Hedge Funds and Systemic Risk Demystified By Glenn Yago, Lalita Ramesh, and Noah E. Hochman

Executive Summary

Estimates of hedge fund market size range from $100 billion to $300 billion, comprising 1,115 to 5,500 different funds.

Hedge funds became a significant force because restrictive regulations in the early 1990s limited other financial institutions (such as life insurance companies, pension funds, banks, and savings and loans) from investing in "riskier" asset classes and utilizing advanced hedging strategies in portfolio risk management.

Systematic data on hedge funds are scarce because of the lack of transparency and regulatory disclosure about their activities and performance.

A review of data and research suggests that many of the claims about hedge funds' influence on financial markets may be overstated. We have found that:

• though precise breakdowns on investor contributions are unavailable, pension fund fiduciary leverage limits of 2:1 have limited their exposure

• bank exposure has been extensive but largely indirect; overleveraging at Long-Term Capital Management (LTCM) was the exception, not the rule, as most hedge funds do not engage in extreme leverage

• a wide variety of investment styles and performance make up the loosely defined universe of hedge funds

• overall, hedge fund performance is only modestly above equity indexes on a risk-adjusted basis; claims of extraordinary performance appear overstated

• while offshore hedge funds are commonly perceived to post higher returns at considerable risk, the empirical record suggests the opposite

• hedge funds do not appear to have precipitated the Asian financial crisis: Long and short positions of these funds are not correlated with changes in currency exchange rates in those Asian countries; hedge funds did not initiate speculative currency attacks

• rather than contributing to excess volatility, some empirical evidence suggests that hedge funds may mitigate it

• hedge fund mortality averages about 20 percent per year, implying an average fund life of approximately three years

For these reasons, it is most appropriate for public policy to focus on banks and their considerable investment in hedge funds rather than on hedge funds themselves. A policy consensus appears to have emerged between central banks and bank regulators that transparency issues are best addressed by regulating hedge funds

indirectly through the source of their funds, since direct regulation would simply drive them offshore.

The shift that has taken place since the crisis involving LTCM allows banks and other financial institutions to participate directly in those markets from which they were previously excluded and in which they were indirectly exposed through lending to hedge funds. This policy change suggests the beginning of a movement by financial regulators from risk-based capital standards to modern portfolio risk management.

It remains to be seen if remediation of hedge fund activity within regulated financial institutions will facilitate a return to liquidity in emerging markets.

Introduction

Managing risk to avoid global market uncertainty is the holy grail of contemporary finance. The promise of hedge funds in this search was obscured when the Federal Reserve, motivated by fears of systemic risk and a market meltdown, intervened to rescue the hedge fund Long-Term Capital Management (LTCM) in August 1998.1 LTCM, which specialized in fixed-income arbitrage, was managed by some of the brightest minds on Wall Street.

The rescue of LTCM by the Federal Reserve's "lifeboat" consortium of 14 Wall Street banks has spurred much debate about an investment vehicle that people know little about. Hedge funds are mysterious to all but the most market-savvy investors. Contrary to conventional wisdom, the term "hedge fund" currently is applied to a wide variety of funds that in most cases are not hedging against risk at all.

This study reviews the hedge fund industry and places it into perspective as an asset class. It focuses on:

• the size and structure of the industry; • the performance of hedge funds and related empirical research; • leveraged exposure of hedge funds and their role of in the Asian crisis; and • regulatory policy initiatives related to hedge funds.

What Are Hedge Funds?

U.S. hedge funds are private investment pools defined by their freedom from the disclosure requirements and regulatory controls of the Investment Company Act of 1940. Before 1996, hedge funds had to limit the number of investors to 99 to qualify for exclusion from the act. In 1996, the National Securities Markets Improvement Act raised the ceiling on the number of U.S. accredited investors to 500. An accredited investor must have a net worth of $1 million, make at least $200,000 in each of the two most recent years, or have a joint spousal income in excess of $300,000 in each of these years. A non-accredited investor is any person not meeting these standards. Institutions and pension accounts are subject to more complex criteria. Most hedge funds require shareholders to wait 30 days for fund withdrawal for more liquid funds and up to three years for others.

