Investment Market LTCM Essay
Alternative Investment and Market Efficiency: In light of the rescue of LTCM is additional regulation of the industry needed? MSc Quantitative and Investment Finance Executive Summary This research paper has two objectives: clarify on the Alternative Investment and investigate which investment strategies are susceptible of having moved asset prices away from their fundamentals. To do so, a break down of the Alternative Investment sector is performed. The structure of analysis employed in this research paper is as follows: Firstly, since the Alternative Investment industry includes an eclectic range of participants operating under a variety of investment mandates, it is worthwhile dissecting the sector to identify potential market movers. Alternative Investment styles will be explained and data on the size, growth and performance will be provided. Secondly, the role of Alternative Investments in financial markets is described. More specifically, liquidity and risk sharing concepts are applied to the activities of such participants. Concerns over the volatility following the globalisation and the institutionalisation of markets are also addressed. Thirdly, an overview of regulatory issues in the over-the-counter markets is completed. Such parallel allows for the understanding of links between transparency, liquidity risk, systemic risk and price distortion. The Long Term Capital Management saga is used as an illustration of such chain effect, where margin calls and threat of liquidation are themselves responsible for unjustified price gaps. Monitoring and controlling risk has become one of the hottest topics in the investment management industry. The continuing falls in the equity markets have brought home the reality to investors that investment has its risks therefore; firms are actively investigating risk control procedures and putting in place procedures to monitor the risk of their portfolios. This has been further fuelled by many well-publicised cases where risk controls have been lax, the highest profile being Barings and LTCM (Long Term Capital Management). One can look at risk in a number of ways. From first principles, risk can be defined as the potential for failure to meet objectives. Hence a client may define risk as the loss of money, a pension fund sponsor may consider it in terms of inability to meet liabilities, a fund manager may view it as underperformance against the benchmark, etc. Hedge Fund blow ups have had varying affects on the economy. At the far extreme, when LTCM failed in 1998, its losses were so big; it threatened the stability of the US financial system. Regulators organised a bail-out to prevent a knock-on effect. However, in 2006, Amaranth, another US Hedge Fund, lost $6.5billion in a month in the natural gas market. It was not bailed out by regulators and instead closed with investors losing out. An Overview of Alternative Investments Sector 1 Introduction 1.1Origins and development of Hedge Funds During the last 60 years, the term Hedge Fund, has been applied to a wide range of collective pools of assets. Stock market cycles, financial innovations, developments of arbitrage strategies and trends in the market place have allowed the definition and characteristics of Hedge Funds to be dynamic over time. Perhaps the most appropriate and insightful description is the one stemming out of Hedge Funds’ origins and the hedging concept itself. The term hedging is referred to when a specific market risk, which is brought by an initial position, is cancelled out through the undertaking of an opposite transaction. Doing so ensures of incoming profits when losses occur from the original position. The development of the derivatives market has allowed such downside coverage of selected risk economically and efficiently, in terms of capital, transaction cost and counterparty risk. Alfred Winslow Jones, a sociologist and investor, was formally the first to introduce the concept in equity portfolio management when he set up his fund in 1949. When managing a portfolio of equities, systematic risk and non-diversifiable risk are incurred. His investment strategy was the following: In order to benefit mostly from stock picking abilities, he used to cancel out a proportion of market risk. Short selling selected stocks enabled him to hedge against a possible downfall of the equity market. Finally, leveraging his long positions procured an expansion of his exposure to stock’s specific risk. Such strategy represents an opportunity for talented managers to go long bullish stocks and short bearish ones. The peculiarity of this investment policy is that it should be partly (exposure is relative to the hedge ratio) independent of market swings. Even though the strategy is highlighting portfolio manager skills in the stock selection process, the ability to adjust the hedge ratio depending on forecasted market behaviour is also rewarded. In more general terms, a perfect hedge, where an equal amount of asset value is held long and short, completely neutralises gains and losses. In theory a fully hedged position should yield a risk free rate because market risk is eliminated. Holding a dynamic hedge allows a window of systematic exposure for profiting from market timing skills. In relative terms, being under hedged in a market downturn increases losses, being over hedged in an upswing cuts profits. That is when comparing both positions to a completely unhedged one. Jones’ fund proved successful in implementing such a strategy combining leverage, and short sales. After successive outstanding performance results following the birth of the Jones fund, the news coverage on its activities increased, reporting details of the fund’s structure and strategy. The term Hedge Fund was attributed to the Jones partnership. The coverage, incentive fees and success of the concept promoted a strong proliferation of similar funds over the years. During the following decades, stocks have had many bullish runs, more than downturns. Holding short positions in such an environment happened to be expensive in terms of opportunity cost. Progressively, the hedging component of the strategy disappeared. Many Hedge Funds ended up managing leveraged and naked equity positions. Such amplified exposure to market risk caused the extinction of many funds over time when faced with strong market corrections because of the absence of the protective leg originally provided by the hedge. Even though only the hedge differs, a leveraged and hedged stock picking strategy can transform itself into pure speculation if the hedge is folded. In general, today’s Hedge Funds do not completely hedge their market risk. Additionally, most Hedge Fund managers are not using derivatives necessarily for hedging purposes but occasionally for speculation. Effectively, options, futures and swaps have enabled managers to leverage their positions in markets cheaply and efficiently due to the low margins required. Also, price relationships between derivatives and their contingent claims are sometimes broken for short moments and represent opportunities for quick and wise managers to exploit these market inefficiencies. This requires considerable computer, software investment and capital at hand for making slight mispricing exploitation worthwhile. Thus leverage is frequently used in arbitrage strategies. It is worth specifying arbitrage activities do not necessarily imply a free lunch since exogenous shocks not considered into a pricing model can trigger changes in market conditions and brake historical price patterns between instruments. Furthermore, liquidity risk must be considered when undertaking arbitrage strategies in thinner markets. 