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Hedge Fund Growth Squeezing Trading Opportunities

by Phillip Morton, Investors Offshore.com

07 October 2004

Research by investment bank JP Morgan has found that the rapid growth in hedge funds has helped to nullify many investment strategies that have been traditionally a good source of trading returns, whilst new opportunities have opened up other markets and strategies.

Although the report observed that hedge funds account for a fraction of assets under management in global terms, high rates of leverage and turnover mean hedge funds may be involved in up to a third of all trades in certain markets.

Nevertheless, with so many traders seeking the same opportunities in the same markets, this is having a neutralising effect on many strategies, especially those involving arbitrage trades, the authors noted. Examples include strategies such as convertible bond arbitrage and cross-market spread trading where traders seek to profit from brief market inefficiencies.

However, the report also identified four areas where opportunities are now at their greatest, including:

  • Bonds rated just below investment grade, as fund managers limited to buying investment grade bonds are forced to sell when bonds are downgraded from triple B, thus forcing down the price and pushing up the yield curve.
  • Bonds that are 12 months away from maturity. These drop out of the bond indices and are sold by many investors whilst remaining too long term for many fund managers.
  • The foreign exchange markets, as the global market place is simply too big to be influenced by most individual hedge funds.
  • Inflation-linked bonds, as these are a relatively new instrument and a lack of liquidity often throws up mis-pricing opportunities.
The report’s authors emphasised that the proprietary trading desks of investment banks and finance houses adopt similar strategies to hedge funds, and the drying up of profitable opportunities cannot be laid wholly at the door of hedge funds.

However, the report considers the current situation as a temporary phenomenon, and the authors forecast that new trading opportunities will re-emerge later this year or next year.

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