Hedge funds operate almost entirely outside the scope of mandatory disclosure and

government regulation. Therefore, publicly available information about them is limited. In fact, regulatory considerations discourage even voluntary disclosure: Publicly reporting returns or other fund information could be construed as soliciting investors and could thus trigger regulation under the Investment Company Act.

Offshore hedge funds are similar investment vehicles which are organized as private partnerships but operate offshore with few restrictions on their portfolios owing to their legal status. Unlike U.S. funds, which restrict the number of accounts, offshore hedge funds have no such restrictions and also provide a tax haven. For this reason, most of the major funds operating within the United States also have offshore vehicles. In November 1996, $31.7 billion of the $68 billion hedge fund universe was invested in offshore entities according to Managed Account Reports (MAR). Subtracting "fund of funds" (investment by hedge funds in other hedge funds) from this universe, assets managed by offshore funds amounted to twice those of onshore funds (see Brown, Goetzmann, and Park 1997). Offshore funds also enable non-U.S. citizens to invest in U.S. securities without being subject to withholding or capital gains taxes. Non-taxed entities may also invest in offshore hedge funds, with the capital of numerous academic endowments being managed this way.

History

Financial returns are the reward for assuming risk. Hedging strategies emerged out of that assumption. The idea that a free lunch could be found in hedge funds was rooted in the assumption that the cost of risk could be limited by advanced quantitative methods and trading strategies. But, as Milton Friedman always reminded us, the search for the free lunch is doomed.

In 1949, A.W. Jones, a sociologist, established in the United States what is regarded as the first hedge fund. Jones combined short-selling and leveraging to create a successful investment strategy to buy long on undervalued stocks and sell short on overvalued stocks. The fund was expected to gain regardless of the direction in which the market moved. This fund was considered "hedged"—hence the term "hedge funds." Another notable characteristic of Jones's fund was an incentive fee structure: All of his own investment capital was kept in the fund. Jones's fund operated in relative secrecy until an April 1966 article in Fortune magazine reported that its impressive rates of return, net of fees, exceeded those of the most successful mutual funds over the previous five and ten years by 44 percent and 87 percent, respectively. This led to the birth of the hedge fund era.

Whereas the original hedge funds of the late 1960s relied on hedging strategies, during the 1980s they began to take positions in global markets. These "macro" hedge funds betted on shifts in stock markets, currencies, and interest rates. Hedge funds since the late 1980s have become even more specialized and have employed sophisticated investment strategies that include aggressive growth, distressed securities, and fund of funds. Today's hedge funds allow managers to use a variety of techniques and leverage to raise returns and cushion risks. Operations of large commercial banks, investment banks, and pension funds resemble those of hedge funds, thus making it very difficult to distinguish hedge fund activities from those of other financial institutions.

Data Availability and Data Biases

Although all estimates suggest that the industry has grown tremendously since the mid-1980s in both number of funds and in assets managed, accurate data are limited because public filings or disclosures are not mandatory. The source of most industry data are hedge fund advisers. These organizations obtain information on hedge funds from their investor clients and, to a lesser extent, from direct contact with hedge fund managers. Among the larger vendors, enumerated in Table 1, are Hedge Fund Research in Chicago, MAR in New York, Tass Management (now a part of Tremont Advisers) in London, and Van Hedge Fund Advisors in Nashville.

The data that hedge funds must provide to investors are very limited, consisting mainly of periodic (monthly, quarterly, or annual) returns. Hedge fund databases also include information drawn from fund-offering documents, such as contractual provisions (fee structure, minimum investment size, withdrawal provisions, etc.) and descriptions of fund investment strategies or styles. While some hedge funds disclose monthly or quarterly statements to individual investors, details on positions, transactions, or strategies are very limited and vague. Secrecy is essential to the hedge fund manager who is trying to capitalize on a given stock, arbitrage situation, or a new, unnoticed, complex trading position.

A major limitation of hedge fund databases is that they typically have data only on funds still in existence or that are new and rapidly growing. Funds that are no longer active are dropped from the database entirely. This practice imparts an upward bias—known as survivorship bias—to performance statistics, since funds that are closed tend to be poor performers.

