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| Hedge
Funds in Emerging Markets |
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| Author
: Gordon de Brouwer |
Published
by: Cambridge University Press |
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| Hedge
Funds: Myths and Limits |
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| Author
: François-Serge Lhabitant |
Published
by: John Wiley and Sons |
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Book
Review by Andrew Cornford * |
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Click to Enlarge
Click to Enlarge |
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In a little more
than a decade, hedge funds have ceased being institutions
understood only by specialists, though popularly
credited with the capacity to wreak occasional
havoc in financial markets, and are gradually
assuming the position (through funds of hedge
funds) of vehicles for retail investment. The
books reviewed here have different aims. That
of de Brouwer is concerned with broader issues
of public policy raised by the behaviour of hedge
funds, and draws on experience acquired as part
of his membership of the Study Group on Market
Dynamics, which reported to the Financial Stability
Forum's Working Group on Highly Leveraged Institutions
set up in the aftermath of the Asian financial
crisis and the rescue orchestrated by the United
States Federal Reserve of the hedge fund, Long-Term
Capital Management (LTCM).Lhabitant's book, by
contrast, belongs to the more abundant line of
books oriented primarily towards practitioners.
Early books of this kind, often by authors with
close connections to the industry as advisers
or investment managers, tended to be largely descriptive
and anecdotal, though they often succeeded in
transmitting a good feel for their subject[1].
Lhabitant is more ambitious and, in addition to
reviewing the institutional |
Definition and origins
De Brouwer and Lhabitant devote considerable attention
to the issue of definition. Both locate hedge
funds' origin in the private investment partnership
set up at the end of the 1940s by Alfred Winslow
Jones, which aimed to generate profits with reduced
market risk by combining long positions in undervalued
stocks with short positions in overvalued ones.
But both describe the difficulty of arriving at
a precise definition sufficiently inclusive to
cover all the institutions and strategies usually
covered under the term,"hedge fund".
Definitions which are mentioned in their books
include the flexible and serviceable one of Goldman
Sachs and Financial Risk Management:
"The term 'hedge fund' is historically
rooted and has evolved over time to include a
multitude of skill-based investment strategies
with a broad range of risk and return objectives.
The common element among these strategies is the
use of investment and management skills to seek
positive returns regardless of market direction."
The fee structures of the funds reflect this objective
with the result that a low or zero return reduces
fees correspondingly and higher returns lead to
higher fees, the incentive part typically being
in the range of 15-25 per cent of annual realised
performance.
This looser definition brings out similarities
between hedge funds and certain categories of
investment companies in earlier periods. As Nicholas
notes in the manual cited above, the lineage of
hedge strategies used by hedge funds today, particularly
those involving arbitrage and hedging, stretches
back to those of the celebrated investor and writer
on security analysis, Benjamin Graham, as early
as the 1920s[2]. Indeed, in his celebrated popular
treatise on investing, The Intelligent Investor,
Graham notes that the operations of the Graham-Newman
Corporation during its life from 1926-1956 included
merger arbitrages and "related hedges",
namely, the purchase of convertible bonds or preferred
shares and the simultaneous sale of the common
stock into which they were exchangeable, both
of which are included among hedge-fund strategies
(for example, among those discussed by Lhabitant[3]).
The definition of Goldman Sachs and Financial
Risk Management accommodates several features
of the operations of proprietary trading desks
of banks, investment firms and insurance companies
as well as of hedge funds (though, as de Brouwer
notes, certain important constraints on aggressiveness
in trading such as the use of leverage tend to
be less binding for the latter). The difficulty
of clearly distinguishing hedge funds from other
institutions carrying out similar operations explains
the now current use of the term, "highly
leveraged institution" (HLI), in discussion
of regulation and the focus of such discussion
on transactions, applicable jurisdictions, balance
sheets and transparency rather than on the type
of firm.
Structures, operations and strategies
Unsurprisingly in view of his focus on the role
of hedge funds in Asia, under the heading of strategies
de Brouwer devotes special attention to macro
hedge funds whose operations involve assessment
of countries' macroeconomic indicators in order
to profit from imbalances in exchange rates, bond
yields and short-term interest rates, and the
prices of asset classes. For his part Lhabitant
not only ranges at greater length over the different
major strategies pursued by hedge funds but also
gives a good concise account of their structures
including one of the key relationship with prime
brokers, the major investment banks which clear
the funds' trades, act as their custodians, provide
the margin financing essential to their leverage,
and lend the securities required for taking short
positions. His review of strategies benefits from
lucid descriptions of the transactional techniques
such as the use of derivatives which hedge funds
employ. In boxes in the text he also discusses
a number of cases which exemplify various points.
