In the light of the latest events in the world economy, financial crisis and the role of the hedge fund industry in it I am writing this paper on the topic hedge fund disclosure of their risk information.
The last two decades experienced a real boom in the hedge fund market, which grew from approximately $500 billion in 2000 to the estimated over $2 trillion as of 2008 (Lo, 2000, p.1, Rummel, 2008). Investopedia defines hedge fund as an “aggressively managed portfolio of investments that uses advanced investment strategies such as leverage, long, short and derivative positions in both domestic and international markets with the goal of generating high returns” (Investopedia). An important feature of hedge funds, which commonly separates it from other investment vehicles, such as mutual funds for instance, is that they are very loosely regulated in terms of money allocations. As a result, despite the fact that hedge funds normally disclose their strategies, the risk associated with the investments is almost never known to the public. Such a policy of nondisclosure of risks associated with the investors’ money is unacceptable and hedge funds should fully disclose all risk information regarding their portfolio allocations to the public.
Hedge funds have always represented a lucrative form of investment for sophisticated money holders as double and triple digit returns in the unprecedented bullish market in the late 1990s created a true euphoria regarding hedge funds as new forms of fixed asset allocation (Lo, 2000, p.1). However, the Long Term Capital Management’s (LTCM) multi-billion dollar crash in 1998 which caused a significant market debacle, in financial markets proved that hedge funds did not represent a risk-free investment. In his speech at the Federal Reserve Bank of Atlanta in May 2006, Chairman Bernanke mentioned that the collapse of LTCM “precipitated the first in-depth assessment by policymakers of the potential systemic risks posed by the burgeoning hedge fund industry.” The more recent collapse of the two multi-billion dollar Bear Stearns hedge funds once again confirmed the fact that hedge funds are quite often take too much risk in their investments.
The current situation with the transparency of hedge markets is based on the Securities Act of 1933 and the Company Investment Act of 1940. According to the Securities Act, hedge funds are sold as private investments and, thus, any information regarding them is not subject to public scrutiny (Securities Act, 1933). At the same time Company investment Act of 1940 grants hedge funds a special status under which they can operate under more loose conditions than other funds (Company investment Act, 1940). Thus, legally, hedge funds are much less regulated by the government agencies and are able to undertake riskier investment strategies. Government’s attempt to monitor hedge funds’ activities in the beginning of the century was challenged in the court and in July 2006 the case was overturned by the court of appeals (Goldstein vs. SEC, 2006).
Nevertheless the excessive risk parameter that is involved in mutual funds’ money allocation is quite often beyond any reasonable limits. The Working Group assigned by the Federal Reserve Commission stated that a new regulation environment should be fostered in order to limit extreme leverage and risk taking by hedge funds (Bernanke, 2006). There are several major reasons from the investor’s point of view why hedge funds should disclose risk information regarding risks involved in their strategies.
First of all, hedge funds, as any other investment vehicles, should realize to the full extent the risks involved with the market exposure of each particular investment or manager. All these risks should be aligned with the fund’s overall strategy in the market openly declared and available for public review. At present, this is far from being the reality with the hedge funds. Oftentimes, separate trades in the funds are taking on very risky positions attempting to gain on total fund’s leverage. Most of the times, investors have no idea what is going on, even if the overall report regarding hedge fund activities is available to them. In 2006, Amaranth hedge fund collapsed asserting $6 billion losses due to natural gas speculations: one specific kind of trade that was too excessive (Rummel, 2008).
Another reason for public risk disclosure lies in the fact that there is a certain proportion of risk-return that each investor is comfortable with. Most of the hedge funds are providing results of their performances based only on the return they provide, while the risk taken in order to provide these returns is quite often beyond the acceptable range of the investors in the fund. Such an approach inevitably leads to higher risk exposures and highly leveraged allocations which would oftentimes be unacceptable in the ordinary equity or fixed income market. LTCM had the highest disproportion of real assets and obligations in 1998. The level of risks undertaken by the fund was oftentimes several times higher the acceptable return, what in the end resulted in a cascade margin calls from the creditors which were nothing to cover with (Coy and Woolley, 1998). Despite the fact that current hedge funds are not operating under such leverages as LTCM, the degree of risk-return is estimated to be much higher than in other types of investments.
Finally, as Lo (2006) put it, hedge funds, as institutions require “stability, and consistency in a well-defined investment process that is institutionalized, and not dependent on any single individual” (p.2). In other words, the complete risk assessment should not only be derived from individuals’ (management’s) prospective. Quite often investment strategies undertaken by hedge funds ignore potential requirements of the investors for steady and reliable returns on their money. This goal is going to the second plan while the short-term profit chase ensues. Thus, the very aspect of relative investment stability is undermined from the investors’ prospective, while hedge fund managers are free to play with the investments at their own preferences. Such inconsistency between the goals of management and investors’ intentions would not be possible should investors have the risk information prior to their investments. On the other hand, this, obviously, would result in the loss of a significant part of potential depositors in the hedge fund, which is the last thing hedge fund managers would like to see.
