By Michael Wallace
Since the "bubble" years leading up to 2000, the use of leverage by hedge funds -- borrowing money and employing derivatives to boost returns -- has subsided. But the industry itself has seen robust growth, with both the number of funds and total assets under management having increased dramatically.
Should that be a cause for concern? Federal Reserve Chairman Alan Greenspan often says hedging through the use of derivatives and other financial instruments has benefited the economy by spreading risk among a greater number of institutions. Indeed, a convergence of cyclical, systemic, and regulatory trends suggests that continued growth in hedge funds poses no immediate risk to the U.S. economy and markets. However, an external shock would warrant vigilance.
One assumption prevalent among the media and "real money" (i.e., nonleveraged) fund communities states that sharply higher U.S. bond yields could raise the cost of leverage. That, in turn, could mean a credit crisis and a shakeout among hedge funds -- similar to the troubles precipitated by the meltdown of Long Term Capital Management in 1998. The idea is that the Fed could inadvertently trigger such a meltdown by continuing to hike rates, eliminating the "easy money" that has aided the growth of the hedge funds.
As do the worries about a housing "bubble" that have spread (see BW Cover Story, 4/11/05, "After the Housing Boom"), the calamity camp's argument contains some kernels of truth but tends to overgeneralize the leverage situation. A January, 2005, Fed working paper, "Econometric Tests of Asset Price Bubbles: Taking Stock", concluded that "for almost every paper in the literature that 'finds' a bubble, there is another one that relaxed some assumption on the fundamentals and fits the data equally well without resorting to a bubble."
Contrary to popular belief, hedge funds don't make returns just by taking short positions (i.e., using borrowed securities to bet on a price decline) against a particular asset class. Instead, the hedges deploy a vast arsenal of approaches: short positions, long positions (bets on a price increase of a particular asset), long-short, neutral, directional, event-driven, multistrategy, equity, bond, global macro, commodity, and others. Although hedge funds aren't subject to the same disclosure and regulatory requirements as other funds, many participate in surveys that highlight their high returns. Thus, most available information about the funds is extrapolated from these.
The Hedge Funds Research (HFR) database, which covers up to a third of the industry in a survey, found that by 2004, the number of funds it reviews had grown nearly fivefold, to 3,671, over an eight-year period. That compares to overall industry estimates of 8,000 to 10,000 worldwide and 6,000 to 7,000 based in the U.S., according to the Securities & Exchange Commission. Assets under management grew more than sixfold, to $327.7 billion, over the same period, according to the HFR's smaller survey sample, which aligns with $600 billion to $1 trillion in assets estimated in a report from the Bank for International Settlements (BIS).
Similarly, Tremont Capital Management estimates that hedge funds have $975 billion in assets under management. In its latest asset flow report, Tremont reported that in 2004 leveraged funds enjoyed a record $123 billion in net inflows, up from $72.2 billion in 2003. But heading into last year's fourth quarter, the pace slowed amid unexpectedly low volatility in stocks and bonds, which hurt fund performance. In the fourth quarter net assets rose only $16.3 billion. Hedge funds' profitability evidently correlates more closely with market volatility than with interest rate moves.
The BIS conceded that increased use of leverage can boost both returns and risk for hedge-fund investors and their counterparties, but lack of disclosure muddies precise risk/return measures. The study found that, despite employing a disparate array of strategies in a variety of fund "families," hedge funds tend to have similar risk exposures. Leverage is achieved not only through traditional borrowing from financial institutions but also via the prevalent use of derivatives. And yet, based on a regression analysis of excess returns on equity investments by hedge funds, the BIS concluded that the degree of leverage employed was at its highest in late 1997 and early 1998 and has steadily decreased over the past few years.
The quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices from the Fed's board of governors, last published in January, takes a comprehensive look at the overall lending climate in the U.S. While it contains no specific reference to hedge-fund borrowing, it offers insight into the environment since the Fed embarked on raising rates last summer.
The Fed reported that both domestic and foreign banks eased their lending standards, tightening yield spreads, loosening restrictions, reducing costs, lengthening terms, and increasing maximum loan size. This relaxation has come in response to increased competition from nonbank lenders, greater depth of secondary markets, and "a less uncertain economic environment."
The report suggests that the impact of Fed policy has been far from restrictive and that further "measured" rate hikes will have a similarly benign impact on issuance of credit unless monetary policy moves well beyond a "neutral" stance. Moreover, this crossover from tight to easy credit is comparatively youthful in cyclical terms -- since the start of 2004. The most recent similar loose-money era ran from 1992 to 1998.
Source: Fed Quarterly Senior Loan Officer Survey, January 2005
It appears, then, that hedge funds are less likely to face a credit crunch in this tightening cycle. But that won't keep them from coming under the microscope. Their proliferation, the growth in assets under their management, their increasing availability to lower-net-worth investors, and rising instances of fraud have prompted the SEC to propose a rule calling for registration of certain hedge-fund advisers. Somehow, hedge funds have managed to slip through the "private adviser exemption" to the Investment Advisers Act of 1940. By advising only institutions and wealthy individuals, they escape SEC registration or oversight, which the agency proposes to redress.
The SEC is seeking to place hedge funds within its oversight to protect individual investors as well as the masses who could be affected -- albeit indirectly -- by systemic crises sparked by fund-trading activities. The specialized industry is resisting the loss of privacy, increased costs of regulation and enforcement, and potential migration of private capital to unregulated overseas competition. The SEC claims that increased enforcement would only boost industry credibility and homegrown capital formation. The gradual rise in rates from historically low levels has apparently not impeded hedge funds' growth or use of leverage. And their exposure to rising rates doesn't seem to pose any major risk to the financial system.
Yet in the wake of the LTCM collapse, corporate governance scandals, and after-hours trading schemes in the mutual-fund industry, the call for greater public accountability among these "private" funds to protect U.S. market viability is understandable. As hedge funds grow in prominence -- and influence -- they may have to get used to the attention.
Wallace is global market strategist for Action Economics