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The Fall of Hedge Funds

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A flood of speculative cash into hedge funds run by "less-experienced" managers has raised the risk of a sudden correction that could trigger instability in financial markets and push the world back into recession, the Bank of England warns today.

The Bank says investors have taken on increasingly risky positions to maximize their profits in an otherwise low-yield environment of falling interest rates and volatile share markets.

The Bank is also concerned that British banks have relaxed their lending criteria as interest rates fell and the housing market boomed, leaving themselves exposed to a surge in arrears as households struggled to pay off their record debt burden.

In its biannual review of financial stability, the Bank warns that large moves in interest rates and sharp falls in asset prices could force investors who have taken out large positions without hedging their risk to unwind their positions in a hurry.

It said that so far, investors had managed to sell out of their bets without triggering any financial stress or causing large and dangerously volatile movements in financial markets. "Nonetheless, further price changes could trigger other sharp asset price movements or market liquidity problems were investors simultaneously to try to unwind common positions, leading to 'one-way' trading," the report says.

"These risks may have been exacerbated by the rapid growth and proliferation of hedge funds over the past year, possibly bringing in less-experienced fund managers."

Launching the report, Sir Andrew Large, the Bank's deputy governor for financial stability and a member of its interest rate setting committee, said: "To the extent that these developments reflect higher risk appetite or misperceptions of risk, they raise an issue for financial stability."

Before I criticize the detail of the above statements as naïve, I first want to criticize the premise.

I find it ironic that the Bank of England issues a warning for something that they are complicit in: global negative real interest rates driving capital into more risky investments. If they are not stupid in making these statements, then they are cleverly laying the groundwork to blame hedge funds for any dislocation as a result.

In fact, a market dislocation is much more likely to come from a different source as a result of this policy than from hedge funds. Global capital imbalances resulting from this policy are historically high by any measure and the implications have seeped into various aspects of the U.S. real economy through debt. The leverage in the financial system may be much higher today as the result of mortgage activity, but on the margin is lower than otherwise because of hedge funds.

The majority of hedge fund managers come from the sell side and trade strategies that broker dealers used to trade (and still do, but to a lesser extent because hedge funds have taken their place). The difference is that the broker dealers use much higher leverage: 40 to 1 versus maybe 5.

Now instead of trading risk, most broker dealers just pass it on to hedge funds for a commission. In actuality it was broker dealer capital that led to the LTCM meltdown: they used their own leveraged capital as the other side to LTCM's portfolio. When LTCM failed, the fund lost levered capital for their investors, but it was the broker dealers' own levered exposure that almost brought the system down.

"Inexperienced hedge fund managers" is a very misleading statement. By far the largest investors in hedge funds are Funds of Funds designed to insulate the ultimate investor from just this scenario. If there are any drawbacks with Funds of Funds it is not in due diligence. I have been through this process and know first hand that they are very thorough and in almost all cases, very experienced investors. A bad hedge fund manager, one who does not understand risk, is unlikely to get significant capital before failing.

I will take on William Safire, the Bank of England, or anyone else in the debate on hedge funds. Most of what you hear about hedge funds is exaggerated if not disingenuous. The biggest problem I see with hedge funds is their incentive structure, but that should be taken care of over time by market forces.

As far as risk goes, I believe the "financial system" is much better off with hedge funds than without them, simply because they employ much less leverage than broker dealers.

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