2009

SAGAR TANEJA
081411287
Contents

Role of Hedge Funds in the development of current financial crisis ........................................ 3

Problems associated with hedge funds:

1. Unregulated ......................................................................................................................... 3
2. Highly leveraged .................................................................................................................. 3
3. Lack transparency ................................................................................................................ 4
4. Illiquid .................................................................................................................................. 4
5. Causes global instability ...................................................................................................... 4
Impact of current financial crisis on Hedge Funds’ performance and potential implications of
this crisis ............................................................................................................................... 6

Future outlook of the Hedge Fund industry and how Hedge Funds are adapting their existing
business models ................................................................................................................... 7

Conclusion............................................................................................................................. 8

References ............................................................................................................................ 9

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Hedge funds are unregulated private investment funds open only to a limited number of people
(wealthy investors). Hedge funds are more flexible in their investment activities and can carry out more
complex trading strategies than other funds. Many analysts have stated that hedge funds are basically
mutual funds for the wealthy.

The minimum initial investment required to invest in a hedge fund is very huge.

Hedge funds basically hedge the investment risks by using a variety of methods such as long, short and
derivative positions, leverage etc.

Role of Hedge Funds in the development of current financial crisis

The more liberal investment rules that govern hedge funds and its flexibility can have negative effects
on financial markets.

Problems associated with hedge funds:

1. Unregulated

As hedge funds are sold only to heavy investors, they do not have to register with the Securities and
Exchange Commission.

Deregulation gives the investment mangers more freedom and they can take decisions on a purely
commercial basis. Unregulated hedge funds may always carry undisclosed structural risks.

Over the years, hedge fund managers with a view to increase returns have adopted different strategies.
Due to this, hedging methods such as short selling have tend to increase rather than decrease the risk. In
fact, because hedge fund managers make speculative investments, these funds can carry more risk than
the overall market.

2. Highly leveraged

Hedge funds are allowed to take more degree of leverage. Leverage always increases the risk. Investors
invest with borrowed money with the expectation of making huge profits but it can always have the
opposite consequences.

The reasons for the failure of hedge funds were the same as for any other investment products.

When the U.S. housing market was booming, most of the investment companies were investing in it as it
was the most profitable sector during that time. Mutual funds and hedge fund companies had invested
considerably in the housing market and some of it was with borrowed money.

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The entire course of action was based upon the fact there was a constant demand for houses.

When the housing market collapsed, it took down all the investors with it. Investors with leverage
suffered the most.

One example is from the beginning of 2007 when Bear Sterns’ hedge funds collapsed. These funds had
highly leveraged portfolios with credit instruments related to the US market for housing bonds
(subprime).

3. Lack transparency

Another problem is that it difficult to determine the contribution of hedge funds towards the financial
crisis. Hedge funds are not transparent entities. Their trading activities are not disclosed publicly.
Investors are not aware how much money they hold and how much leveraged they are.

4. Illiquid

Hedge funds are considered illiquid as they often require investors keep their money in the fund for at
least one year.

Richard Marston, a finance professor at University Of Wharton quoted that "Preventing investors from
redeeming their assets when many are desperate for cash will permanently alienate some of them."

5. Causes global instability

Critics of hedge funds state that hedge funds can cause instability in an economy of a country by
speculating against its currency.

Dr. Mahathir Bin Mohamad, the former Prime Minister of Malaysia have stated that “ hedge funds can
destroy the economies of poor countries by manipulating their national currencies. We are now
witnessing how damaging the trading of money can be to the economies of some countries and their
currencies.”

Market analysts have different opinions about how much the hedge funds contributed to the
financial crisis.

Hedge funds have grown significantly over the last 10 years. Some analysts state that although the
hedge fund industry isn’t as big as the mutual fund industry, hedge funds operate with huge sums of
money and hence can’t be overlooked.

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According to this graph the share of hedge funds as compared to other funds is quite low.

The largest hedge fund in the world is JP Morgan Asset Management, which had a managed capital of
USD 45 billion at the end of 2007. This is only a few per cent of the capital managed by the world’s
largest fund companies and pension companies. It is therefore reasonable to assume that the influence
of individual hedge funds on entire markets is limited.

Analysts argue it isn’t really about assets under management, but leverage the funds can take up.

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Impact of current financial crisis on Hedge Funds’ performance and
potential implications of this crisis

According to many theorists, the financial crisis has affected the hedge funds’ industry quite badly.

According to Barclay’s database on hedge funds, as many as eighty nine per cent of the hedge funds in
the database had a negative return in September 2008.

The above graph shows how the return for hedge funds declined over the months.

