Should we outlaw Hedgefunds?

A couple of weeks back I wittnessed a discussion meeting here at QUT on whether Hedgefunds should be outlawed, or at least heavily regulated. The main speaker was Dr. Robert Bianci who has sent a large part of his PhD degree on the functioning of Hedgefunds. The PowerPoint slides of the discussion meeting can be found here.

The background to this presentation was the recent unrest on the financial markets and the belief in some quarters that overly risky investments (such as the infamous sub-prime lending ni the US mortgage markets) have contributed to this volatility. What gave this position some currency is the following quote from the European Central Bank (dug ug by Chris Coleman-Fenn):
“… the increasingly similar positioning of individual hedge funds within broad hedge fund investment strategies is another major risk for financial stability which warrants close monitoring despite the essential lack of any possible remedies. This risk is further magnified by evidence that broad hedge fund investment strategies have also become increasingly correlated, thereby further increasing the potential adverse effects of disorderly exits from crowded trades.”

This raises the spectre of regulation down the line and the main question of the meeting was whether this was really warranted and if so, what could be done.

An important part of the presentation was to hear what hedgefnuds actually were because I certainly didnt have a good feel for what they were before the meeting. There are various vague definitions in usage, such as the following 2003 definition of the Australian Prudential Regulation Authority :

Although the term is widely used, there is no clear definition of what constitutes a hedge fund. For the purposes of this article, hedge funds are regarded as funds that have some of the following characteristics, (i) funds that rely heavily on a single strategy, with broad delegations for the use of gearing and derivatives, (ii) funds that have a reliance upon a single individual to execute the investment management process, (iii) a relatively short trading history; and/or (iv) target an absolute return rather than a benchmark return

Dr. Robert Bianci explained hedgefunds to be, in the generic case, investment funds with particularly big clients (money lenders) who as such were subject to less rules than banks. The main difference in behaviour is that hedgefunds borrow much more than they have in terms of own assets from clients, i.e. they sometimes have outstanding obligations up to 2000 times the amount of own money. This contrasts to banks who are bound to have a minimal amount of capital as collateral against their borrowing. Hedgefunds thereby run much more risk of bankrupcy than banks. Robert argued the European central bank was getting quite nervous about hedgefunds and was considering limiting their activies, especially given the recent volatility of the sharemarkets due to bad loans on the mortgage market. Alex Stanley argued that no extra regulations were required for hedgefunds because their investors and business partners were all ‘big boys’ who knew what they were doing. Chris Coleman-Fenn on the other hand argued that hedgefunds should also have some minimal capital requirement or at least needed to be forced to disclose more about their activities. The market imperfections Chris hypothesised to exist were both the severe asymmetric information between the hedgefunds and their clients (whereby a hedgefund manager did not have full incentives in the sense of not suffering personally from huge losses), as well as the possibility that the large amount of additional borrowing hedgefunds engage in would be able to lead to contagion phenomenon on markets generally (stampedes). The lack of disclosure in the current system made a proper assessment of this volatility-risk potentially caused by hedgefunds hard to assess.

I personally found the observation that hedgefunds were mainly funded by big investors a fairly compelling reason not to worry too much about their activities. There are good arguments to protect small investors from the chinanicans of the big boys, but consenting well-informed adults should be able to do whatever they want to each other. I concede the possibility that hedge funds would be part of a stampede (contagion) but cant really see how their very existence changes the possibility of stampedes.

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Andrew Reynolds
14 years ago

Well said.
The other thing that often gets missed, though, is how they help the markets generally – a large part of the trading that gets done day by day on the markets is by these hedge funds. The amount of liquidity they bring narrows trading spreads enormously, reducing trading costs for everyone buying and selling on the markets – like the super funds we all have money in.
By also short selling they hasten adjustment process as well – so if the market or a currency is heading south they get it there quickly, allowing a price to be re-established before panic sets in.

Jc
Jc
14 years ago

What Andrew said and double it.
You have to be a seasoned investor in most hedge funds before they touch you, which means you have to be counted as a professional who knows the risks involved.

There are thousands of funds around the world that can be described as hedge funds and there are about 1,000 that die each year due to bad performance.

The ones that got clobbered this year as a result of the debt mess are not the funds people expected were at risk. they were for the the most part supposed to be “safe”. They bought securities such a shome mortgages etc. that does impact the pricing of debt to the man on the street.

The also do great things. they sponsor firms by adding extra cash with the hope of taking them public and terrorise bad managements by getting them fired. The final clean up of the mess which is Coles was primarily instigated by hedge funds of a sort.

If an activity has a positive rate of return, is legal it is by definiton a plus to the economy as a whole.

observa
observa
14 years ago

And it only takes one good shakeout for their flavour of the month status to dissolve, thereby resolving any perceived larger problem. Furthermore, just when did regulators like APRA ever have a role, other than to show up after the event and commiserate with the punter about where his hard-earned went and why. Taxpayer funded mourners are certainly not my cup of tea.

David Rubie
David Rubie
14 years ago

Looking at the fallout from the debt crisis, it certainly seems that they don’t add to any stampedes, but they do make them (mercifully) shorter. Any extra liquidity is a good thing – especially where it replaces the rubbish fake liquidity provided by market makers on traditional exchanges. You can quibble over their management structures and the fees they extract from the (so called) professional investors, but that’s a consenting adults thing and probably shouldn’t be subject to anything. Usually the massive management fees end up in a shareholder dividend somewhere anyway.

However, when we see them trumpeted by cabbies or flogged on late night channel 10 as a get-rich-quick scheme for leveraged mums and dads, I’d get worried. Most of the silliness should really be education rather than regulation though, but getting somebody to caution people what to do with their money is so unfashionable I wonder who will do it.

Mark U
Mark U
14 years ago

Not sure about hedge funds, but perhaps we should outlaw Powerpoint.

observa
observa
14 years ago

The simple rules of investment should be drummed into kids when they’re knee high to a grasshopper-
1. The greater the return the higher the risk
2. Don’t put all your eggs in one basket
3. If anyone tells you they’ve got a dead cert, they’re lying unless they’re talking to you on the Riviera with their feet in a bucket of champers. Besides why would they tell you and share the champers.
4. If a bloke from the Govt reckons he’s from the regulator, you should trust him he’s here to help, then he’s a professional mourner paid for with your taxes.

Paul Frijters
Paul Frijters
14 years ago

Observa,

agree on point 1-3 but not entirely on point 4. Modern financial markets involve complicated anonymous interactions in a situation where asymmetric information does exist. That kind of thing does not work well without a high degree of trust that the asymmetric information is not abused, a trust that is ultimately enforced by sophisticated monitors and regulators. Financial markets can be so developed BECAUSE they are regulated and monitored, not despite of this. The question was whether hedge funds needed more regulation and by and large I veer to the ‘no’ camp on that one, but I’d not go so far as to disapprove of market regulation entirely which should be regarded as the police in a crowded market: not there to spoil the fun but to scare away the crooks. Sure, there’s an optimum police presence, but its not zero.

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
14 years ago

Well put Paul. Problem is Hedgies are a global phenomenon.