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Someone To Watch Over Me

The Bear Sterns experience showed that the market will not know how to react when hedge funds implode. In this case, we know its the CDO market, which had been weak for more than a year, and we know 60 mortgage related companies have closed shop over the past year - its a risky business. When the two funds failed, investors will over-react because the best assumption is to be cautious. Surely there are more similar hedge funds using similar investing strategy in a similar asset class. Could this be the trickle before the downpour?

This will continue to be the trend every time a hedge fund collapses, investors will over-react because they do not have additional information on what hedge funds buy and how leveraged they are. The Bear Stearns and Amaranth incidents will propel all to accept greater oversight and transparency for hedge funds. One of the most important issue is to reveal what are the leverage limits and in what instruments. If it was pure equities, even 3x-5x is OK especially its a hedged bet. However, if its primarily in derivatives (which in itself is already leveraged), we may need to rethink. We should not put a cap on things like leverage or what instruments a fund can or should invests in, but the information should be made clear from the start to potential investors. Any deviation from the prospectus should be punished severely.

More regulations will be needed as more US pension funds are invested in hedge funds nowadays. The proportion of U.S. corporate-defined benefit pension funds investing in hedgefunds has increased to 24% in 2006, up from 19% in 2004 and 12% in 2000. Total corporate pension fund assets allocated to hedge funds in 2006 was 2.1%. Because of hedge funds’ risky nature, rapid growth, lack of oversight, and recent losses, some wonder if they are appropriate investments for workers’ retirement funds. In 2004, the Securities and Exchange Commission issued a rule requiring manyhedge fund advisers to register as investment advisers under the Investment Advisers Act. The rule took effect in February 2006, but in June 2006 a court challenge was upheld, and the rule was vacated. In early 2007, while the Bush Administration called for increased vigilance rather than new government rules to handle industry risks, Congress has asked the Government Accountability Office to examine the use of hedge funds by public and private sponsors of defined benefit pension plans. Time for a change, hedge funds can no longer operate as if they own the world, or live by their own rules solely. If we had know how many hedge funds played the CDO market and what's their size and leverage levels, investors could better predict the impact - and when you can impact on the smooth running and perception of risk in financial markets, you need to be more transparent and have better oversight.


rask3 said…

I'm no expert on hedge funds, but everyone knows the risks of over leveraging which only serves to magnify the risk/reward ratio.
But hedge fund investors are supposed to be very knowledgeable, with deep pockets and huge risk appetites.

The collapse of LTCM in 1998 and the subsequent government ordered bailing out reminds me of the adage that if you owe a bank a few grands, you should be worried; but if you owe it a coupla billions the bank should be worried.

Will things change?

Salvatore_Dali said…

one two billion losses will not trigger a collapse in the hedge funds, its just the worry that there are more such cases waiting in the wings...

all said, hedge funds need to reveal a lot more info so that financial markets can assess the inherent risks in each asset class better. info such as leverage ratio, type of asset class exposure, hedged or unhedged position, etc..
rask3 said…

Agreed. I'm all for transparency.
Do you think that over leveraging of financial instruments, beyond a certain limit, should be banned? I feel it would do some good.

Salvatore_Dali said…
i don't think there should be a physical limit to leverage or exposure, just let the shareholders know about it first .... we cannot and should not put a cap as to what is "good investing" because that throws out individual performance and persuasions ... regulations and oversight must be there to ensure all important information is available for all to monitor their investments and make their investing decisions... when its shrouded in secrecy like hedge funds... its very silly... we don't have to go to the exact security name or stock name to know what they are buying or selling, just the asset class and exposure / leverage.

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