Ground Floor:Despite the general optimism on the global economy coming from the recent G7 meeting, the finance ministers still found plenty to worry about. This time hedge funds were put on the list of items which needed a bit of scrutiny, writes Sheila O'Flanagan.
The industry has continued to grow rapidly - currently about $1.5 trillion (€1.14 trillion) under management, but regulation is slight.
Hedge funds boast about their ability to deliver superior performance regardless of the direction of markets, and one of the reasons that people favour them so much is because they offer absolute rather than relative returns. Which means that they tell you how much you've actually made, not how well you've done against a benchmark.
For this, the fund managers themselves charge hefty fees - sometimes up to 20 per cent of the profits as well as a management fee - but they justify it on the basis of delivering exceptional profits.
They do this by using a range of trading strategies (often kept very close to their chests) and by leveraging their exposure so that the potential returns can be enormous.
Obviously the flip side of this is that the potential for disaster is equally enormous but the key to managing the downside risk is in the term "hedge". The fund managers will make a selection of offsetting trades against the original trade in order to limit the potential for Armageddon.
There's a certain dichotomy here: gung-ho trading offset by ever more complex trades to try to limit potential losses can tax even the most understanding of investors.
But, of course, when they get it right (as many of them do), the rewards can be spectacular. It is, however, the risks that are worrying the G7.
Peer Steinbruck, the German finance minister, suggested that those risks have become even more "complex and challenging". That's a slightly more benign view than the one previously put forward by a former minister who called them "locusts".
Obviously, you'd think that taking big positions but then offsetting the potential downside by a series of other trades, would reduce those complex and challenging risks. But that's not necessarily the case.
Hedge funds are big users of derivatives, products that can sometimes leave a trader teetering between success and failure. The cataclysmic failure of Long Term Capital Management (LTCM) in 1998 and more recent failures such as Amaranth, show that even if the money mavens think they've got it right, it can still go horribly wrong.
The Fed - fearing global market meltdown - bailed LTCM out, and Amaranth lost over $6 billion in trading natural gas contracts before another hedge fund stepped in.
Because hedge funds have grown so much over the past 15 years, the potential for anyone who's got it wrong to impact very severely on the financial markets is what's worrying the G7 crew.
Hedge fund managers, however, are violently opposed to the kind of regulation that they feel is already strangling other market participants. (The truth is, of course, that traders hate any kind of regulation whatsoever. There's always a trade that would be just perfect if some pesky risk management guy hadn't put a ridiculous limit in place to stop you doing it.)
One of the complaints made by the regulators is that the industry isn't transparent. The hedge fund managers protest that their strategies are proprietary and that making them transparent would mean losing their edge. Many funds are personality driven in that they are run by "star" traders who won't let anyone know how they manage the fund.
Most do not register under the Investment Advisers Act in the US and get around regulation by only selling to "accredited investors" (people with a very high net worth).
While the rich might be able to take the hit of a trade that goes pear shaped, the G7 fears that contagion would affect the entire financial system.
The concern of the G7 is not unjustified. When hedge funds first started to make their appearance they were generating returns in excess of 14 per cent over their less aggressive competitors. But, as more and more people devise similar strategies, those excess returns have been declining.
One way to increase them again is to get involved in riskier ventures. And that's partly what the G7 is afraid of.
At the recent summit in Essen, the Germans proposed a series of measures designed to encourage greater transparency in the industry. Both Britain and US have come out in support - despite the fact that they are, as always, less keen on rules and more in favour of self- regulation.
US treasury secretary Henry Paulson said that market discipline was the most effective way to ensure that risk concerns were addressed.
Indeed. As a capitalist by nature I'm with Paulson in the notion of market discipline being a reasonable check on behaviour. The only problem with the markets is that they are populated by a very undisciplined lot! With the possibilities of making more money (both for themselves and for their clients), most traders tend to trade up to whatever limits are imposed on them - and sometimes beyond.
When a particular strategy is working well there is a temptation to increase the exposure to it, even if you are already at the limit of what that exposure should be.
Which is not to say that the fund managers themselves want to lose the plot completely either. Many of them invest significant amounts of their own money in the funds that they manage and so have a vested interest in not losing it all in an LTCM type blow-out.
At present, hedge funds are so lightly regulated that they can do pretty much what they want. The problem is that sometimes what we want and what is actually good for us are two very different things.
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