Hedge Fund Research shows that more than 275 funds of hedge funds were liquidated in 2008. The total
number of liquidations was 1,471 in 2008 compared to 848 liquidations in 2005 indicating a 70 per cent
increase.

In September 2008, the Securities and Exchange Commission imposed a ban on short selling as it was
believed that the practice had been used to accelerate falls in share prices, especially in financial
companies.

The ban on short selling had a negative effect on hedge funds. Richard J. Herring a finance professor at
University Of Wharton said that "With the ban on short selling, the liquidity in several markets simply
dried up."

Three weeks later the ban was removed as it was found to be not useful.

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In 2001, many hedge funds adopted a policy of diversifying their portfolios. They included property and
commodities in their portfolios and they made huge profits. When the financial crisis took place,
investors sold their assets to reduce borrowing in their portfolio. This led the prices of all assets
including property to decline causing a negative effect of diversification.

Usually, when hedge funds assume any risk (credit, duration risk, liquidity risk) they receive a premium.
A large part of the hedge funds’ profits make these risk premiums. However in this crisis, risk taking has
not led to high profits. Instead the crisis has been so damaging to the market wiped out all of the profits
previously gained from these premiums. The increased risk premiums have simply not compensated for
the losses made.

According to Thomson Reuters there has been a 30% decline in industry assets. The negative
performance of hedge fund managers led many investors to exit the industry.

Future outlook of the Hedge Fund industry and how Hedge Funds are
adapting their existing business models

The good thing about hedge funds is that even in situations like the financial crisis, hedge funds can
make profits.

Market analysts say that investors can make use of this situation. The current environment is ideal for
investing and trading in hedge funds.

Even in the past hedge funds have been able to exploit and benefit from situations like these. This is due
to the hedge funds managers’ ability to identify and opportunistically take advantage of dislocations in
the market through long and short positions.

This is evident from the fact that HFR's Fund Weighted Index had positive performance of more than 12
per cent for the first seven months in 2009

This turmoil has presented many opportunities for investors despite the fact that the assets of both
investors and money managers have reduced.

 The reduction in the size of the hedge fund industry as a result of the financial crisis, means that
fewer managers and less assets are left to profit from these opportunities.

 With a decrease in competition, wider spreads and opportunities would be created for hedge
fund managers to exploit.

 The dispersion of returns among managers and hedge fund strategies has increased resulting in
greater diversification benefit for investors in hedge funds.

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  Volatility is high in global equity markets in 2009 despite economic recovery. Hedge fund
managers can profit from high volatility in equity markets with the trading systems to take
advantage of the volatility. Managers who are skilled in security selection can profit from lower
equity valuations that accompany the decline in equity prices

In order to attract customers to the market, many hedge fund managers are offering investors
incentives and concessions

Many funds have cut their fees from the standard 2% of assets managed and 20% of profits to keep
investors. Some funds have waived the 20% part. Others have reduced the fees of the fund manager
from 2% to 1%.

Other incentives include:

 More transparency

 Tighter terms in the offering memorandum

 More favourable liquidity terms through improved liquidity share classes or other fund
structures (such as UCITS, as well as a more accurate match between assets and liabilities.)

Conclusion

Although it is clear that hedge funds had a very small role to play in the financial crisis, reforms need to
be taken.

Investors, regulators and the common public have criticized the way how hedge funds operate.

Hedge funds had a role to play in the development of previous crises like the Long Term Capital
Management Crisis and the IT Crisis. Economists and market analysts fear that hedge funds might be the
sole reason for the next crisis.

Economists state that secrecy cannot be tolerated in the market anymore.

Investors have demanded that hedge funds should be regulated at least to some extent. Market analysts
have argued that hedge funds need to provide investors with more information regarding their
activities. Some amount of transparency is required. Investors have also demanded that funds should
loosen their withdrawal rules.

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REFERENCES :

www.wikipedia.com

www.investopedia.com

http://www.researchrecap.com/index.php/2007/12/21/role-of-hedge-funds-in-subprime-crisis-
examined/

http://www.washingtonpost.com/wp-dyn/content/article/2008/10/24/AR2008102403485.html

http://www.hedgefundlawblog.com/obama-on-financial-reform.html

http://www.reuters.com/article/reutersEdge/idUSTRE5315J420090402

http://knowledge.wharton.upenn.edu/article.cfm?articleid=2185#

http://www.sadec.com/Report/r1003.html

http://www.business24-
7.ae/Articles/2009/9/Pages/13092009/09142009_06e1e1cb088e49078bba94f5dbfbd02a.aspx

http://www.rgemonitor.com/financemarkets-
monitor/254088/the_role_of_hedge_funds_in_financial_crisis

http://www.riksbank.com

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