Risk disclosure for the hedge funds is not the issue that has only proponents of the idea. There are, as a matter of fact, many professionals in the financial area who believe that regulations requiring hedge fund risk disclosure cannot help the situation and, therefore, should not be adopted. For instance, Matthew Lynn, the head of a hedge fund based in London, argued that disclosure of risk information would be detrimental to the very existence of hedge funds as investment entities (Lynn, 2007). His main arguments against detailed risk disclosure are based on the facts that: a) risk parameters for hedge funds are central to its line of business (the same as formula for Coca Cola); b) disclosure of risk would undermine some strategies of the hedge funds such as secret buyout of securities; c) up to this point, hedge funds have not made markets unstable under current conditions and imposing extra limitations on them would suppress innovation and mobility (Lynn, 2007). However, there are counterarguments to all these statements.
It is inappropriate to claim that risk parameters are of the same value to hedge funds based on the same notion of comparison to the other companies’ core products or services. Rather, it is more appropriate to compare them to the company’s financial statements, which help investors determine whether the company is worth investing to. After all, risk disclosure does not require hedge funds to disclose their structure of operations or provide detailed list of investments. Secondly, secret buyouts of the securities could not be significantly affected by risk disclosures since they are going to be revealed only in the end of the certain period. Therefore, it would be impossible to recognize any buyouts conducted by the hedge fund until that time. Finally, the claim that hedge funds did not cause any market disruptions is simply absurd: in 1998 the Government had to create a special bailout Commission to guarantee LTCM astronomical obligations which threatened to send negative ripples throughout the entire financial system (Coy, Wooley, 2007). The same thing happened in 2007 with the Bear Stearns hedge funds. Almost every time a large hedge fund collapses, the interconnected financial structure of the market is at risk, and, if the level of this interconnection is fairly high, the government has to step in. Therefore, hedge funds do cause significant market disruptions, which are the direct consequence of their credit risk policies.
Hedge funds’ risk transparency has been on the issue since the late 1990’s when the first major collapse of a hedge fund occurred and threatened to bring the entire financial system to a halt. Despite certain steps undertaken by the government agencies towards transparency in hedge funds risk exposures, the situation is still far from being settled. Nevertheless, each time a hedge fund goes down due to unjustified high risk exposure, it takes down the investments of many stakeholders who would not invest in the fund had they enough information regarding its risk-return ratio. A possible regulation requiring hedge funds disclose their risk involvement would not turn away the aggressive investors who are willing to take additional risk for a higher return possibility. At the same time it would ensure that those who are not willing to take on such a risk are protected from the failures that the current system yields. Therefore, legislators should devise a special regulatory framework that would make hedge funds reveal their risk parameters.
References
Bernanke, B. S. (2006, May 16). Hedge Funds and Systemic Risk. Speech at the Federal Reserve Bank of Atlanta’s 2006 Financial Markets Conference, Sea Island, Georgia Retrieved March 15, 2008 from http://www.bis.org/review/r060522a.pdf
Coy, P. & Wooley, S. (1998). Failed Wizards of Wall Street. Business Week Online. Retrieved March 15, 2008 from http://www.businessweek.com/1998/38/b3596001.htm
Goldstein vs. SEC. (2006). Retrieved March 30, 2008 from http://www.seclaw.com/docs/ref/GoldsteinSEC04-1434.pdf
Lo, A. W. (2000). Risk Management for Hedge Funds: Introduction and Overview. Retrieved March 10, 2008 from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=283308
Lynn, M. (2007, October 17). Hedge Funds Can’t Reveal Secrets and Do Business: Matthew Lynn. Bloomberg. Retrieved March 30, 2008 from http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aABI8tRBTVkU
Rummell, N. (2008, February 25). GAO: Hedge funds have improved disclosure, but concerns still exist. Financial Week. Retrieved March 10, 2008 from http://www.financialweek.com/apps/pbcs.dll/article?AID=/20080225/REG/33290841/10 36
Hedge Fund Definition. Retrieved March 30, 2008 from http://www.investopedia.com/terms/h/hedgefund.asp
University of Cincinnati. General Rules and Regulations Promulgated under the Securities Act of 1933. Retrieved March 30, 2008 from http://www.law.uc.edu/CCL/33ActRls/rule501.html
Fung, W. & Hsieh, D. A. (2005). The Risk in Hedge Fund Strategies: Theory and Evidence from Long/Short Equity Hedge Funds. Retrieved March 5, 2008 from http://finance.wharton.upenn.edu/~rlwctr/DHsieh.pdf
A very good paper on different types of risks involved in certain hedge fund strategies is written by two professors specializing in hedge funds and (Duke and London School). A number of other scholars provided great primary statistical data for the paper as well.
Jagannathan, R., Malakhov, A., Novikov D. (2006, January). Do Hot Hands Persist among Hedge Fund? Retrieved March 5, 2008 from http://www.usc.edu/schools/business/FBE/seminars/papers/F_10-6-06_JAGANN- HedgeFund.pdf
The paper contains a hand-on empirical evaluation of personal factors driving hedge funds’ decisions. Peer-reviewed and presented at the USC Financial seminar.
Ding, B., Getmansky, M., Liang, B., Wermers, R. (2006, November). Market Volatility, Investor Flows, and the Structure of Hedge Fund Markets. Retrieved March 5, 2008 from http://www.isenberg.umass.edu/finopmgt/uploads/basicContentWidget/15365/Getmansky%20paper.pdf
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