Hedge funds are now estimated to manage funds worth more than $1 trillion and they are having a fundamental impact on currency, bond and equity markets, writes Michael Sweeney
The explosion in the size of the industry has prompted much comment from regulators, investors and central bankers. The latest to add his voice is Alan Greenspan, chairman of the US Federal Reserve since 1987, and so better placed than most to give a view on trends in the industry.
He spoke about hedge funds in an answer to a question during his recent testimony to the US Senate, arguing that such funds have become major contributors to the flexibility of the financial system by increasing the system's ability to absorb shocks.
Hedge funds seek out abnormal rates of profit by identifying areas of market inefficiency, which provides liquidity, eventually aligning prices across markets and so eliminating inefficiencies.
Mr Greenspan also noted that such abnormal profits would attract a large number of entrants, which has certainly been true, chasing a diminishing array of opportunities, which would inevitably result in a decline in the rate of return, a process that may also be under way.
In time many of the new entrants will leave the industry, some after suffering losses and some seeking a higher rate of return on capital elsewhere.
But for all the negative publicity that hedge funds have generated - notably the $4.5 billion (€3.7 billion) collapse of LTCM at the height of the Asian currency crisis in 1998 and the closure of the Tiger Management fund in 2000 - they have become one of the biggest growth sectors in the global financial sector; the $1 trillion managed by 8,000 funds in 2003 compares with $38 billion managed by 600 funds in 1990.
The term "hedge fund" applies to a wide variety of pooled investments where the fund manager is free to operate in a variety of markets and to use investments and strategies with variable long- and short-term exposures and varying degrees of leverage.
Hedge funds are loosely regulated, at least compared to the more conventional mutual funds and unit-linked funds, which have far fewer investment instruments at their disposal and which operate within a far more rigorous regulatory regime.
Despite their growth, hedge funds are still less than 10 per cent of the size of the world's mutual fund assets. One of the key differences between hedge funds and conventional mutual funds is that the hedge fund manager focuses on generating an absolute return rather than generating a return relative to a benchmark. And unlike conventional fund managers who charge fees based on the amount of funds under management, hedge funds also charge performance fees - sometimes as high as 20 per cent of the absolute return.
In contrast to mutual funds, the size of individual hedge funds is much more sensitive to the level of absolute returns generated over a shorter timeframe. In other words, the flow of investment into and out of individual hedge funds may fluctuate considerably in any given year.
In general, hedge funds can generate large absolute returns on investment when markets are trending upwards or downward and when interest rates are low, which reduces their funding costs. Conversely when financial markets are going through trendless periods - as both currency and equity markets have in the first half of 2004 - the opposite is the case and hedge funds can suffer badly.
But despite the potential volatility in absolute returns, more and more money is flowing into hedge funds from institutional investors, and hedge funds are increasingly seen as a legitimate asset diversification even for low-risk investors such as pension funds. At the end of 2003, it was projected that 25 per cent of the money invested in funds of hedge funds came from institutional investors, up from 16 per cent at the end of 2001.
Some pension funds see the higher returns from hedge funds as a way of plugging gaps in their balance sheet - more important now given the mark-to-market valuation that pension funds are required to conduct under the FRS17 directive and the subsequent deficits in many large occupational funds. One of the biggest pension funds in the world is the California state pension fund CalPERS, which now has a small portion of its $168 billion assets tied up in "alternative investments" such as hedge funds and private equity funds. Well over 20 per cent of US corporate and public pension funds are now investing in hedge funds.
Despite the scare stories, hedge funds have established themselves as another asset class alongside bonds, equities and property and cannot be ignored by institutional investors and pension funds. They are a natural market phenomenon in efficient capital markets, but investors in hedge funds should plan their investment carefully given the unregulated nature of hedge funds and the myriad of funds on offer.
We may have more hedge funds "blow-ups" like LTCM and Tiger and the funds will no doubt continue to be blamed by policymakers, regulators and company chairmen for generating "unwanted" market movements. But there is no doubt that they are an attractive product for investors and are here to stay.
An indication of the growth in the hedge fund industry is the fact that many of the global leaders, including the likes of UBS, HSBC, Goldman Sachs, Deutsche Bank, CSFB, JP Morgan and Citigroup, are now all active hedge fund players, usually having acquired established funds of hedge fund players.
And at home the economic impact of the growth of hedge funds for Ireland has been quite dramatic. Ireland has now become a world centre for hedge fund administration and the Dublin Funds Industry Association has recently estimated that almost $200 billion of "alternative" funds (AIFs) are now managed from Dublin, making it the leading administrative centre in Europe. In excess of 1,500 people are employed directly in the industry in Dublin while many more are employed indirectly in the various professional firms serving the industry.
Michael Sweeney is chief executive, Bank of Ireland Global Markets
