This is high compared with the 0.2 achieved by equities and the 0.5 achieved by US bonds since 1994. Admittedly, such aggregate return data need to be interpreted carefully.6 Nonetheless, the available industry databases are useful in identifying broad trends within the hedge fund industry. Hedge funds and market volatility Throughout the last twenty years, it has become conventional wisdom to associate hedge funds with extreme market volatility. The premise is that hedge funds push market prices temporarily away from their equilibrium, either in the short- or the medium-term. The traditional counter-argument sees hedge funds fundamentally as stabilizing market participants who identify arbitrage opportunities, take profits as these inefficiencies get eliminated and provide the market with liquidity. A survey of available analytical work suggests it is difficult to conclude that hedge funds decisively and adversely affect market volatility. This raises the question of whether direct observation of market price action can provide us with additional clues. One area worth examining is the macro and the managed futures segment of the hedge fund industry where recent inflows have been substantial. A number of markets that hedge funds in these strategies are typically engaged in have recently become more liquid as demonstrated, for example, by the increase in turnover and rise in non-commercial positions in the gold and oil futures markets (graphs 3 & 4). Market observations also suggest that many technically driven hedge funds appear to hold similar positions on the basis of trading systems, driven by related trigger points.
The obvious counter-argument is that despite recent inflows, no hedge fund segment is large enough to materially affect price action in today’s vast global market place. This argument may be too simplistic for two reasons: First, hedge funds across different strategy segments are often involved in similar trades. Second, it is not sufficient to evaluate the potential impact of various segments of the hedge fund industry by looking at the nominal size of the invested capital base. Market information, as well as survey data, suggests that the managed futures segment, for example, is significantly more leveraged than the overall hedge fund industry. As a result, the capital deployed in a number of hedge fund segments can exceed by a wide margin what is suggested by the various providers of flow data. Merely considering the nominal asset base of a hedge fund strategy may significantly underestimate its potential impact. Leverage is therefore an important issue in any assessment of how hedge funds affect overall market conditions. Hedge funds and leverage In the aftermath of the 1998 LTCM crisis, the use of leverage by hedge funds was one of the central points in a wide range of industry and policy discussions. The basic premise was a simple one: The use of leverage is an important investment tool for hedge funds in their quest to generate absolute returns commensurate with their fee structure. At the same time, leverage can magnify market risk, credit risk and liquidity risk.