The growth of hedge funds - Insight into market declines

June 10, 2006

Hedge funds currently have over $1 trillion in global assets, and are growing significantly. Hedge funds are private partnerships that offer above market returns with higher risk. They use complicated trading techniques, including commodity options, currency futures and short selling. They are often guided by sophisticated computer programs that automatically generate buy or sell orders when the market triggers certain parameters. The amount of leverage these funds use greatly magnifies any market corrections. Unlike mutual fund managers, hedge fund managers receive a a percent of any return, and receive nothing if there is a loss.

What It Means:
Hedge funds are not required to register with the SEC, and so are less regulated than mutual funds, bonds and savings accounts, which means nobody really knows where this large amount of money is invested. Their focus on leveraged derivatives means that when the market changes direction, as it recently did and may continue to do, these funds must make huge shifts in their investments to cover their positions. This increases the swings in the market, and ultimately the volatility in your portfolio.

Long-Term Capital Management was a hedge fund that nearly collapsed in the summer and fall of 1998. Since so many banks and pension funds were invested in LTCM, its problems led to the global market decline that year. Without the swift intervention of Fed Chair Alan Greenspan, the entire financial system threatened with a collapse. There is growing concern that the large role of hedge funds in today’s markets could cause a repeat of that panic.

Action Steps:
Since the market is going through an uncertain phase, it is really important that you not react in a panic and do anything dramatic, like sell all your stocks and move everything into cash. However, since the market seems to be changing direction, now is a good time to review your portfolio and perhaps shift some of your holdings into safer funds, such as large cap, and out of riskier ones, such as small cap.

Source:

Hedge Funds, Leverage and the Lessons of Long Term Capital Management by The President’s Working Group on Financial Markets, 1999.

Remarks by Chairman Ben S. Bernanke At the Federal Reserve Bank of Atlanta’s 2006 Financial Markets Conference, Sea Island, Georgia, May 16, 2006