Hedge Funds

Hedge funds are a special type of mutual fund, with estimated assets of more than $1 trillion. Hedge funds have received considerable attention recently due to the shock to the financial system resulting from the near collapse of Long-Term Capital Management, once one of the most important hedge funds (see the FYI box, "The Long-Term Capital Management Debacle"). Well-known hedge funds include Moore Capital Management and the Quantum Group of funds associated with George Soros. Like mutual funds, hedge funds accumulate money from many people and invest on their behalf, but several features distinguish them from traditional mutual funds. Hedge funds have a minimum investment requirement between $100,000 and $20 million, with the typical minimum investment being $1 million. Long-Term Capital Management required a $10 million minimum investment. Federal law limits hedge funds to have no more than 99 investors (limited partners) who must have steady annual incomes of $200,000 or more or a net worth of $1 million, excluding their homes. These restrictions are aimed at allowing hedge funds to be largely unregulated, on the theory that the rich can look out for themselves. Many of the 4,000 hedge funds are located offshore to escape regulatory restrictions.

Hedge funds also differ from traditional mutual funds in that they usually require that investors commit their money for long periods of time, often several years. The purpose of this requirement is to give managers breathing room to pursue long-run strategies. Hedge funds also typically charge large fees to investors. The typical fund

FYI. The Long-Term Capital Management Debacle

Long-Term Capital Management (LTCM) was a hedge fund with a star cast of managers, including 25 PhDs, two Nobel Prize winners in economics (Myron Scholes and Robert Merton), a former vice-chairman of the Federal Reserve System (David Mullins), and one of Wall Street's most successful bond traders (John Meriwether). It made headlines in September 1998 because its near-collapse roiled markets and required a private rescue plan organized by the Federal Reserve Bank of New York.

The experience of Long-Term Capital demonstrates that hedge funds are far from risk-free, despite their use of market-neutral strategies. Long-Term Capital got into difficulties when it thought that the spread between prices on long-term Treasury bonds and long-term corporate bonds was too high, and bet that this "anomaly" would disappear and the spread would narrow. In the wake of the collapse of the Russian financial system in August 1998, investors increased their assessment of the riskiness of corporate securities and, as we saw in Chapter 6, the spread between corporates and Treasuries rose rather than narrowed as Long-Term Capital had predicted. The result was that Long-Term Capital took big losses on its positions, eating up much of its equity position.

By mid-September, Long-Term Capital was unable to raise sufficient funds to meet the demands of its creditors. With Long-Term Capital facing the potential need to liquidate its portfolio of $80 billion in securities and more than $1 trillion of notional value in derivatives, the Federal Reserve Bank of New York stepped in on September 23 and organized a rescue plan with Long-Term Capital's creditors. The Fed's rationale for stepping in was that a sudden liquidation of Long-Term Capital's portfolio would create unacceptable systemic risk. Tens of billions of dollars of illiquid securities would be dumped on an already jittery market, causing potentially huge losses to numerous lenders and other institutions. The rescue plan required creditors, banks, and investment banks to supply an additional $3.6 billion of funds to Long-Term Capital in exchange for much tighter management control of funds and a 90% reduction in the managers' equity stake. In the middle of 1999, John Meriwether began to wind down the fund's operations.

Even though no public funds were expended, the Fed's involvement in organizing the rescue of Long-Term Capital was highly controversial. Some critics argue that the Fed intervention increased moral hazard by weakening discipline imposed by the market on fund managers because future Fed interventions of this type would be expected. Others think that the Fed's action was necessary to prevent a major shock to the financial system that could have provoked a financial crisis. The debate on whether the Fed should have intervened is likely to go on for some time.

charges a 1% annual fee on the assets it manages plus 20% of profits, and some charge significantly more. Long-Term Capital, for example, charged investors a 2% asset management fee and took 25% of the profits.

The term hedge fund is highly misleading, because the word "hedge" typically indicates strategies to avoid risk. As the near-failure of Long-Term Capital illustrates, despite their name, these funds can and do take big risks. Many hedge funds engage in what are called "market-neutral" strategies where they buy a security, such as a bond, that seems cheap and sell an equivalent amount of a similar security that appears to be overvalued. If interest rates as a whole go up or down, the fund is hedged, because the decline in value of one security is matched by the rise in value of the other. However, the fund is speculating on whether the spread between the price on the two securities moves in the direction predicted by the fund managers. If the fund bets wrong, it can lose a lot of money, particularly if it has leveraged up its positions—that is, has borrowed heavily against these positions so that its equity stake is small relative to the size of its portfolio. When Long-Term Capital was rescued, it had a leverage ratio of 50 to 1; that is, its assets were 50 times larger than its equity, and even before it got into trouble, it was leveraged 20 to 1.

In the wake of the near collapse of Long-Term Capital, many U.S. politicians called for regulation of these funds, and the SEC has put in a new rule that hedge funds will have to register with the agency. However, because many of these funds operate offshore in places like the Cayman Islands and are outside of U.S. jurisdiction, they would be extremely difficult to regulate. What U.S. regulators can do is ensure that U.S. banks and investment banks have clear guidelines on the amount of lending they can provide to hedge funds and require that these institutions get the appropriate amount of disclosure from hedge funds as to the riskiness of their positions.

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