Explain and critique the role of Hedge Funds in the financial markets and describe their importance as clients of investment banks. Provide five examples of investment strategies used by Hedge Funds.

Introduction

The role that hedge funds play in financial markets around the world has been subject to much debate.

While proponents argue that they help the markets, critics accuse them of contributing greatly to the

global economic recession due to their actions. Irrespective of these arguments, the fact remains that

hedge funds have increasingly been in the spotlight.

This paper aims to shed light on what hedge funds are and to critically analyse their role in financial

markets as well as describe their importance to investment banks. To achieve this, the next section will

introduce hedge funds and analyse their role in the financial markets from a theoretical perspective. The

following section will explain the importance of hedge funds as clients of investment banks and also ways

in which they have influenced these banks. The main criticisms levied against hedge funds will then be

analysed before a brief update on the current position and performance of hedge funds in the wake of the

global economic crisis.

Role of Hedge Funds in Financial Markets

Hedge Funds Defined

Atherton (2007) describes a hedge fund as ‘an investment that aims to make money year in, year out, no

matter what the financial climate (known as an absolute return). Both Atherton and Parkinson (2006)

agree that defining hedge funds is almost impossible as ‘the definition of a hedge fund is imprecise, and

distinctions between hedge funds and other types of funds are increasingly arbitrary’ (Parkinson, 2006).

Atherton (2006) views the difficulty from a different perspective, pointing out that hedge fund is ‘an

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umbrella’ term for a huge range of different investment strategies and risk levels. They are both agreed

that hedge funds’ primary focus is not to maximize wealth but instead to preserve it.

Arbitrage Pricing Theory

The arbitrage pricing theory (APT) will be used to describe the role hedge funds play in financial markets

in theory. APT relies ‘on the idea that there are few fundamental sources of risk in the economy and that

investors will demand compensation in the form of expected returns for bearing these risks’ (Goetzmann

& Ross, 2000, 5). They go on to explain that according to asset pricing theory, ‘when prices deviate too

far from their equilibrium values, astute investors – arbitrageurs looking for bargains – will step in and

buy up the underpriced assets, driving them back to their correct relative values’ (Goetzmann & Ross,

2000, 4). Consequently, hedge fund play a role of driving assets prices to their equilibrium levels in the

financial markets. To explain how this occurs, let us consider the diagram below.

Er

A*

A

M

Rf R (β)

Figure 1: The Arbitrage Effect

Figure 1 above shows a situation where Rf is the risk free asset (let us assume it is government bonds), M

is the market portfolio. The vertical axis shows the expected returns (Er) to be obtained from a given

level of risk, while the risk or exposure as a result of market factors is represented on the horizontal axis

R.

A is a high risk asset which lies with the market portfolio on a straight line, known as the Security Market

Line (SML). The SML ‘shows the risk/return trade-off where risk is measured by beta, that is, only by

the systematic risk element of the individual security’ (McLaney, 2006, 196). When compared with the

market portfolio and the risk free element, A has a higher risk, however, that risk is compensated for by

higher expected returns. However, the question remains as to why A is on the SML instead of

somewhere else on the graph. According to Goetzmann & Ross, this is because ‘hedge funds step in to

take advantage of the mispricing (2000, 7). They go on to state that APT relies on the ability of

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investors to understand the systematic risk of securities and their willingness to uncover and exploit

deviations from a security market line’ (Goetzmann & Ross, 2000, 7). A* in Figure 1 represents what

Goetzmann & Ross call ‘arbitrage in expectations, because a positive profit on the investment is expected

but not guaranteed’ (Goetzmann & Ross, 2000, 7).

Hedge fund managers focus their efforts on spotting A* opportunities which are the deviations from the

SML that APT talk about. A* as can be seen in the diagram has the same level of risk as A but higher

expected returns. Therefore, the more of A* that a hedge fund acquires, the greater the expected profit

from the transaction. Before long other hedge funds and even other types of investors will either spot or

know about the opportunity and invest in security A*. As demand for A* increases, its price will

eventually increase and consequently, its expected return will reduce to equilibrium level A. This is the

point where the hedge fund manager who first spotted the opportunity will cash in by selling the shares at

a profit.

The APT thus ‘argues that the existence, or even the potential existence of hedge fund operators will keep

security prices close to their equilibrium values’ (Goetzmann & Ross, 2000, 8), which means they

perform a very important role in financial markets.