Another source of performance bias arises from the inclusion of new funds in databases. Often funds operate on a very small scale for a number of years before they are marketed to a wider group of investors. At this time their historical returns often are backfilled into hedge fund databases. These typically above-average returns are not offset by below-average returns of small unsuccessful funds that are

never actively marketed.

Additional questions about data reliability are raised by the possibility that only fund managers with positive returns release information. Fund managers are under no obligation to report negative returns or to publicize the poor performance of a fund. Yet, this information is needed for the vendors to establish accurate hedge fund industry performance.

Industry Size

Not surprisingly, estimates of industry size vary. Recent estimates place the number of funds at between 1,000 and 5,500 and capital managed at between $175 billion and $300 billion. The hedge fund industry is roughly the same size as the private equity industry and an order of magnitude smaller than the mutual fund industry. Van Hedge Fund Advisors estimates that there were 3,000 U.S. hedge funds operating in 1994 with a total asset value of $140 billion. The same year, there were 1,100 offshore funds operating with assets of $96 billion. As shown in Tables 2 and 3, MAR estimated that the industry comprised 904 funds with assets of $76 billion in 1996.

Soros Fund Management and Tiger Management are probably the two largest fund managers, each managing about $20 billion. Each runs multiple funds; for example, Soros's funds include Quantum Fund, Quasar International Fund, and Quota Fund, and Tiger Management's funds include Tiger Funds and Jaguar Funds. A hedge fund advisory group recently released a list of the top ten hedge funds (shown in Table 4).

Aggregate Hedge Fund Exposures and Leverage

Hedge funds sometimes employ significant amounts of leverage, resulting in aggregate exposures that far exceed capital under management. Leverage needs to be understood in the context of capital structure and can be very useful in creating greater value. Excessive leveraging, however, can lead to the assumption of unsustainable risks, as periodic market or business crises demonstrate. LTCM, for example, managed assets in excess of 30 to 50 times its capital.2 It employed extreme leverage in part because its reputation as an elite hedge fund resulted in generous lending terms from commercial and investment banks. In addition, a large percentage of its portfolio consisted of government securities, which can be borrowed against to a far greater extent than most other hedge fund assets. Table 5 indicates the amount of bank and security firm exposure to LTCM, illustrating the complex leveraging relationships between the fund and its lenders and investors.

It is believed that hedge fund assets are more typically between one and 10 times their capital. According to news reports, leverage at George Soros's Quantum Fund rarely exceeds 3 to 1, while leverage at Julian Robertson's Tiger Fund Management is less than 10 to 1. Van Hedge Fund Advisors estimates that 70 percent of hedge funds use leverage but that the vast majority employ leverage of less than 2 to 1 (see Table 6).

Aggregate hedge fund exposures—that is, the total value of hedge funds' long and short positions—significantly exceed capital under management but are extremely difficult to estimate. Moreover, owing to their heavy use of derivatives and other off-balance-sheet investments, even defining these exposures is difficult. Just as no reliable estimates of aggregate exposures exist, neither do reliable estimates of exposures by asset class or type.

Who Invests in Hedge Funds?

Investors include wealthy individuals and institutional investors such as endowments, foundations, and commercial and investment banks. A precise proportional breakdown of investor contribution is not available nor disclosed. It is also difficult to determine the extent to which pension funds—either corporate or public—have been significant investors. However, industry practitioners report that despite the lack of statutory limitations, most pension fund fiduciaries limit leverage in hedge funds to

2:1, which is an ERISA standard. Hence, pension fund exposure is probably not excessive.

Some Hedge Fund Industry Strategy Definitions

As mentioned earlier, not all hedge funds "hedge" at all. Funds usually subscribe to an investment strategy and make decisions that stay consistent with it. Table 7 is a partial list of definitions that shows the diversity of the hedge fund industry.

Industry Performance

Tables 8, 9, and 10 distinguish different investment styles and compare hedge fund returns to the S&P 500 and the J.P. Morgan Government Bond Index (see Brown, Goetzmann, and Park 1998). Looking at compound annual returns, the tables indicate that on average, macro, sectoral, event-driven, and global funds outperformed the S&P for the time period under consideration. Short sales underperformed the S&P index, as did market-neutral funds.