But for extended profiles of the often unusual
or eccentric personalities among hedge funds'
founders and managers fuller sources are the writings
of financial journalists which also illustrate
the risks and rewards of the different strategies
historically followed by hedge funds[4].
Asset allocation and performance
Both authors provide overviews of the industry's
performance. But as is appropriate for a book
intended to guide investors, Lhabitant's coverage
is much more extensive and includes a survey of
hedge-fund indices and research providers together
with some useful observations on various statistical
biases to which the data are subject[5]. Lhabitant's
review of hedge funds' performance leads naturally
to his treatment of investing in hedge funds including
through funds of hedge funds. Here Lhabitant dwells
on limitations of the conventional approach to
portfolio selection based on means and variances
of returns as applied to hedge funds. Some of
his points are technical such as the ways in which
variances of investment returns are affected by
hedging through derivatives. But scattered through
his discussion are a number of more general critical
observations on the tendency to to give too much
emphasis to the statistical measure of risk as
variance/volatilty of returns. Only in his annex
on statistical techniques useful in analysing
hedge funds' performance does he bring his concerns
on this subject together when he writes (p.246):
"It is difficult to reach a consensus
on how to define risk. Indeed different investors
will have different concerns, depending on the
nature of their portfolio and/or the nature of
the institution that employs them. They will therefore
perceive risk differently. A pension fund may
see risk as the failure to face his liabilities.
An asset manager may perceive risk as a deviation
from its benchmark. A statistician may define
risk as potential deviations from the average.
And a private investor may consider the probability
of missing a target return and by how much.[6]"
Hedge funds
during the Asian crisis
The heart of de Brouwer's book concerns the role
of hedge funds in the Asian financial crisis of
1997 and the subsequent controversy concerning
a subject which has become a sensitive issue in
relations between the world's traditional financial
powers and several countries in the region. After
allegations that hedge funds had contributed to
the crisis an IMF study of spring 1998 downplayed
their role[7]. The grounds for this conclusion
were the small weight of hedge funds compared
with other institutional investors in global financial
markets, estimates - admittedly uncertain - of
the scale of hedge funds' participation in the
market for the Thai currency, the baht, and comparisons
of the funds' leverage (and thus their capacity
to take large positions in the markets for currencies
and other assets) with that of the proprietary
trading desks of other financial firms. Research
by United States economists at the same time,
which used data on hedge funds' returns from different
asset classes and on their net assets values to
make inferences about their positions, tended
to support the first of the points of the IMF
study. The work from these sources benefitted
from being first in time and thus exerting a disproportionate
influence on the subsequent debate, for example,
serving as the source of Lhabitant's skimpy treatment
of the subject. However, governments in the region
continued to be concerned by the destabilising
influence of hedge funds and other speculators
in their financial markets, that of Hong Kong
buying stock in its own market in August 1998
to thwart the so-called "double play[8]"
and that of Malaysia imposing capital controls
to restrict offshore operations in its currency,
the ringgit.
The next major report from an international source,
that of Working Group of the Financial Stability
Forum (FSF) on Highly Leveraged Institutions in
April 2000, expressed a more nuanced view as to
the role played by hedge funds and other HLIs[9].
Acknowledging the difficulty of assessing the
separate influences of more general market pressures
on vulnerable features of some Asian economies,
on the one hand, and of the operations of HLIs,
on the other, the report none the less drew attention
to "the potential" of "large and
concentrated HLI positions…to influence market
dynamics". This cautious conclusion, reflecting
in part the need for compromise within the Working
Group, was based on the findings of a Study Group
of which de Brouwer was a member and which are
also the principal base for the more detailed
examination in his book of market dynamics in
selected Asian economies around the time of the
Asian crisis and its aftermath.
De Brouwer believes that the operations of macro
hedge funds and to a lesser extent financial institutions'
proprietary trading desks, though only one of
many factors in the events of this crisis, were
at times an important source of instability in
the region's financial markets in 1997-1998 and
contributed to the overshooting of exchange rates
and other asset prices,. He is critical of the
focus in the IMF study on the relative global
size of hedge funds and other types of financial
firm. What matters in his view is the size of
their positions in relation to those of other
actors in particular markets in the region. He
also believes that too little attention has been
paid to leader-follower patterns of behaviour
in these markets: groups of hedge funds sometimes
appear to act as if in packs and, vis-à-vis
other firms, assume the role of leaders owing
to their willingness to take large positions in
particular assets and currencies based on what
is widely regarded as superior knowledge. To exemplify
his points de Brouwer reviews developments during
this period in the markets of Thailand, Hong Kong,
Indonesia, Malaysia, Singapore, Australia and
New Zealand.