The importance of hedge funds’ role is not lost on Parkinson (2006) who noted that ‘although the role of

hedge funds in the capital markets cannot be precisely quantified, the growing importance of that role is

clear. Total assets under management are usually reported to exceed $1 trillion. The trading volumes of

these funds account for significant shares of total trading volumes in some segments of fixed income,

equity and derivative markets.

Hedge Fund Strategies

Brown (2005) states that there are, give or take, 8000 hedge funds in operation around the world, with the

majority being in the USA. Connecticut and London have become the new big homes for hedge funds.

Friedland (2008) notes that there are around 14 unique investment strategies implemented by hedge funds

with varying degrees and levels of risk and return. Let us look at five of these.

Convertible Arbitrage

Investopedia (n.d.) describes convertible arbitrage as ‘an investment strategy that involves the long

position on a convertible security and short position in its converting common stock’. The convertible

arbitrage strategy is designed to exploit opportunities for profit where there is mispricing (as in Figure 1)

of the convertible security as opposed to the converting underlying stock. Convertible arbitrage contains

very low risk (Scharfman, 2009).

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Risk Arbitrage

This strategy involves the purchase of shares of companies that are subject to merger or takeover

speculation (targets), especially ones of the hostile variety, while taking up short positions in the potential

acquirer (Stefanini, 2006). Hedge fund managers expect to exploit profit opportunities through

speculation and disciplined risk management. The risk is considered to be moderate in this strategy.

Long/Short Equity

McFall Lamm (2004, 3), describe long/short hedge fund managers as ‘those who hold a long equity

portfolio offset by a portfolio short equity holdings. The short portfolio serves as a hedge against market

declines but also provides an opportunity for managers to add value by selecting stocks more likely to

underperform the market’. The emphasis is more on the long than the short portfolio as usually, the

former is greater than the latter. This strategy however comes at very high risk (McCullough & Blake,

2009).

Managed Futures

This strategy involves both long and short positions being assumed in futures contracts, fixed income

securities and options on futures contracts. It is low risk and they are run by regulated Commodity

Trading Advisors (CTAs).

Global Macro

Nicholas (2006, 1) describes the Global Macro strategy as an approach to investment which ‘attempts to

generate outsized positive returns by making leveraged bets on price movements in equity, currency,

interest rates and commodity markets’. The strategy is global as it involves positions being taking in any

markets or instruments, especially those with limited downside risk (Nicholas, 2006). Nicholas (2006, 1)

also states that ‘the macro part of the name derives from managers’ attempts to use macroeconomic

principles to identify dislocations in asset prices.

Importance of Hedge Funds to Investment Banks

The importance of hedge funds to investment banks is two-fold. Firstly, they represent a profitable client

segment. Secondly, the implementation of hedge fund strategies by investment banks has considerably

strengthened their performances.

According to Wilson & Walker (2009), ‘hedge funds remain the single most important investor group for

investment banks, contributing nearly a third of overall equities revenues, with assets predicted to grow a

further 10 percent this year’. Commenting on a research undertaken by Morgan Stanley, they also noted

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that ‘hedge funds provided up to 40% of capital raised by US and European banks’. Morgan Stanley

also forecasted that ‘hedge fund assets will grow by 10% to $1.6 trillion by the end of the year and could

reach $2 trillion by the end of 2010 if its most optimistic predictions come true’ (Wilson & Walker). The

latter prediction seems ever more likely when it is considered that in the latter part of 2009, assets reached

$1.8 trillion (Armistead, 2010). Banks like Barclays and Credit Suisse have benefitted from these strong

hedge fund performances, pocketing considerable fees for services rendered like prime brokerage.

Not only have hedge fund managers contributed positively to the income of investment banks, the latter

have learned the nature of the business and have horizontally integrated into the business of hedge fund

trading.

The table below serves a dual purpose. It shows what the top hedge funds asset positions are and also

highlights how significantly investment banks have entered into the business.

Rank Hedge Fund Capital($ millions)

1 Bridgewater Associates 38600

2 JP Morgan Asset Manager 32893

3 Paulson & Co 29000

4 D.E. Shaw & Co 28600

5 Brevan Howard Asset Mgt 26840

6 Man Investments 24400

7 Och-Ziff Capital Mgt Group 22100

8 Soros Fund Mgt 21000

9 Goldman Sachs Asset Mgt 20585

10 Farallon Capital Mgt 20000

10 Renaissance Technologies 20000

Table 1: Top 10 Hedge Funds Source: Marketwire

Table 2 shows the top 10 Hedge Funds in 2009, taken from the top 100 list published by Alpha Magazine.

