Hedge funds are hot — there’s no debating that. But should you, the individual investor, jump in? And will the growth of this unregulated investment vehicle forever change the way Americans invest?
These questions are all the more important when you consider that the hedge fund business is a secretive and often controversial industry. Hedge funds have attracted a great deal of investment money over the last few years, and they are no longer the preserve of the super wealthy.
And while some say the trillion-dollar hedge fund industry can have a positive influence on the markets — injecting liquidity and making asset pricing more efficient — others caution that the building influence of hedge funds could instead be a ticking time bomb, potentially sending shock waves through the investment world if there is ever a stumble in the markets.
Gerald Corrigan, the former head of the New York Federal Reserve who is conducting an investigation into the financial risks posed by hedge funds, says that while another Long Term Capital Management (LTCM)-style crisis — a hedge fund that famously imploded in 1998 — isn’t likely, hedge funds do pose a significant risk to the market and investors.
“Is there another LTCM out there? No,” he said.
“Is it possible that there are fifty hedge funds that are such look-alikes, [in terms of what they are doing,] that even though they are independents that together they have the potential of a Long Term Capital Management? Well, it’s possible,” Corrigan added.
Echoes of 1998 were heard earlier in May when a downgrade of General Motors’ debt rating sent ripples through the financial markets, and much of the market’s sell-off was due to global hedge funds, who had suffered big losses in their GM holdings.
On that day in May, no one knew the extent of the hedge funds’ losses, or how they would impact the world’s markets. That’s because hedge funds are a bigger force than ever in the market, and they’ve introduced new risks to every market player, from the biggest Wall Street firm to the smallest individual investor.
And hedge funds are feeling the heat from all sides.
Investors expect outsized returns, and as the industry expands, delivering those returns has become harder says James Chanos, president of Kynikos Associates, a hedge fund. The drive for bigger returns is pushing funds to take greater risks, and the strategies that work attract a crowd, raising the stakes for when things go wrong.
A string of hedge fund losses could prompt investors to demand their money back, and it could hurt the banks that extend credit. One hedge fund collapse, like a single stone dropped into a pool of water, causes hardly a ripple. But drop handful of collapses causes a ripple that soon becomes a shock wave.
And hedge funds have moved the prime time for profit-making to before Wall Street’s opening bell, to the detriment of smaller investors.
“We’re seeing in many cases … 70 to 80 percent of a day’s impact before 9:30 a.m.,” said Laszlo Birinyi of market research firm Birinyi Associates. Opportunistic investors are aggressively buying or selling and as a result there’s not a whole lot on the table for traditional investors, he added.
Meanwhile, the Securities and Exchange Commission, the financial industry watchdog, wants to better understand the good and the bad of hedge funds. By February, most of them must register with the SEC, a move that may shed more light on the industry, but may not hedge against their risks.