Concerning the Thai case de Brouwer gives estimates
of the scale and timing of HLIs' short positions
in the baht which differ from those of the IMF
(larger and taken over a more extended period).
In Hong Kong hedge funds assumed exceptionally
large short positions in a wide range of assets,
four large funds, for example, accounting for
most of the doubling of short open positions in
HSI (stock) futures in May and June 1998. Elsewhere
hard data on market dynamics during 1997-1998
are less available and de Brouwer has relied heavily
on his consultations with national authorities
and market participants. He focusses primarily
on exchange rates, and his findings as to the
role of HLIs in cases of overshooting vary: for
example, their influence was swamped by that of
domestic residents in Indonesia in 1997 but was
important in the depreciation of the Australian
dollar in the early summer of 1998 (their large
positions here being partly due to the depth and
liquidity of the market for the Australian currency
which faclitated its use for proxy hedges and
other transactions with no connection to the economy's
fundamentals).
De Brouwer also criticises the research on hedge
funds mentioned above which attempts to infer
their positions in different asset classes from
data on the funds' aggregate returns and net asset
values, whch, unlike their market positions, are
publicly available information. The basic assumption
here is that since the aggregate return of a fund
is a weighted sum of the returns on its constituent
assets, positions in these assets can be inferred
through the multiplication of its net asset value
by the coefficients estimated from a regression
of the aggregate return on the returns of assets
thought to be in its portfolio and thus serving
as asset weights. De Brouwer has a number of technical
objections to this approach, not least the arbitrary
choice of indicators for returns on the assets
assumed to be in the portfolio. Perhaps more importantly
he tests the accuracy of the method by applying
it to an artificial portfolio consisting of United
States equities, yen, ringgit, Australian dollars,
Singapore dollars, and the Indonesian rupiah.
On the basis of historical data the aggregate
monthly return on this portfolio is regressed
on those of the six assets to estimate coefficients
to be used as just described to calculate asset
positions, which are then compared with actual
positions. De Brouwer's finding is that the inferred
positions differ substantially from the actual
ones, often proving misleading with respect to
magnitude, sign, and the timing of significant
changes.
Regulation
As befits his practitioner focus, Lhabitant's
discussion of regulation concerns rules bearing
directly on firm structure, relations with investors,
and transactions. For the United States he provides
lucid and succint accounts of the key major laws
dating from the period of the New Deal and of
the 1996 National Securities Markets Improvement
Act, all of which involve the oversight of the
SEC, and of the rules which are the responsibility
of the Commodity Futures Trading Commission and
are relevant to hedge funds owing to their involvement
in trading derivatives on organised exchanges.
He notes that hedge funds are usually structured
to take full advantage of various features of
the United States regulatory and fiscal regimes
(including gaps concerning subjects such as disclosure
requirements). The book also includes briefer
accounts of regimes in Switzerland, Germany, Italy,
France, Ireland, and other offshore centres. However,
the cut-off date for these accounts is not specified,
and they do not include recent regulatory changes
in several European countries sanctioning the
sale of funds of hedge funds to retail investors.
De Brouwer's review of regulation is designed
primarily to highlight areas where the crises
of 1997-1998 indicated weaknesses of existing
rules. Since many of these weaknesses involved
cross-border operations, he believes that the
approach to strengthening these rules should be
international but, as a former official of the
Reserve Bank of Australia with experience of the
process of international policy making, is well
aware of the problems of achieving international
agreement on changes. His proposals are directed
at various obectives: to reduce the potential
of HLIs to be a source of systemic financial risk
or otherwise destabilise financial markets; to
ensure that all economic actors in financial markets
are subject to supervision and market discipline
which are adequate; and to ensure that decision
makers – both supervisory authorities and market
participants – have the necessary information
for these purposes. In practical terms these objectives
overlap, as is evident from de Brouwer's review
of several initiatives and proposals since 1997-1998.
De Brouwer examines at length the issue of greater
disclosure concerning hedge funds' positions.