1.2Today’s Hedge Funds Strategies In order to have a more descriptive insight on Hedge Fund investment strategies, the following section will cover the scope of trading styles. Dynamic and leveraged, short and long, strategies can provide payoff structures which bring substantial diversification benefits to traditionally balanced portfolios. Sophisticated investors in quest for ever higher returns are ready to pay significant fees and handle substantial volatility. In order to have a more descriptive insight on Hedge Fund investment strategies; the diagram below cover the scope of styles as reported by the Hedge Fund Research website. Many of the categories are self explanatory; please refer to Appendix 1 for strategies definitions extracted from Hedge Fund Research Website. 1.3Hedge Funds Key Features Alternative managers have the possibility to use wide array of financial instruments contrarily to mutual fund. Investments in asset backed and mortgage backed securities, illiquid equity stocks, low grade bonds, commodity futures, other derivatives and similar claims in emerging markets. Performing investments in such non traditional assets often implies significant diversification benefits for the casual bond, cash and equity investor. For most individuals, Hedge Funds are an adequate vehicle for positioning themselves in such exotic assets. Managers, in order to minimise the moral hazard effect, often inject an amount of capital directly into the fund. In doing so, an alignment of incentives with other shareholders is created, making the funds’ stock initially more marketable. Participation in a Hedge Fund also has disadvantages. Shares are not liquid as redemption is permitted infrequently (monthly, quarterly, etc…). The net asset value (NAV) of the fund can be transmitted only to existing shareholders. Due diligence in reporting to investors is limited and performance is not based on benchmarking with indices or selected instrument baskets but evaluated on an absolute basis. This feature is beneficial to Hedge Fund managers since they are not constrained of holding securities solely for the purpose of replicating the performance of reference indices. 1.4Legal and Tax Issues In the United States (US), where the majority of Hedge Funds are located, the limited partnership (LP) structure is very convenient in avoiding the regulatory burden applying to registered funds with the Security Exchange Commission (SEC). More precisely, by undertaking a private offering under special circumstances, such legal entities are not obliged to register under both the Securities Act and Investment Company Act. More specifically, Hedge Funds rely on a private offering exemption provided by the Section 4(2) of the Securities Act or the related safe harbor under Regulation D of the same Act. In general, offering interests must be sold to accredited investors which can be generally defined as wealthy individuals or institutional investors. Such privilege is rarely used in practice since there would be disclosure due diligence to these non accredited investors. At the time of the offering, no general advertising or general solicitation can be undertaken to market the deal. Offers can only be communicated to investors with whom the general partner had a pre-existing relationship. Avoiding the Investment Company Act is beneficial to Hedge Funds since investment constraints concerning short selling, the use of leverage and reporting diligence are imbedded in them. Hence, the Hedge Fund partnerships structure allows for the avoidance of the compliance requirements imposed by both Acts. Such exemption is given to funds with less then 100 limited partners. The prevention of such regulatory constraints, the investment flexibility gained by such circumvention and the requirements needed to benefit from the exemption has helped characterising Hedge Funds in the following manner:
- “An investing partnership that is unregulated”
- “One that seeks high rates of return by investing in virtually any form of financial instruments”
- “An entity that takes long and short positions and invests in many markets”
- “An entity that uses leverage”
Many offshore Hedge Funds have been settling in tax neutral jurisdictions where taxes are kept to a minimal level. This allows the averting of a double tax liability. In order to benefit from the special tax status, the fund must perform most of its business activities in or from the offshore territory. Offshore funds directly depend on the jurisdiction they are involved with. This explains why they take a variety of legal forms from one jurisdiction to another (such as investment companies, trust and limited liability partnerships LLP) in order to maximise the tax and disclosure benefits. EMPIRICAL THEORY AND LITERATURE 2Price Distortion: Empirical and Theoretical Grounds The Alternative Investment identified two large classes of Hedge Funds which are more susceptible, due to their size, concentration, and investment strategies, to manipulate markets, namely Global and Macro Hedge Funds. Hence, Macro Hedge Funds, which take positions on changes in global economic conditions as reflected in equity prices, currencies, and interest rates. The extensive news coverage on both selected investment schemes, the Hong Kong Double Play and the Yen Carry Trade, was directly accusing Hedge Funds of being their main implementers. Before addressing the details of these strategies, and overview of key issues stemming from the Asian Pacific Economic Cooperation summits, lead by Malaysian Minister Dr. Mahitir, will demonstrate such Hedge Fund market manipulation represent real political and economical concerns. Two strategies have been established in the literature to gain insight on speculator’s potential impacts on price equilibrium. Both will be explained subsequently. Secondly an empirical methodology introduced by Goetzman et al., but strongly influenced by the Fung and Hsieh (1997) study, will be tackled. Hence, regression analysis will be applied in order to evaluate the potential exposure major macro Hedge Funds accumulated in Hong Kong and Japan under the previously chosen trading techniques. A review of the herding literature will follow. The herding concept is a powerful one, since it allows uncovering a framework potentially used by speculators, where they voluntarily move asset prices away from their true value and then benefit from the explosion of such price bubble. 2.1.The Asia Pacific Economic Cooperation Worries The association which is composed by 21 member countries was directed by Malaysian Prime Minister Dr. Mahitir has been keen to publicly and denounce the negative impact Hedge Funds and currency traders have had on its national economy. It is of no surprise that regulation of short term capital flows was the main issue of discussion in the summits he chaired. It is worth going over the concerns which surfaced during the APEC group meetings in order to grasp the importance of Hedge Fund trading and the stemming threats of market inefficiencies. Some of these countries have claimed to be direct victims of speculative attacks on their currencies over the year, such as Hong Kong, Japan, Taiwan, Indonesia, Thailand, Malaysia and Australia. During the summits the clear cut conclusion that currency speculators were responsible for the Asian Crisis was confirmed by most members. Some delegates have stated the size of managed pools of capital some Hedge Funds had accumulated was equal to the resources of some countries and that bank lending should be tightly controlled in order limit their market power. In the same line, Dr. Mahitir recalled that currency trading turnover was largely exceeding levels of commercial activities, rendering the creation of a virtual money concept. The considerable leverage potential traders have, allows them to move astonishing figures on screen, perhaps dislocating currencies and disturbing trade. He said that even though these amounts were virtual, social and political consequences were very real. Mahitir has called for Hedge Fund licensing and registration of currency traders, restrictions