Hedge Funds Gain Popularity, But There Are Risks

Caroline Maxwell, Investors Offshore.com

22 February 2001

Hedge funds, it seems, are no longer the exclusive domain of the super-rich. These funds, which provide diversification, and reduce risk by investing in niche areas, or by shorting stocks, performed exceptionally well last year, with the average hedge fund up 8%, and those which took advantage of the volatile market conditions by shorting tech stocks returning an average of 30%.

Hedge funds are usually limited by law to 100 investors, and unlike mutual funds, tend to require a lock-period of between one and three years. In the past, the minimum investment was likely to be not less than $1 million, but as the hedge fund bandwagon slows to allow brokers and individual investors to jump on, this has greatly reduced, in some cases to around $100,000, or even $10,000 for hedge funds structured more like mutual funds.

The influx of institutional money received by hedge funds of recent times, in combination with the increasing interest shown by individual investors have meant that financial service companies are climbing over each other to get in on the act, offering funds of hedge funds, taking equity positions in them, and in some cases, setting up their own hedge funds. As Michael Ocrant, editor at MAR/Hedge observes: 'Hedge funds really delivered, so you've got a lot of money flowing in and incredible interest being shown.'

However, there are down-sides to hedge fund investing. The amount of leverage often used by the funds can lead to escalating losses if the manager bets wrong, and the lock-up period means that it is difficult for investors to withdraw from a fund that is clearly in trouble. Lack of regulation also increases the risk of fraud, which is an issue being addressed more and more, as individuals and institutions get in on the act, prompting fears that hedge funds may eventually end up as nothing more than expensive mutual funds. There are also concerns that increased regulation could harm the hedge fund industry in other ways.

Regulators working on the proposed new Basel Capital Accord hope to introduce legislation requiring more disclosure of risks by banks and their clients, and demanding the use of risk controls which would force leveraged bank clients (such as hedge funds) to sell assets when prices fall. These measures, if implemented, instead of increasing stability, could have exactly the opposite effect.

Avinash D. Persaud, the managing director of global research for the Boston based State Street Bank, fears that too much disclosure could be harmful, as if lenders know that a hedge fund needs to sell something quickly, they will sell the same asset, driving prices down even lower. Mr Persaud also feels that the 'value at risk' systems required by Basel II (Son of Basel…!) strike at the very heart of hedge fund strategy. Many fund managers operate by buying a particular asset class while everyone else is selling, or vice versa, but under the 'value at risk' systems, banks would be obliged to snatch away loans in this situation.

Hedge Funds, so far at least, have an impressive track record (with the obvious exception of the LTCM debacle of 1998). But with the increased interest, they are now being placed in an entirely new situation, and it may be wise to think carefully before joining the headlong rush…

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