This subject has proved more contentious than
one might have expected. In December 1998 the
Committee on the Global Financial System[10] set up
a Working Group on Aggregate Positions (the Patat
Group) to examine the scope for collecting and
disseminating aggregate data on financial markets,
but according to de Brouwer the initiative was
eventually dropped largely under pressure from
the Federal Reserve. This might be considered
surprising in view of the existence in the United
States of its own system for the reporting of
foreign-exchange and derivatives positions and
of the key role attributed to transparency in
the functioning of its financial system[11]. Other
topics considered by de Brouwer include the tightening
of margin requirements on hedge funds (a subject
of much attention after the LTCM crisis), a code
of conduct for participants in the foreign-exchange
markets, the regulation of electronic broking
in these markets, and selective controls over
capital transactions. Many of his reflections
here bear not only on policy towards hedge funds
but also on the broader issue of practical steps
for improving international financial stability
more generally.
June
30, 2004.
[1]
Examples are R.Hills, Hedge Funds: an Introduction
to Skill Based Investment Strategies (Leighton
Buzzard, Bedfordshire: Rushmere Wynne, 1996);
J.G.Nicholas, Investing in Hedge Funds: Strategies
for the New Market Place (Princeton: Bloomberg
Press, 1999); and S.Lavinio, The Hedge Fund Handbook:
a Definitive Guide for Analyzing and Evaluating
Alternative Investments (New York, etc.:McGraw-Hill,
2000).
[2]
See Nicholas, op.cit. at note 1, p.26.
[3] See B.Graham, The Intelligent Investor: A
Book of Practical Counsel, fourth revised edition
(New York, etc.: Harper and Row, 1973), pp. 205-206.
A more detailed account of "related hedges"
can be found in B.Graham and D.Dodd, Security
Analysis, first edition (New York: McGraw-Hill,
1934), pp. 282-285 and 667.
[4] Good recent examples are P.Temple, Hedge Funds
The Courtesans of Capitalism (Chichester, etc.:
John Wiley, 2001) and two monographs on the rise
and fall of LTCM, N.Dunbar, Inventing Money; the
Story of Long-Term Capital Management and the
Legends behind it (Chichester, etc.: JohnWiley,
2000) and R.Lowenstein, When Genius Failed: the
Rise and Fall of Long-Term Capital Management
(New York: Random House, 2000).
[5] In a
chapter amusingly entitled "Dance of the
seven veils" Temple, op. cit at note 4, also
provides a survey of different web sites with
information on hedge funds.
[6] In his popular treatise on
risk Peter Bernstein uses a quotation of a family
trust manager to make a similar point: "
volatility per se, be it related to weather, portfolio
returns or the timing of one's morning newspaper
delivery, is simply a benign statistical probability
factor that tells us nothing about risk until
coupled with a consequence".
[7] See P.L.Bernstein, Against
The Gods: The Remarkable Story of Risk (New York,
etc.: John Wiley, 1996), p. 261.
See B.Eichengreen, D.Mathieson, B.Chada, A.Jansen,
L.Kodres and S.Sharma, Hedge Funds and Financial
Market Dynamics (Washington, D.C.: IMF, May 1998).
[8] The "double play"
involved actions by market participants to generate
profits from large short positions in the equity
market by pushing up interest rates through sales
in the money and foreign exchange markets and
thus exerting downward pressure on stock prices.
[9] FSF, Report of the Working
Group on Highly Leveraged Institutions (April
2000). Established in 1999 the FSF brings together
representatives of the ministries of finance,
central banks and financial regulators of G7 countries,
the BCBS and other international bodies concerned
with financial regulation, the IMF, the World
Bank, the OECD, Australia, Hong Kong and the Netherlands
for the purpose of strengthening understanding
and cooperation regarding surveillance and supervision
of the international financial system.
[10]
The Committee on the Global Financial System was
established by the G10 as a forum of central banks
to identify potential sources of stress in global
financial markets, to further understanding of
them, and to promote their smooth functioning
and stability.
[11] Since 1999 the Treasury
Bulletin of the United States Treasury has published
statistics on the foreign currency positions of
market participants including separate information
for long and short spot, forward and futures transactions
and for options, the obligations as to periodicity
(weekly, monthly, and quarterly) varying with
the scale of institutions' participation. Quarterly
information is also available from the Office
of the Comptroler of the Currency on large banks'
derivatives positions in OCC Bank Derivatives
Report.
* Book Review for The
Journal of Financial Regulation and Compliance. |
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