on bank lending which support such activities and limits on trading volumes. These requirements would be applied to private-sector financial institutions involved in international capital flows, such as investment banks, Hedge Funds and other institutional investors. Australia has been less conservative, demanding for disclosure of speculative activities, including exposures on individual transactions. In general, drastic measures have been discussed to limit Hedge Fund impacts in financial markets, proving concerns over Hedge Fund impacts are substantial. Asian authorities are aware of the costs of undertaking such regulatory measures in financial markets but they see a need for it. Still most agreed transparency and disclosure requirements had to be primary concerns. There are two legs to this regulation argument and are worth paying attention in order to distinguish between types of speculation. Propositions made during the council sessions have demonstrated the debate can turn political rapidly. A fundamental issue remains even though speculators activities have taken immense proportions. Some Asian economies have themselves been slow on disclosure of reliable economic indicators. Many Asian countries have had a dubious banking sector for too long. Some financial institutions in these countries have been lending without stringent selection and monitoring of borrowers. The length of time for the write off of such bad loans was often a source of asymmetrical information rendering speculative operations on some major national banks profitable. The point was weaknesses in some Asian countries have been highlighted after the market corrections. Speculative activities, including the short sales of bank shares, have put pressure on the stock index, causing massive sales of the involved currency. Hong Kong and Japan are examples of such financial institution crisis. Hedge Fund activities are suspected to have accelerated and magnified the process of convergence of asset value to fundamentals, in the occurrence by implementation of the double play of Hong Kong. Clearly, the causality proposed by Mahitir and other politicians, saying Hedge Funds are at the source of the 1997 Asian market turmoil is hard to prove. In a sense, perhaps Hedge Funds were the first to uncover the hidden structural problems and synchronously implementing proper trades to cash on the situation. Still, what remains is that Hedge Funds could have sufficient aggregate market power to drive some currencies out of their peg, whatever the underlying economical fundamentals of the targeted nation. Herding theories in this case render self fulfilling prophecies even more realistic, since such momentum trades imply a one bet. Georges Soros himself explains the trading phenomenon, where equilibrium is not reached because of massive capital flows which cause sudden price movements. These price exaggerations then affect the fundamentals rendering the ex-ante price movements justifiable; “In the normal course of events, a speculative price rise provokes countervailing forces: supply is increased and demand reduces. But there are exceptions. In foreign exchange, for example, a sustained price movement can be self-validating, because of its impact on domestic price levels. The same is true in the stock market where the performance of a stock may affect the performance of the company in question in a number of ways.” 2.2.Investment Strategies Susceptible to Market Impacts A few strategies have been known to have created substantial distortion in markets due to their implementation by sizeable Hedge Funds and their use of substantial amount of leverage. The following sections are describing such strategies. Regressions will be applied subsequently in order to help quantifying Hedge Fund exposure during the implementation of the two selected investment schemes. 2.2.1The Yen Carry Trade Borrowing at low cost and investing in higher yielding instruments has been a long tradition in financial markets. Since the recession began (1998) in Japan, rates have been lowered repeatedly, making the country an appropriate source of fund. As long as the Japanese economy would not resume, cheap funds would be available at a low risk. The strategy of borrowing in yen at floor rates and investing back abroad at decent rates in respectable low risk securities is well known in the markets. In fact, American and Canadian trading departments often report that the investment strategy is the “closest thing you could get in the global markets to a free lunch”. Indeed, the Japanese Central Bank had kept its bank rate at less than 1 per cent in order to attract capital and fueling growth. Japan’s benchmark 10-year bond was yielding 0.75 per cent in October, compared with 5 and 4.72% for the Canadian and American equivalents. Hedge Funds have been known to intensively and extensively participate in the Yen Carry Trade. Some reporters say the difficulties which many macro Hedge Funds were facing during the months of September and October 1998 and the weakening U.S. dollar made the Yen Carry Trade less of a free ride. Since some Hedge Funds were supposedly massively leveraging themselves in Yen, any slight turnaround, accompanied with margin calls on investments made abroad, could trigger a wave of U.S. dollar sell off. Buying Yens was necessary to reimburse the initial loans and was indispensable to cover possible foreign exchange losses. Many Hedge Funds have been accused of herding when unwinding simultaneously their yen positions, hence affecting significantly the exchange rate over a few days. The dollar yen exchange rate on October 7 was seen as especially vulnerable to Hedge Funds’ capital flows. The global turnover in yen trading alone amounts to $1trillion a day and the resources of just one large Hedge Fund can reach tens of billions of dollars. During the day, in less than six hours of trading, the dollar lost 6% against the yen from Y131 to Y123, reaching a low of Y120 later in the day. The following day, October 8, the dollar plummeted to Y112 in a few hours. The result was a loss of 20% in less than 3 days. Such volatility in the dollar yen was unseen since 1970, when the U.S. currency replaced the gold standard. Many research reports communicated 2 months prior, indicated the dollar could appreciate up to Yen180, leading many to believe the rates had derailed from their fundamentals. The volatility in the exchange rate was very impressive over the period ranging from June to November 1998, and since the Yen Carry strategy was certainly massively used by the most reputable macro Hedge Funds, it is worth inquiring a possible market impact. Following the statistical methodology introduced by Brown, Goetzmann and Park, a similar set of regression will be run on the dollar yen exchange rate over the prior year. 2.2.2The Hong Kong Double Play Hong Kong Monetary Authorities (HKMA) which are well known for being free market proponents, plunged US$15.2 billion in their blue chip stocks as an offensive move to counter attack Hedge Funds performing the double play. The strategy was simple. Hedge Funds and other speculators shorted the currency against its peg in huge amounts. News reported they shorted in amounts reaching $2 billion in the first week of August and $4 billion the following week. They simultaneously went short on a massive amount of stocks and index futures. Both moves ensured a self financing position since authorities would have to raise the interest rates to defend the currency peg, and consequently deflating stock prices. The pressure on the equity market would yield profits on short equity positions, fueling more funds to short the currency off its peg. As a counter measure, the government intervened during 10 days starting August 14, by buying 33 listed companies in proportions corresponding to their weight in the Hang Sang stock index, and hence squeezing short