Some investment styles—event-driven, global, market-neutral, and fund of funds—have been less volatile than the S&P 500, while others, such as macro, sectoral, and short-sales funds, have been more volatile. Despite the volatility, adjusting for risk (accomplished by dividing the average annual compound return by the annualized standard deviation), sectoral and macro funds fare modestly at best against the S&P 500, while market-neutral and even-driven funds fare very favorably. In fact, most adjustment styles (except for short sales) seem to do moderately well in most years against the index even after adjusting for risk.

Furthermore, hedge funds fared better and outperformed equity and bond mutual funds during the six quarters since 1990 in which the S&P 500 had negative returns, as indicated in Table 11.

According to Tass Management's database, U.S. equity hedge funds posted negative returns (net of fees) of 2.32 percent, compared to an average of Morningstar domestic equity mutual funds which were down 5.17 percent from January through September 1998. The S&P rose 4.8 percent during this period. As shown in Table 12, global equity hedge funds were also down 7.15 percent, compared to 11.9 percent for the average international equity mutual funds. European equity hedge funds were the best-performing sector, up 18.23 percent compared to only a positive 7.00 percent for Morgan Stanley Capital International's Europe, Australasia, and Far East Index. Hedge funds investing in other hedge funds (the fund-of-funds universe) almost had no movement; they were down 0.69 percent, compared to a drop of 5.17 percent for mutual funds. Emerging-market hedge funds fell by 35.66 percent, compared to a fall of 35.21 percent for diversified emerging-market mutual funds.

Brown, Goetzmann, and Ibbotson (1997) studied the performance of offshore hedge funds prior to the Asian crisis. This study is particularly interesting because hedge funds are thought of as being a bet on manager skill, and the compensation structure is such that hedge fund managers are paid to take risks. While offshore hedge funds are commonly perceived to post higher returns at considerable risk, the study arrived at the opposite conclusion. It showed that offshore hedge funds underperformed the S&P 500 index from 1989 to 1995, posting an equal-weighted mean return of 13.36 percent as compared to the S&P 500's return of 16.47 percent. While returns were lower, standard deviation also was considerably lower at 9.07 percent compared to the S&P's deviation of 16.32 percent. The authors found no evidence of differential manager skill as reflected in persistence of performance of raw returns or risk-adjusted returns.

What We Know About Hedge Funds: The Empirical Record

The empirical record on hedge funds is already developed and addresses some key questions:

• Did hedge funds precipitate the Asian financial crisis? • Are hedge funds market leaders? • What role did the Asian carry trade have in hedge fund strategy? • Do hedge funds stabilize markets?

The findings of the literature on hedge funds are summarized in Table 13.

The Role of Hedge Funds in the Asian Crisis

Brown, Goetzmann, and Park (1997) also investigated whether hedge funds were responsible for the crash in Asian currencies in late 1997. The authors estimate the changing positions of the largest 10 currency funds in one currency—the Malaysian ringgit—against a basket of Asian currencies. To do this, they adapted Sharpe's (1992) analysis and decomposed fund returns to conclude that volatility in the long

and short positions of these funds has not correlated with changes in the exchange rate.

The authors tested the hypothesis of currency manipulation by a fund by regressing the monthly percentage change in the exchange rate (the dependent variable) on fund currency exposure. Even though measurement errors cannot be entirely eliminated, results show that exposures vary widely, both positively and negatively.

The hypothesis of zero exposure can be strongly rejected for only a few periods; nevertheless, exposure seems not to correspond to currency shock. The authors cite several instances where the aggregate exposure of funds to the ringgit was highly positive or negative, though the exchange rate did not change at all. Conversely, from June through September 1997—a period when the net hedge fund exposure was negative—the ringgit dropped by 10 percent. Regression results seem to corroborate this circumstantial evidence that hedge fund managers in no way affected the ringgit.

Regressions on a basket of Asian currencies—those of the Philippines, Taiwan, Thailand, Japan, Malaysia, Singapore, China, and India—also indicate that a change in the value of the currency basket was unrelated to any unusual exposure by the funds. Moreover, the top 10 hedge funds were buying into the ringgit as it fell in late summer and early fall 1997.

Were Hedge Funds Market Leaders?

