Playing with fire
By Marcel Côté
Hedge funds, loosely regulated funds reserved for institutional and sophisticated investors (with financial holdings in excess of $1 million), are a hot topic. Their managers claim they generate higher returns. While this may have been true in the past, it is no longer the case. For almost two years now, hedge funds have yielded lower average returns than mutual funds. It’s time to curb the enthusiasm of the dream merchants singing their praises and better regulate these funds to prevent a possible blowout from sparking a financial crisis.
Hedge funds are very diverse. Many are leveraged (i.e. they borrow money to add to their assets) and as a result have significantly increased portfolio risk. Many hedge funds don’t hesitate to sell short or invest in derivatives, which also raises risk levels. Some specialize in specific investment sectors and in emerging countries. Lastly, there are the “funds of funds,” which limit their investments to other hedge funds. What they have in common is they are relatively unregulated as they are intended for sophisticated investors who understand their particular investment strategies, which vary greatly from one fund to another. Most hedge funds also impose restrictions on redemptions, limiting them to specific dates once or twice a year and requiring prior notification. This facilitates the management of the funds’ liquidity positions.
High fees for the portfolio managers, typically 2% of assets a year, plus 20% of profit, are another common feature of performance funds, whatever their investment policy. In addition, as fund managers are very active, commissions to brokers are added to the fees, increasing investment costs.
The estimated 8,000 hedge funds worldwide manage close to $1 trillion, compared with $7 trillion invested in mutual funds. However, while mu- tual fund assets grow slowly, hedge fund assets post an annual growth of about 20% to 25%. More importantly, hedge funds represent a large percentage of market transactions, some days accounting for more than a third of market activity. They are also big users of derivatives, for which prices are structurally more volatile than those of shares and underlying bonds.
Regulators are concerned about this strong market presence and the relative lack of regulation as the high volume of hedge-fund transactions has significantly increased market volatility. Not surprisingly, the US SEC plans to introduce stricter regulations on hedge funds next year.
Tightening regulations is justified by fears that a liquidity crisis among performance funds could trigger a financial crisis. For example, a sudden rise in interest rates could create serious problems for some highly indebted funds, which could in turn lead to a loss of confidence and massive share- dumping in response to a run on redemptions. This spring, Montreal hedge-fund manager Norshield faced such a liquidity crunch and had to sell off its half-billion dollar investments portfolio.
This was an isolated fraud-related incident that had no further consequences; but a sudden interest rate hike could have a broader systemic impact on a large number of funds.
In 1998, Long Term Capital Investment, a highly leveraged US hedge fund, faced a similar crisis. To avert financial panic, the US Fed had to organize a US$3.5-billion bailout in a matter of days. There’s no guarantee this couldn’t happen again, and that worries experts.
Early hedge funds could claim to yield higher returns, due to market imperfections. But today hedge funds occupy too large a market share and can no longer make this assertion. Their superior returns depend mainly on higher risk levels, particularly for leveraged hedge funds. The falling returns of the past two years are dramatic. The 2004 average return was below market levels, and all signs point to a repeat performance this year.
One reason for this is high operating costs. They have to outperform the market by more than 2% just to be at par. But don’t lose sleep over hedge- fund investors. Hedge funds use no magic formula: when they buy, someone else sells. At equal risk, it balances out in the end; some will generate higher returns, others lower.
If investors who have access to these funds want to gamble, that’s their business. However, society can demand that markets be protected against a collapse. That’s why hedge funds should be quickly regulated and, in particular, be required to disclose more timely information about their liquid-ity and debt level. The faster we move in this direction, the more effectively investors will be protected against a major accident triggered by hedge funds that dance too close to the fire.
Marcel Côté is a partner at SECOR Inc. in Montreal |