sellers in the Hang Seng futures contracts, forcing them to close out their August contracts, and making it expensive to roll over their short positions in subsequent contract months. A company was formed to manage the stock holdings and took the mandate to sell back-acquired shares gradually. HKMA also revised their trading rules. In order to put a stop the massive amount of short sales, they imposed the ownership of stocks to cover positions and tightened obligations to settle deals in less than 2 days. In futures market, they required large short positions to be disclosed to regulators and were stricter on margin limits. A special margin surcharge of 150% percent of contract value on index futures was imposed in August. Even though principles of non-interventionism have been broken, HKMA have avoided a devaluation but at an astonishing cost. The amplitude of the operation clearly proves convergence in speculative and leveraged trading strategies can put extreme pressure on a financial system. The additional regulatory measures have been suspected to drive futures’ business to Singapore. Indeed, the Hong Kong devices such as disclosure of large short positions in futures contracts must be implemented to other jurisdiction in order to be efficient. The necessity to have a simultaneous implementation of a uniform set of regulatory measures on a global basis in order to avoid business migration will be discussed in section 3 but is clearly illustrated in the case of Hong Kong, where foreign investment banks threatened to move out. 2.3Group Psychology in Financial Markets The following statement of Hong Kong Leader Tung Chee-hwa nicely bridges to the following topic, proving Hedge Fund activities have been the subject of great concerns and explains the massive counter interventions on behalf of Asian central banks. “The turmoil experienced by countries in Asia was compounded by the activities of the international Hedge Funds”. “The fact is they can create this herd instinct mentality and that herd instinct, and the activities of Hedge Funds, leads many other international financial institutions to follow, to act together, and they together create havoc in many financial markets around the world, including Hong Kong”. Sociologically speaking, many studies have demonstrated the tendency of the human nature to undertake similar actions previously assumed by peers in a context of uncertainty and competitive pressure. Even though financial decisions rotate around computer analysis and controlled research by field specialists, it is the human nature which is the primary driver in the decision process. Since the proportion of institutions managing investments has been increasing greatly over the past years. The interaction between both types of investors (informed vs. uniformed) has been the subject of extensive research. Some behavioural models have been presented to explain well known market inefficiencies such as price bubbles and some simple but empirically lucrative ex post trading strategies. Interestingly, empirical tests can be grossly segregated into two by types of strategy used to reject the market efficiency hypothesis. The first group composed among many others of De Bondt and Thaler (1985), Jegadeesh (1990) and Lehman (1990) suggest that contrarian trading strategies yield significant excess profits. Others, such as Grinblatt, Titman and Wermers (1995) provide evidence on the abnormal profitability of relative strength strategies that consists in buying recently increasing stocks and selling the ones that undertook losses. The second group consists of people, who suggest the momentum strategies, and a theoretical analysis is made of the effects on the hedge funds based on correlated market transactions. Prices of hedge funds can be affected drastically due to transactions of alternative money managers, making the prices move completely out of line. The second group include studies such as Grinblatt, Titman and Wermers (1995) who explained how mutual funds and equity markets were correlated and how mutual funds impacted the equity markets. This study has created a theoretical framework for alternative managers to understand the markets dynamic effects and has created a window for understanding the affects of correlated markets. 2.3.1The Herding Concept Devenow and Welch (1996) note in their herding literature review, that herding is generally defined as “behaviour patterns, which are correlated across individuals”. They propose another notion of herding which is “systematic erroneous decision-making by entire populations”. Two frameworks will be presented to highlight incentives driving speculators such as Hedge Fund managers to ride trends, and thus amplify market volatility by voluntarily destabilising markets. 2.3.2Herding among Institutional Market Participants Investor choice of money manager is often based on past performance appraisal. Comparing them to competitors’ results usually performs an evaluation of historical returns. Since investors look at returns on a comparative basis, investment managers could have a natural tendency to pursue similar strategies in order to preserve their reputation. Authors report a popular sentence written by Keynes that indicates the phenomenon was thought of a while ago: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” The statement clearly indicates managers might have a biased investment decision process due to their willingness to shelter a positive standing in the market place. Such influence might drive managers to pass over other sources of valuable information and simply follow what other’s do. By mimicking, a manager insures himself to keep his reputation if the investment goes sour. In the end, he will not be the only one affected, and investor will not consider his ability, as being relatively inferior since other managers will also are victims. Authors refer to this as the “sharing the blame effect”. The system holds if unpredictable forecasting errors occur systematically. This allows for the occurrence of coordinated losses, which will render the comparative analysis useful on the behalf of investors. Scharfstein and Stein indicate that such framework could explain overreactions by money managers to shocks triggering discrepancies between fundamental worthiness of instruments and market prices. Furthermore, the liquidity of shares and the availability of performance records promote investor migration from one asset manager to another, further reinforcing the managers’ herd bias. In the case of Hedge Funds, this is not representative. Shares cannot be quickly redeemed and reporting is infrequent. Still, more and more data is available and competition increases rapidly, making relative performance assessment more probable. Herding behaviour can be applied to other institutional participants. Major bank proprietary trading desks also perform similar activities as Hedge Funds. Since they benefit from more resources in terms of research staff they could be the initial momentum creators. Samuel Gwynne (1986) also refers to herding in bank lending committees with regard to lower developed countries stating credit analysis was doomed to be similar from one bank to another. This is so since no bank wants to take the blame all by itself if a default arises. Hence similar credit approvals are given because widespread failure is forgiven. This could also apply in the context of bank lending to Hedge Fund managers. Few major banks want to miss the boat for higher returns and transaction income; even if fundamental reasoning might prove Hedge Funds do not have very solid credit worthiness. The presence of reputable competitors in the market would ensures that the lenders are not prone to high risks and can be sure of their monies being safe. 2.3.3Positive Feedback Trading The following framework is often drawn from the intuition provided by Keynes as Devenow, Welch (1996) and Froot, Scharstein and Stein as indicate. These researchers state Keynes’ perspective on the behaviour of professional investors as being similar to judges in a beauty contest. Keynes argues the judges are more tempted to discover who the others will select instead of following their own judgment concerning the candidates. Momentum Trading, which consists in buying in upward trends and selling in downward trends, is also referred to as Positive Feedback Trading. Speculators have been known to be trend riders and theoretical frameworks have been constructed to enlighten the incentives of undertaking such behaviour. The authors propose an alternative scenario to previous literature, which states the stabilising effect of speculators. The initial theory proposed the concept that rational speculators would be quick to “buck the trend” by acting as contrarians in such a way that market prices would revert to fundamentals rapidly. De Long and its peers bring the idea that speculators could profit on the influence they create and further magnify the trend by enticing positive feedback traders to jump in and finally taking bigger profits. Authors differentiate between rational speculators and positive feedback traders. In this game theory framework, speculators would buy on good news, but knowing feedback traders’ orders would kick in soon after making the prices go up further, such speculators would accumulate more securities in the first place, driving prices further out of line and thus bracing even more feedback trader demand. Authors refer to Soros’ investment strategy of betting on future crowd behaviour, even if it implies a contradiction with fundamentals. In a more general manner, speculators’ knowledge of sequential behaviour of uninformed investors or feedback traders entitles them to a profit if prices are inflated further. Authors assert that such behaviour could explain the short term positive correlation of stocks long term negative correlation encountered by studies of past returns by Fama and French (1988), Poterba (1988) and others. Since Hedge Funds have had a great deal of news coverage for being successful speculators. Theoretically, it would be a concern if the hedge funds find out that there are uninformed investors who would be willing to follow the bets blindly. This can be misused by the hedge funds, as it could start investing without actually analysing the markets and mimickers would follow in expecting to make profits. Hedge funds could continue to be a part of the investments until the prices rise to the maximum and exit out before the fund crashes. 2.3.4Margin Calls and the Snowball Effect All banks/ brokers demand investors using margins to deposit additional security or cash so that the minimum margin is maintained. When an investor is called up for a margin it could be for the reason that one of the securities bought has decreased in value. Here the customer would either have to deposit more money to ensure that the minimum margin requirement is met or sell a part of the security. De Long et al. refers to margin calls25 aspositive feedback trading like delta hedging, stop loss orders. Apart from margin calls, even the force fire sale of securities that are held by banks as collateral, are considered to be automatic triggers for feedback trading. The financing of purchases is done using margins. The borrower is enabled to purchase securities using the bank’s capital, but if the value of the acquired assets decreases, further cash or short-term securities must be deposited in the margin account. If this margin call for supplemental cash down is not meet, the lender has the right to sell the securities bought on credit. If the sale occurs in a low liquidity trading session, this can further put pressure on the market price triggering subsequent margin calls. Hence, the collateral’s value is stuck in a downward spiral. The momentum can be further accelerated if other Hedge Funds were also participating in the acquisition of similar assets on the basis of credit margins. There has been a trend for the banks to provided secured (with collateral) loans to hedge funds. The security that is acceptable for these types of loans is mainly which can be easily liquidized. Loans are normally fully backed by a security in interest of the banks safety, i.e. every dollar that is lent is covered by an agreement to unilaterally sell one dollar of the security. The above – mentioned techniques provide a fundamental of the rational framework to help understand any irrationality from the investor. The market inefficiencies have been strengthened and most of the times hedge funds are accused for it. The same is true for dynamic hedging procedures and margin calls. Empirically, it is a task of considerable importance to uncover such possible manipulation on behalf of Hedge Funds. Furthermore, the extensive use of Chartism and technical trading rules by speculators and traders provide evidence of wide spread momentum investment techniques which draw more information on volumes and trends rather then fundamental research. 2.4. Regression Analysis of Past Performance The SEC does not regulate hedge funds, hence information about the hedge funds are not easily available in public. Due to this factor it is not at all feasible to make a direct analysis of their exposure to a certain instrument and its potentially correlated price movements1. Since Hedge Fund portfolio composition remains anonymous, researchers have been using past performance to uncover their asset mix. In case of passively managed mutual funds, Sharpe (1992) identified the asset allocation weights of mutual funds by regressing their performance on selected asset class indices. However according to Fung and Hsief (1997), this model was not very indicative in case of active trading strategies used by alternative managers. However a lot of measures had to be performed to gain insight on this method. Many researchers have used Sharpe (1992) methodology to detect whether or not hedge funds play a role in alteration of financial asset prices. Researchers like Brown, Goetzmann and Park (1997), they discussed the ten most prominent global hedge funds and proved that they did not have a significant influence on the Malaysian ringgit during the 1997 Asian crash. The main aim of these analyses is to understand whether or not considerable price fluctuations were coordinated with large estimated open positions. To understand and analyse this a regression is done on the asset price of the fund’s implied exposure to this asset. However using regressions for hedge funds is not the optimal mode of analysis. This is due to the fact that most authors rely on monthly net asset values. But this is not the best source of information since there can be extensive changes in the positions as the turnover rate managers create in their positions can be very varied and high. Also relying on monthly data is not the best and optimum choice of many econometricians, since this data does not provide accurate information and could cause some misleading and distorted results that might just complicate the situation more. Also if the data is closely analysed, there is a high attrition rate present, this rate signifies a Survivor Bias is present in the data sets. These kinds of bias occur in data sets when the closing funds are missed out of the data set. As an example, if an Event Driven Hedge Fund Index reports 25% annual return, it does not mean you would get, on average 25% annual return even if you go back in time. This is so because the composition of that index changes when near bankrupt funds are taken out of it. Hence if you would have invested with the initial index mix, you would have achieved a lower return, since bad Hedge Funds are no simply taken out of your portfolio, they also decrease your real portfolio return. Brown, Goetzmann and Park (1997) have analysed