Kodres and Pritsker (1996) indicate that hedge funds tend to herd together to some extent but are not followed by other investors. Funds' ability to collect information is inhibited by their low overhead and, hence, their small staffs. While it is possible to find instances where they did take the lead, for instance in the 1992 European Exchange Rate Mechanism (ERM) crisis, other investors have been in other instances the first to take a position against a currency peg. The distinction between hedge funds and institutional investors is blurred by the fact that the proprietary trading desks of commercial and investment banks invest in a manner similar to hedge funds. Moreover, as mentioned earlier, mutual funds, insurance companies, and university endowments are also among the most important investors in these funds.

The Asian Carry Trade

In search of higher spreads, international investors funded themselves in developed countries and invested in East Asian fixed-income debt. This carry trade was very profitable over an extended period for hedge funds as well as for other institutional investors. As pressure on the Thai baht built up, investors began to liquidate their long positions in these securities. Returns to carry trades on the yen and the dollar turned sharply negative with the devaluation of the baht in the third quarter of 1997, as shown in Table 14.

According to an IMF report (Eichengreen and Mathiesen 1998), the evidence shows that hedge funds were not the first to liquidate their forward contracts and were at the rear of the herd, which was led by domestic corporations and banks. Most hedge fund liquidations came much later in the process, in May 1997. Estimates of hedge fund involvement are imprecise, since funds may have sold the baht forward through offshore counterparts and through foreign and domestic banks. After July 2, 1997, the IMF report argued that domestic corporations fueled the depreciation by rushing for foreign exchange cover, surprising fund managers. Van Hedge Fund Advisors estimates that offshore hedge funds lost 7 percent of their value in August 1997. According to the IMF report, hedge funds also did not precipitate the decline of either the Malaysian ringgit or the Philippine peso.

Do Hedge Funds Stabilize Markets?

Fung and Hsieh (1997) studied investment styles of hedge funds and commodity trading advisers (CTAs) using monthly returns. They extend a model of mutual fund investment styles to attribute styles to hedge fund strategies and conclude that unlike mutual funds (whose returns are highly correlated with standard asset classes), hedge funds and CTAs have a low correlation with returns on mutual funds and standard asset classes. The diverse strategies followed by hedge funds seem to suggest that instead of contributing to excess volatility, they might actually be mitigating it. Kodres and Pritsker (1996) also find that large hedge funds tend to buy when prices fall and sell when prices rise, another characteristic that would stabilize markets.

Hedge Fund Mortality

Hedge funds have functioned as mutual funds for high-net-worth individuals; their prospective return on capital and insulation from risk have been their most attractive selling points. Many hedge funds have performed well and have played a valuable role in providing market liquidity. Others initially have thrived but ultimately did not survive the risk necessary for returns. Hedge fund mortality is, in fact, generally

high. During the 1990s, mortality has averaged 20 percent per year, implying an average fund life of approximately three years. Hedge funds' performance during times of market turmoil is quite unpredictable. Of the 1,500 funds that Financial Risk Management tracks, only 279 funds have been around long enough to post five years' worth of returns. Those that survive into 1999 will attest to their managers' expertise.

An above-average number of funds may fail outright during 1998. In general, funds are closed not because they have lost all of their equity but because they have become unprofitable to keep open. A shrinking asset base can result in management fees that are insufficient to cover fund expenses. The "high-water-mark" provisions typical of most incentive fee structures actually provide incentives to close following a period of poor performance. Hedge fund managers derive a great deal of their compensation from incentive fees, which are paid only when these managers earn a positive return.3 High-water-mark provisions require them to make up all previous losses before additional fees are paid.

Systemic Risk and Regulation

The Asian crisis and the subsequent bailout of LTCM raised several questions about regulation and risk.

What Should an Appropriate Regulatory Response Be in the Event of a Crisis?

The response of regulators depends on the perception of risk. Are hedge fund troubles the result of irrational exuberance on the part of investors, or are they due to improper incentives of the financial system, possibly abetted by existing regulations?

In the latter case, a further infusion of liquidity by a lender of last resort (such as a central bank) might provide only a temporary reprieve while exacerbating the underlying problem. This would signal financial institutions that they could always rely on such bailouts and that their downside risk was insured.