It shows Bridgewater Associates top. Interestingly, it also shows that two investment banks made the top

10 list, i.e. JP Morgan ranked second and Goldman Sachs ranked ninth. A year before JP Morgan had

been the top hedge fund.

Criticisms of Hedge Funds

Hedge funds have consistently come under criticism from some quarters. For one, they say hedge funds

‘exacerbate the problems of stock price volatility and ‘short-termism’, while campaigners also fear the

effects private equity firms may have on corporate responsibility’ (Ethical Corporation, n.d.). Kanter

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(2010) also reports on the suspicions being raised by European politicians that the hedge funds were

partly to blame for the Greece economic crisis as a result of them betting on whether or not the ailing

economy would be bailed out. Stromqvist (2009) also stated that the criticism of hedge funds had

‘largely been that a highly leveraged hedge fund or group of hedge funds could have a strong impact on

prices on the financial markets by launching speculative attacks on certain companies, sectors or

currencies’. The situation, according to the critics could become worse due to herd behavior as other

investors follow suit.

Finally, hedge funds come under fire for allegedly causing financial bubbles, which occurs, ‘when the

price that market players pay for a financial asset, for example shares or properties exceeds the value that

the asset has in terms of the income that it can realistically be expected to generate’ (Stromqvist ; 2009,

2).

The disgruntlement in Europe has led to disagreement between the European and the US with the UK

seemingly caught in the middle. European finance ministers met in March 2010 to consider proposals

which will mandate hedge funds to make disclosures with regards to their trades and debts, thereby

ensuring that any risk to the financial system may be identified and managed. Another radical rule from

the perspective of hedge funds would be their requirement to disclose their trading strategies should the

proposals be accepted. Only Britain was against the proposals and for good reason. Currently, 80% of

European hedge funds are based in the UK (Armistead, 2010) and the fear is these new rules will make

investors shy away from the European market (which effectively means the UK) in favour of other

regions where more relaxed rules are in existence. London is especially concerned that ‘hedge funds with

money held in accounts outside the EU will be treated different from hedge funds with money inside the

27 country bloc’ (Kanter, 2010).

While London’s concerns are valid it is worth noting that hedge funds will operate wherever they can

preserve their funds' and clients' wealth and as long as that remains the case in Europe, the rules may not

have the negative impact as some suggest. On the other side of the argument, the perception of hedge

funds is that they are all very risky and involve highly speculative actions which cause financial system

instability. However, as was shown on the five examples given above on hedge fund strategies, the risks

vary from strategy to strategy. Furthermore, less than 5% of hedge funds implement the most volatile of

the strategies, i.e. the Global Macro (Scharfman, 2009)

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Recovery of Hedge Funds

Notwithstanding the negative press hedge funds received at the early stages of the current economic

malaise (admittedly, they are still getting it in some quarters), it is increasingly being accepted that hedge

funds were more victims of the downturn than antagonists. Therefore, the blame for the economic crisis

must surely be placed elsewhere. The table and graph below shows data on absolute return for the five

different hedge fund strategies explained above.

 Strategy

Jan-10

(%)

Feb-

10(%) YTD (%)

Convertible and Equity Arbitrage 0.46 0.23 0.69

Managed Futures -1.6 0.57 -1.03

Macro 0.14 0.18 0.32

Global Equity -0.03 0.43 0.4

Composite 0.06 0.65 0.71

Table 2: Absolute Return (%) Source: http://www.absolutereturn-alpha.com/Investment-Performance-Index-Performance.html

Table 2 shows that the different investment strategies yield different returns. This buttresses the point

that hedge funds should not be badged together. The graph below highlights the upturn from the ill-effect

of the global economic crisis.

Figure 2: Composite Absolute Returns Source:

http://www.absolutereturn-alpha.com/Investment-Performance-Index-Performance.html

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Conclusion

This paper has explained through the Arbitrage Pricing Theory the important role played by hedge funds

in financial markets. It has also shown how as clients they have contributed to the profitability of

investment banks while they have also become competitors as investment banks have entered into the

trading, with some maintaining dominant positions.

While some of the criticisms of hedge funds seem valid, there is not substantive evidence that it

contributed to the current economic downturn as believed in some quarters. Consequently, the move by

the EU to set rules aimed at regulating hedge funds is raising concerns that the European markets will

lose business. As hedge funds recover from bad performance and publicity, the scene is set for them to

resume their role of driving equilibrium in the financial markets.

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