a reason for the misleading data. Firstly they feel that since there are incentive fee structures implemented quarterly, thus the analysis could very well provide misleading data, hence making yearly and quarterly data more valuable and reliable. There are very few alternative investment information providers, like Tass Management, Hedge fund research, Van hedge advisors, etc. Secondly, since hedge fund managers decide what information needs to be submitted, there could very easily be a reporting bias. Managers could demand that his performance reports are retrieved from the list if the performance is poor or the manager might not even submit the data. Some of the above mentioned providers have also dropped of some of the poor performing records. The authors also noted that there is an attrition rate of 20% for the offshore funds, and a 7% annual failure rate for International Monetary Fund reports. Also since these funds work under minimal regulations and there are a large number of non-standardised jurisdictions, tracking the fund mergers and restructuring of partnership or closures details are very difficult to find. As noted by a few authors 90% of the hedge funds have been created in the last five years, making the track record short and the number of observations available are very low. Also there is a very high water mark provision in regards to the incentive fee structure, making this a direct incentive for managers to close down all the funds that in losses and open up newer funds with new initial investors. All these factors form the reason for the possible bias in the reports. As already discussed the hedge funds are very small players in the exchange-traded contracts. The main presence of the funds is felt in the over-the-counter markets, where there are no large position requirements that further complicate the evaluation of outstanding positions. Further on in the research a detailed analysis of hedge funds and this issue is made. 2.4.1. The Brown, Goetzmann and Park (1997) Methodology Post the huge crashes in the past in the London and New York stock exchange, the markets finally seem to have recovered and the equities appear to provide substantial premium over bonds. The Brown, Goetzmann and Park methodology’s aim is to find out the market adjustment to the new information. This methodology has been adapted from Sharpe’s (1992) style analysis approach that decomposes fund return. The method tests the hypothesis whether the hedge funds were responsible for the Asian market crash in 1997. Hence, they chose to estimate the largest ten currency funds in one currency the Malaysian ringgit and a basket of Asian currencies. Brown et. al have followed a very systematic method to explain this study. They aim at firstly explaining the econometric procedure, followed then by a hypothesis test, collection of useful hedge fund data and finally the result of the study. Further, here we discuss each of these steps in detail.
- Econometric Procedure:
As mentioned already this method has been adapted from Sharpe’s (1992) style analysis, where, the return of any funds at a time is represented as a linear combination of returns to passively managed classes. This was expressed by the following formula: The equation (1), can be estimated with a constant. Also the coefficient provides an estimate of the pre dollar exposure of funds to a given asset class. The total dollar value exposure of the fund to the proposed security at the time t can be calculated using The analysis aims at estimating the value Ei,t,k of particular currencies. The positivity constraint on the coefficients and the first constant are relaxed. As indicated before, since Hedge Funds’ portfolio composition is unknown to the public, the objective of the procedure is to extrapolate, through regression analysis, their exposure to a certain asset supposedly victim of price manipulation. The k is set as 1 for the hypothesis of Malaysian ringgit. The return of fund is regressed on the return of a specific asset k. Here, the Sharpe (1992) model is reduced to a one-factor model: R it = ? kt+ ? kt R kt+ ? kt (2)
- Hypothesis Test:
The claims of Mohamad Mahatir, the Prime Minister of Malaysia, provide a clear hypothesis of the test. Presuming that the market manipulations are normally undertaken for profits, the hypothesis of currency manipulation can be tested by a given fund, or a group of funds using the following formula: Rkt = a + g E kt + e t (3) However, authors noted that there is a small problem Ekt can be estimated using equation (2) – via rolling regression; this induces an error for individual funds. Averaging across exposures can mitigate the errors, however this would only mitigate the problem and would not eliminate it since Rkt might be correlated with errors in the ?kt measurement. The conclusion is if indeed there is manipulation, large Hedge Fund positions (individually taken or aggregated) will be correlated with whips in the market price of the selected asset.
- Author’s Data Collection source:
The SEC does not regulate hedge funds unlike mutual funds (which are regulated by SEC). Hence getting data for them is relatively more difficult. The authors thus used monthly return information for major hedge funds over the last four years from an advisory service and data vendor called Tass. 2.4.2. Regression analysis results A few macro hedge funds have been selected to implement the Goetzmann et al methodology. The choice of funds were those which were at least eight years old, so that the regression could be performed on a hundred and three monthly returns for each of the eight funds. The data has been collected from Gottex America, who collects the data from HFR. The range of the data collected is from February 1990 until July 1998. The funds are checked for their exposure to the Heng Sang Index and the Dollar Yen rate. The first step is to introduce a variant of the Goetzmann methodology. This will be implemented to estimate the regression betas. The discovered coefficient is then multiplied by the dollar amount of funds under management and then aggregated across funds. Then the changes in aggregate exposure are regressed on the changes in the Honk Kong stock index and subsequently on the changes of the dollar yen rate. Before all of this a graph is chalked out to give an idea if large changes in aggregate exposure are associated with large swings in the susceptibly moved index or FX rates. In order to estimate the betas, a rolling regression with a window of thirty-two monthly observations, out of the hundred and three are used. Hence, final regressions are made on seventy observations because of this observation window. The next step is to perform regressions similar to that Goetzmann et al. Here we regress the nominal value of the aggregate exposure to the change in value of the Hong Kong index and the Yen dollar rate, rather than regressing changes in aggregate exposure on change in the Hong Kong index and the Yen dollar rate. The method is intuitive, however it would be more useful if the data was more easily and freely available. The first regression explains how funds return with only one explanatory variable, which however does not mean that they are the only ones. A correlation of the Yen dollar rate and the other Asian assets are made, and the Heng Sang Index are closely correlated. The study however, does provide a basis for future analysis and highlights the possible aggregate exposure of Hedge funds. Step 1: Regression of Changes in Aggregate Exposure to the Changes in the Heng Sang Index and the Y/$ rate. The analysis of Yen dollar can be very interesting and can emphasize on how the hedge funds have had a positive aggregate exposure. The size of change required to have an impact on the price is not seen through the regression. This is dependant on the intra – day liquidity of the market, i.e. small volumes traded in bundles