Who Should Be Regulated?

Systemic risk is mostly associated with banks, since their failure is considered costly to society. This is because banks are more fragile and highly leveraged (low cash-to-asset ratios, high short-term-to-total-debt ratios, and liabilities payable on demand at par value) than nonbanks and therefore are more susceptible to problems.

The derivatives market—in which banks as well as hedge funds are important market players—is also viewed as a potential source of systemic risk because of its concentration, lack of transparency, and interconnectedness. These features, along with uncertainty in valuing credit risks, can potentially lead to liquidity problems in securities markets. Yet, the low cost of hedging risk has made derivatives a competitive alternative to more traditional interest-bearing securities. Declining bid-ask spreads over the decade indicate greater liquidity in the market. Edwards (1996) has shown that these markets are not particularly concentrated and defaults are

independent across dealers and over time. Consequently, by reducing information deficiencies, participants in the derivatives market could be expected to lower transaction costs and enhance efficiency.

Can Systemic Risk Propagate Through the Markets for Derivatives?

Certainly, insofar as banks participate actively in securities markets, they would be adversely affected by a liquidity crunch in those markets. Depositors might also doubt the solvency of their bank under such conditions.

Aglietta (1996) has argued that market illiquidity can force banks acting as market makers to rely on dynamic hedging and to effectively transmit the liquidity gap to underlying markets. According to him, "the most insuperable difficulty to reach a correct estimate of credit losses is the fact that the correlation between the stochastic processes governing default probabilities and financial market variables is unknown" (Aglietta 1996, 20). This problem led Duffee (1994) to conclude that the joint stochastic behavior of defaults and credit exposure could result in a serious underestimation of credit risk. Aglietta also refers to the Fisher Report (BIS 1994), which back in September 1994 recognized a widening gap between the ability of financial firms to manage their own risks and their inability to assess the riskiness of other participants.

Even when banks are not directly involved in derivatives markets, the case of LTCM has alerted regulators to the dangers of excessive leveraging of banks to financial firms that are directly engaged in these markets.

Should Financial Firms Be Bailed Out?

To the extent that there is a significant societal cost or third-party risk as a result of leveraging, should financial firms be bailed out through an infusion of liquidity? Regulators have responded to this question by weighing third-party costs (taking into account the huge exposure of European and American banks to LTCM) against the possibility of creating moral hazard incentives and have tended to opt in favor of a bailout. Leading up to the Asian crisis, however, banks had made substantial profits, and some have argued that they might have been able to weather the storm without a bailout. Moreover, bailouts could signal banks that interconnectedness ensures that as long as they invest "enough" money in risky investments, they will not be allowed to fail.

Regulators are in the process of reconsidering existing rules in favor of rules that encourage an incentive-based approach to capital regulation in order to avert such crises in the future. According to this approach, banks themselves would choose the level of capital suitable to their portfolio. A penalty would be assessed if this level of capital were inadequate after the fact. In this way, regulators could utilize the existing risk-assessment technology of banks while providing them with an incentive to monitor themselves.

Managing Risk

Even before the recent crisis, banks and other financial institutions (LCTM being one

of them) had been using sophisticated risk-management models. The "value-at-risk" (VAR) model was one of the most popular, but it, too, could not anticipate a crisis.

VAR models use historical volatilities to project a range of future values, factoring in historical correlations to take into account the beneficial effects of diversification. Assuming normally distributed future values, the range is depicted as a bell curve. The value at risk, or cutoff point on the curve (expressed in standard deviations away from the mean), defines the boundary of future values that will result in large losses. Interpreted this way, the lower the probability of a big loss, the higher the VAR.

On the basis of past performance, VAR models anticipated stable spreads and assumed that banks always had the option of liquidating their positions. The likelihood of this obviously would become much more remote in the event of a crisis. Part of the rationale for bailing out LTCM was that, had it been allowed to go bankrupt and liquidate its net positions (estimated at $200 billion), the divergence between the price of government bonds (which would have risen) compared to riskier securities (which would have fallen further) would have been hugely exacerbated. This would only have made the situation worse by increasing the cost of liquidating positions for all market participants.

