Hedge Funds

inSight

13 Jun 2002

Hedge Funds

Hedge funds have almost doubled in size since the end of 1998, and they are now targeting retails investors. Are they about to reach saturation point?

Given Hong Kong's past experience with the hedge funds, or highly leveraged institutions, or whatever other name they are called, readers will not be surprised to learn that we in the HKMA have been monitoring their development closely. This has not been easy, simply because there is a dearth of publicly available information. There is also a lack of regulatory information, given the unregulated nature of the industry globally. And, as a regulator in an international financial centre that has a reputation for being free and open, it is not our habit to make use of clandestine means for doing so. But we do talk to whoever has an interest in international finance, including fellow regulators who, like us, have the responsibility for maintaining monetary and financial stability, and safeguarding the integrity of the monetary and financial systems. We also talk directly to those operating hedge funds, sometimes in the capacity as a potential customer, exploring alternative investment strategies in the management of the Exchange Fund. Most are quite forthcoming, at least in terms of the success of their business and their investment strategies. Perhaps this is because they consider that it is in their interests to work with the authorities, if only for the purpose of removing the stigma of the hedge fund label.

We continue to have mixed feelings about the hedge funds. On the one hand, the continued lack of transparency (and the lack of a consensus among regulators on hedge fund disclosure) means that there is no reliable system for monitoring or detecting any build-up of destabilising market concentration, or for assessing and managing systemic risks. Free and open financial markets, particularly those of medium size and adequate liquidity, continue to be vulnerable.

On the other hand, the hedge fund industry has grown rapidly worldwide in recent years, to the extent that any international financial centre has no alternative but to embrace them. At the end of last year there was an estimated US$400-500 billion under management by hedge funds, almost double the amount at the end of 1998. The number of active hedge funds has also risen sharply to around 4,000 to 5,000, up from about 2,500 to 3,000 in three years. Most interestingly, the average rate of return achieved, according to available hedge fund performance indexes, seems to have been significantly higher than the trends of the underlying financial markets.

We shall continue to press for further reforming the international financial architecture to reduce the vulnerability of the medium-sized open financial markets. We support greater transparency and disclosure, and better counter-party risk management. We also support an appropriate degree of regulation, particularly when, in addition to systemic risks, investor protection considerations are involved.

The Securities and Futures Commission has recently made a strategic move to allow the public offering of hedge funds through the promulgation of the Hedge Fund Guidelines. This in effect takes the hedge funds from the market for the wealthy and the professionals to the retail level. We support this initiative, both from the point of view of the development of Hong Kong as an international financial centre and in the interest of providing retail investors in Hong Kong with a wider choice. Furthermore, the Guidelines will have the beneficial effect of promoting greater transparency and understanding of the industry. They are also structured in a manner that effectively excludes the large predatory macro hedge funds that were so prominent in the nineties, which in any case have largely scaled back or ceased operations.

I am sure investors wishing to make use of the hedge funds know quite well that they should first attempt an appreciation of the risks they will be exposed to in relation to the return expected. But let me offer a point of view here. In your attempt, you will probably be confronted with a lot of esoteric jargon - convertible arbitrage, dedicated short bias, event-driven risk arbitrage, distressed securities, etc. They are all very interesting market plays - no tongue in cheek, and frankly I admire the adroitness of their designs. But perhaps it is important to bear in mind one fact. Hedge funds mostly aim at identifying what we call market anomalies (sorry for yet more jargon), for example, the price of a derivative instrument being, in their expert opinion, out of line with that of the underlying financial product, and at taking advantage of those market anomalies. This they do by typically entering into a hedged position involving activities in both the derivative and the underlying markets that bet on the disappearance of those anomalies. As such, their market activity will itself contribute to the narrowing or the disappearance of an identified market anomaly. (Incidentally, this is why hedge funds theoretically stabilise rather than destabilise financial markets.) One question that I have been asking, and perhaps you as investor should also ask, is that if there are more and more hedge funds making these plays, would not the occurrence of market anomalies and so the opportunity for making attractive returns also disappear? After all, the hedge fund industry has grown so much already in recent years. There is keen competition in the industry, to the extent that it is now targeting retail investors as well. Is this not a possible sign of saturation? And there is always the possibility of market anomalies widening in such an uncertain and troubled world.

 

Joseph Yam

13 June 2002

 

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