would effect the market if the market were to be thin, and vice versa. A change in exposure would be correlated with changes with the underlying. However, the biggest drawback of correlation analysis is that we can never be sure of what variable caused the change in the other. However, Hedge funds have been making adjustments following all the swings. Thus, proving that the portfolio rebalancing affected the market prices would be quite difficult to prove empirically. In the case of the Heng Sang Index, major macro Hedge Funds did not seem to be holding aggregate short positions at the time the market correction occurred. Even though while performing the analysis, individual funds had significant short positions, at the aggregate level, they cancel out. With these results, hedge funds were buying or holding Hong Kong assets at the time the correction occurred. They did not benefit substantially from short aggregate position under the analysis. There are several weaknesses in this analysis though. The data is infrequent and not verified; hence we cannot be sure of how genuine the data is. Also there is more than one possibility while using only one variable. Also as seen with Fung and Hsieh, there are a few funds performing on the basis of some extremely dynamic strategies, which makes it even more difficult to uncover the exposure to specific assets, especially monthly data. The first step has helped us understand that a change in a selected hedge fund is highly correlated to the changes in the underlying. This is understandable else managers would be able to change very simply and logically the positions of their funds during the market rise or fall. However the main aim of this operation is to discover the lagged changes in positions i.e., the funds could have been starting a herding pattern if their changes in position were occurring before price corrections, which is not the case (as explained by the graph). There have not been large negative changes in positions before the sharp fall in Heng Sang returns or fall in the US dollar as supposed to the Double play or the Yen Carry. Step 2: Regression of Aggregated Nominal Exposure to the HS index return and the Y/$ rate The second step implements the Goetzmann methodology, a study of the nominal values of aggregated exposures is studied here. The regressions used here is mainly to capture if the underlings affect the size, or impact for a hedge fund. It is not possible for us to confirm that the biggest macro Hedge funs, with their combined exposures can move the selected underlying. If the selected macro hedge funds were able to move the Hong Kong stock index and the yen dollar rate, we could have expected to have a positive and significant regression coefficient. Since this is not the case for both the Hong Kong market as well as the Yen dollar market, hence we cannot reject the hypothesis that lambda is equal to zero. 2.4.3. Conclusion on the Empirical Analysis and Herding Theories Detecting the hedge funds’ potential market impacts, will always remain an econometric challenge, along with the lack of appropriate data sets makes it only more difficult for econometrist. Perhaps more sophisticated and powerful econometric tools could help arriving at a solution. From the above analysis, it is quite evident that hedge fund managers aren’t leading or creating momentums (step 1), neither were they affecting the markets with their considerable potential aggregate exposures (step 2). However this is argued by some herding theories. The theories indicate that there could be motives for the managers to do so. The possible motive could be to protect their reputation in case of severe uncertainty or possibly to make gains by misleading other people with the bandwagons effects. Another reason was that bank credits could represent a negative factor since they could be responsible for the development of margin call chain effects and this could go on to cause price snow ball effect in the collateral susceptible to be liquidated in financial markets. All these factors together could mainly be the reason for the market inefficiencies and substantial volatility observed in recent times. It is quite possible that hedge funds did really disturb the markets however this is not easy to demonstrate with simple regression analysis. If it is true that hedge funds do actually disturb markets and impact the economic fundamentals of countries, it would be the best reason to increase regulatory international framework in the alternative sector industry. Regulating the hedge funds and other trading bodies would mean a trade off since their trading activities are beneficial to the financial markets in some way or another. This however, will be discussed in detail in the next sections. 2.5Risk and Benefit Tradeoff and Future Consequences 2.5.1Risk Hedge Fund Pose to the Financial Systems Not all Hedge Funds represent a threat in terms of systemic risk and market integrity. Macro and Global funds, with their massive size and extensive leverage possibilities can mutually reach a critical mass in the OTC (Over the Counter) market which must be considered closely by regulatory bodies. The problem arises when a group of institutional herd on the same strategy. The pressure these participants can jointly impose on the system leaves place for price dislocations, and this even in the most liquid markets, such as the dollar yen exchange rate. Furthermore, the implementation of such strategies on a massive scale does bring concerns of systemic risk if events turn unexpectedly disagreeable. Such fears must be alleviated by a formal quantification of funds’ exposure when sequential margin calls are not being met in order to avoid possible severe liquidity crisis as the ones seen in 1994 in the bond market and in October 1998 in the MBS (Mortgage Backed Securities) market place. “When such large chunks of speculative capital move all at once in the same direction, Hedge Funds cease to be nimble raiders exploiting market inefficiencies: rather they themselves become the market.” Judging from the size of losses concerning Hedge Fund placements investment banks disclosed their risk management systems and credit assessment structures. These losses also prove some Hedge Funds have been relying so extensively on bank capital through lines of credit and other margin investments devices that they can endanger some participating financial institutions. 2.5.2Risk Absorption and Market Completeness Alternative Investments play an important role in financial system. By their presence and low risk aversion, they facilitate the redistribution of risks between market participants. Indeed, Hedge Funds by example are willing to take on risks which few players would dare to undertake. Efficient risk sharing is a primary function of the financial system. Enhancing high leverage can be seen as function of market completeness and efficient risk allocation. Alternative Investments offer the possibility for risk seeking participants to gain indirect exposure to sophisticated markets which require constant monitoring. These also represent vehicles for more risk-averse investors which want to move their portfolio to a better position on the risk efficient frontier. As stated by Gibson et. al.(1994), once market imperfections are considered, such possible misstatement of risk exposure (such as use of leverage), these risk allocation benefits can be diminished. Furthermore, the asymmetries of information other market participants have concerning their portfolios can also cause problems in difficult times. 