Regulatory Reform

Goldman (1998) reiterates the emphasis on regulatory reform as being of crucial importance in averting—or at least mitigating—such crises in the future. He identifies the restrictive role of regulation, which discouraged financial institutions such as banks, life insurance companies, and pension funds from engaging in risky lending. Since the demand for capital from emerging markets was inherently very risky, the slack in lending was taken up by unregulated investors. Risky lending activity was reflected in the $400 billion in investor equity managed by unregulated hedge funds prior to August 1998. Leveraged, this amounted to a much larger asset size, which may have been between $1 trillion and $2 trillion, according to this report. Investment activity by hedge funds was concentrated in risky assets such as mortgage derivatives in addition to emerging-market debt.

Recent proposals for regulatory reform would discourage bank lending to hedge funds while permitting banks to enter those risky markets themselves. As mentioned earlier, regulators have begun to consider a portfolio approach to risk management as opposed to the earlier risk-based capital requirements for banks that evaluated the risk of each asset individually. This approach was reflected by the Basle Committee's recent (1998) decision—some features of which are summarized in Table 15—that innovative financial instruments should not account for more than 15 percent of banks' Tier 1 capital. This decision was motivated by an attempt to define a broad limit (while preserving the distinction between Tier 1 and Tier 2 capital) rather than prescribing exactly which instruments should be included in each tier. Until now, the Bank of International Settlements (BIS) applied the formula indicated in Table 16 to the risk weighting of bank assets.

The distinctions among default risks of the various categories were much more blurred in reality than was suggested by the BIS risk weights assigned to each category. The portfolio approach would perhaps lower the cost of capital. Regulators hope that by allowing banks to invest in risky assets under the umbrella of supervision, the process will become more transparent. Public disclosure would encourage safer bank practices.

Regulation and Transparency

The most potent discussion presently regards regulating funds by demanding more transparency. The justifications offered for regulating hedge funds are consumer protection, systemic risk, and market integrity. Brooksley Born, chair of the Commodity Futures Trading Commission (CFTC), has been warning for nearly a year about the risks of unregulated over-the-counter derivatives financial contracts used to hedge positions on credit instruments. Regulatory agencies such as the SEC, CFTC, and Federal Reserve all are currently conducting separate investigations.

Regulating hedge funds is not as easy as it might appear. The largest problem is the diversity of strategies and complex use of financial instruments and trading positions. Table 7 showed 18 different strategies that ranged from distressed securities, macro funds, and aggressive growth to funds that invest in other funds. Some of these funds are long and others are short. A closer dissection of any group of these funds finds investment techniques that are as diverse as the fund strategies themselves. We find a variety of macro funds that take no positions in any market, differentiated from macro funds that take risk-adverse positions in developed markets and funds that take high-risk positions in only emerging markets.

A further problem with regulation is in differentiating hedge funds from other institutional investors. All over the financial services industry we find operations similar to those undertaken by hedge funds at large financial institutions. Most investment banks have trading desks that utilize similar investment strategies by trading derivatives, foreign currency exchanges rates, and taking positions on interest rates in less developed countries. Commercial banks have the ability to take highly leveraged positions with similar situations. Almost every player in the financial services industry also invests in hedge funds.

Federal Reserve Board Chairman Alan Greenspan's recent testimony before the House Committee on Banking and Financial Service made a strong argument against regulation.

It is questionable whether hedge funds can be effectively directly regulated in the United States alone. While their financial clout may be large, hedge funds' physical presence is small. Given the amazing communication capabilities available virtually around the globe, trades can be initiated from almost any location. Indeed, most hedge funds are only a short step from cyberspace. Any direct U.S. regulations

restricting their flexibility will doubtless induce the more aggressive funds to emigrate from under our jurisdiction. The best we can do in my judgment is what we do today: Regulate them indirectly through the regulation of the sources of their funds. We are thus able to monitor far better hedge funds' activity, especially as they influence U.S. financial markets. If the funds move abroad, our oversight will diminish. (Emphasis added)

Mechanisms to enable partial hedge-fund position disclosure already are in place. Although hedge funds are exempt from formal SEC disclosure, they are subject to statutes governing against fraud and other criminal activities. The CFTC regulations must be observed by all funds that participate in FX derivative market trading. The CFTC also requires reporting for futures positions above a certain threshold along with broad inspection powers. All funds are subject to the Federal Reserve reporting system for large foreign currency positions on the British pound sterling, Canadian dollar, German mark, French franc and Japanese yen. Weekly, monthly, and quarterly disclosures are required, depending on the value of the contract. The Treasury Department has the authority to request information on positions in to-be-issued and recently issued securities. The SEC requires quarterly filing for institutional investment managers that have accounts totaling more than $100 million in exchange-traded NASDAQ securities or holdings.

