. Since that time the number of hedge funds and their activities have increased sharply.
Finally, and a growing concern for the monetary authorities, many of the derivative contracts (or trades) entered by the traders on behalf of the hedge funds that they represent remain unconfirmed for significant periods of time. During this time these contracts are essentially informal and unregistered promises. This means that a major failure on the part of a large enterprise or a country could create major difficulties in determining quickly and precisely who owes and who is owed money. Should such an event occur in connection with a technical failure on the part of a large-value payment system, as happened to a computer at the Bank of New York in 1985, the consequences could be very serious.
The payment systems have been called “the transportation systems of a monetary economy”—because they are the vehicles that carry the enormous and increasing flows of daily payments. Quoting a report of the European Central Bank (ECB): “…credit risks in a net settlement system are extinguished only with the settlement of all net positions in the system…As a result, the failure of one participant to meet its obligations at the time of settlement could lead to the unwinding of payments that other participants had already treated as final”. This could lead to a “domino effect” and to systemic risk. See ECB, p. 73, 2006. See also De Bandt and Hartmann, 2002, especially pages 273-276.
There have been frequent statements on the part of concerned central banks on the need to impose more stringent rules on the hedge funds, including the need for them to register and to better report on their activities. So far the hedge funds have resisted these initiatives on the grounds that these steps would increase costs and slow down technical advances. This reported, potential conflict between safety on one hand and technical progress (and presumably efficiency) on the other is becoming more frequent in market economies and is often used as an argument for resisting controls and regulations.

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