2.5.3Fueling Market Liquidity Managed Futures are important participants in Exchange traded commodity contracts. Their presence and activity lowers the cost of business for other participants which use futures for hedging purposes. Hedge Funds also fuel liquidity but specifically in more exotic markets. Their interests for higher yields and their tolerance to a wider set of risks made the developments of innovations easier for investment bankers since they could market primary offerings to Hedge Fund managers with considerable appetite for more complex payoff structures. Additionally, Alternative Investment managers support the secondary market in complicated instruments by applying arbitrage strategies. 2.5.5Globalisation and Volatility The demand for Alternative Investments has been developing rapidly over recent years. Extremely wealthy investor have not been the only ones investing in the eclectic sector, institutional participants have also joined in. American pension funds and university endowments have also been enthusiastic in Hedge Fund investments, giving considerable acceleration to their growth. Dynamic and leveraged, short and long, strategies can provide payoff structures which bring substantial diversification benefits to traditionally balanced portfolios. Sophisticated investors in quest for ever higher returns are ready to pay significant fees and handle substantial volatility. The popularity of such vehicles and the impressive concentration of capital in the hands of a few money managers have caught the attention of many authorities. The extensive leverage used by some funds has also been the subject of great concerns for the banking sector. Banks themselves have been relying on their trading activities to achieve target revenues. The intensity and popularity of active portfolio management have already had an impact on the behaviour of central bank authorities around the world. The massive scale of speculative short term capital being transferred on a global basis over unregulated transaction networks must be controlled to avoid price dislocations and chain reactions in the case of defaults, mainly triggered by asymmetries of information due to a lack of transparency. As openly declared by Soros and many traders, the successful investment process consists of identifying fads before anybody else. Such investment behaviour clearly provides grounds for high volatility periods and diverging prices from their fundamentals. Also, the opacity of Hedge Funds, which are known to be obliged to sell part of their holdings due to margin calls, can create temporary market disorders, as seen in deep market such as the MBS and dollar yen markets. The observation of such phenomenon stresses the importance of considering the human nature in investment and lending decisions, even though computerised systems and sophisticated theories are widely used in the decision process. When considering closely such behaviour, we quickly realise the human nature is itself a major source of market imperfections. Such considerations can represent reasons for imposing the presence of supervisory bodies ensuring of proper information dissemination. DATA & ANALYSIS RESULTS 3Data on the Expansion of Hedge Fund The start of 2008 showed a slow start in which a record $194 billion came into the Hedge Fund industry. According to Hedge Fund Research (HFR) it only attracted $16.5billion in new investor capital in the first quarter of 2008 with a total assets virtually unchanged at $1.875 trillion, compared to $1.868 trillion at year-end 2007 as shown in chart 1. Chart 2 examines the distribution of dollars invested in Hedge Fund by fund size and fund investment style. The chart 2 shows that the number of Hedge Funds has dropped between 2007 year end and the first quarter of 008 by 0.43% this can only indicates that 33 Hedge Funds has closed due to either redemption by investors or loss in the market. Equity Hedge is the largest strategy composition with a market share of around 39% based n the asset under management at the end of the first quarter of 2008. 3.1LTCM Returns Between 1994 and 1996, LTCM saw an impressive record of returns greatly outperforming S&P 500 index. LTCM returns were 28%, 59% and 57% respectively. The following chart depicts LTCM returns from its high days to when the collapse happened. Hedge Funds disasters have more to do with unskilled management of the market as well as business risk and fraud. Louis Moore Bacon presented at the 2000 Hedge Fund Symposium in April in London and presented five warning signs for investors to look out for when investing in Hedge Funds: (Size, leverage, transparency, funding and hubris). The last point of Bacon’s warning signs are the sin of hubris, or arrogance and price. Consider the following exchange between Myron Scholes and Andrew Chow. Chow was quoted in the Wall Street Journal (16 November 1998) as saying to Scholes: “I don’t think there are many pure anomalies that can occur” to which Scholes responded: “as long as there continue to be people like you, we will make money”. This excerpt highlights two aspects: first, it was not necessarily lack of self-confidence that brought down LTCM. Secondly, Myron Scholes highlights that, traditional money managers to a large extent focus on relative returns whereas Hedge Funds focus on making absolute returns. This arguably extends to the fact that LTCM had all of Bacon’s warning signs. In terms or size, LTCM with total assets of $129billion at the end of 1997, was significantly larger than other reporting hedge funds at the time. In terms of leverage, the aim was 20-30 bps on each position and an annual return for the fund of 30%, which is only achievable though high leverage. The notional amount of LTCM’s total OTC derivatives position was $1.3trillion at the end of 997 and $1.5trillion towards the end of 1998. In regards to transparency, LTCM’s fate got considerably worse once the market knew its positions and how it was going to trade to unwind positions. The fall-out from the liquidation was far greater than it might have been as LTCM margined all its capital in terms of funding. According to Bacon it was the “height of hubris” that after the debacle it claimed that market conditions had been a “one off” or “perfect storm”. But it failed to realise that it had been the “perfect storm”. LTCM’s strong returns were largely the result of the leverage that it had assumed. The company’s strategy was to find inefficiencies in the market and generate returns using leveraged positions. This has resulted on LTCM having a leveraged ratio of 28:1 indicating that return on asset to be 2.11% compared to return on equity of 59%. In 1997, however, the fund showed a dramatic fall and only returned 17% and underperformed the S&P 500 index which had a staggering 31% return. Suprisingly, LTCM’s managers argued this fall in returns and blamed it on the market combinations between copycat strategies from other Hedge Funds and Banks leading to a decrease in spread. LTCM invested mainly in market inefficiencies in the fixed income markets where the majority of such activity took place.. After its poor performance in 1997, however, LTCM explored a number of new investment opportunities. One of the markets that LTCM entered into after 1997 was the equity volatility market, where the traders found that options traded at a price, which according to the Black-Scholes formula would imply volatility well above the historical volatility of the underlying. The explanation that LTCM came up with for this divergence was that there was a greater demand for options than there was a supply. According to the Black-Scholes formula, the volatility of the underlying asset and the price of an option on that asset are directly correlated. Therefore, increases in the prices of options due to the high demand for these securities were implicitly increasing the volatility implied by the options prices. LTCM therefore sold options, which meant that they were implicitly selling volatility; a commodity that they believed had become overpriced. In addition, they started investing in trades known as equity pairs. In these trades, LTCM found that stocks were sometimes listed on two different exchanges or had