Conclusion

Overleveraging, excessive bank lending, and overreliance on fragile financial models precipitated the hedge fund crisis. Hedge fund managers proved they knew more about math than markets. Consistently inconsistent global economic complexities confounded sophisticated financial models. Some hedge funds failed because their models could not tolerate low-probability events (i.e., that recurring statistical problem of fat tails).4

There seems, however, to be little basis for the more dramatic fears about hedge funds: that they are sources of speculative currency attacks, that they are universally overly leveraged, and that they are a source of systemic risk. Compared to $3.2 trillion in mutual funds, the ceiling estimate of $300 billion in hedge fund assets cannot destabilize or manipulate $30 trillion in global financial markets. Similarly, some of the more euphoric claims about hedge fund performance are overstated. Though hedging strategies play an important role in contributing to market stabilization and risk management, the universe of hedge fund returns, survivorship, and overall performance is modest at best.

Calls for regulation hinge upon the threat of systemic risk. But requirements to raise margin calls and collateral or concerns about moving markets seem overdrawn based upon current evidence. Whether hedge funds continue to operate independently or whether they morph into hedging operations within the regulated banking system, they create new pools of investment capital that, given the variety and dispersion of their trading strategies, have poured capital into emerging equity and bond markets.

Most regulatory concerns can be resolved by monitoring bank lending to hedge funds. As in other financial crises, the problem appears to concentrate in excessive bank lending rather than capital market operations alone. This problem could be resolved simply by disclosing the source of funds rather than restricting hedge funds

directly. The convergence of low transparency by governments and banks negatively affected both emerging markets and their investors, including hedge funds.

The regulatory sea change underway is in the shift from risk-based capital requirements to portfolio risk management for financial institutions. Increasing such flexibility could remove the restrictions on riskier lending that shut financial institutions out of profitable high-yielding investment strategies in the first place. It would also enable financial institutions to reinvent themselves through principles of modern portfolio theory rather than regulatory restriction in risk management and assessment. Capital adequacy standards have not been successful in limiting financial crises while portfolio risk management, when disclosed and evaluated, can.

With the potential demise of more aggressively leveraged hedge funds and the remediation of their function through financial institutions, as proposed by the BIS, a very serious question remains unanswered for the developing world: How will growth be funded in emerging markets? The lessons and legacy of hedge funds and their future will be defined in the answer.

Glenn Yago is Director of Capital Studies, Lalita Ramesh is a Research Associate, and Noah E. Hochman is a Research Analyst at the Milken Institute.

Endnotes: 1William Hunter, Senior Vice President and Director of Research at the Federal Reserve Bank of Chicago, describes systemic risk as follows: "In broad terms, systemic risk can be defined as the risk that a shock to the financial system significantly impairs crucial functions such as asset valuation, credit allocation, and payments and settlements and imposes significant costs to the real economy." In Barth, Brumbaugh, and Yago (forthcoming). 2According to news reports, LTCM had $125 billion in assets and $2.3 billion in capital at the end of August 1998, or assets equal to roughly 54 times its capital. Of course, its leverage was inflated by August losses equal to almost half (44 percent) of the fund's capital. Still, these figures suggest that at the beginning of August LTCM's asset-to-capital ratio was more than 30. 3Fee structures today typically range from 15 to 20 percent of new profits. 4Portfolio models based on the assumption of a normal distribution do not assign a high probability to the occurrence of a large loss. If models were to assign a higher probability to such large losses, one would expect more observations in the tails of the distribution, making it fatter.

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Van Hedge Fund Advisors International, Inc. 1608 Chickering Road., Nashville, TN 37215. www.vanhedge.com.