Hedge funds and Private Equity - PES

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Based on this observation, one could conclude that the potential impact of failing hedge funds
remains small. By contrast, the FSA argues that a hedge fund with say $1 billion of assets under
management may have a far greater market impact than a traditional investment fund with the same
amount of assets under management. 67 Besides the absolute and relative growth in the assets
under management, this is due to several of the factors that we turn to in the next subsections.
5.3 Short selling
Historically, hedge funds are often associated with “short selling”, i.e. the use of strategies
allowing investors to gain from the decline in price of securities as well as currencies or raw
materials. However, short selling has a longer history than the first hedge funds, which were set
up after World War II. For instance, short sellers were blamed, in part, for the Wall Street Crash
of 1929.
It is only a limited segment of hedge funds that is actually practicing short selling. Yet those who
do are often charged of being trend-setters, i.e. of causing price depreciation independent of
the underlying market fundamentals. This was for instance the case during the currency crisis
of 1992, where some believed that the short selling strategies of the Soros-led Quantum hedge
fund were the sole cause of the devaluation of the British Pound.
In the light of the current size of assets under management, there can be little doubt that some
hedge funds – alone or through concerted action – can influence prices independent of fundamentals,
thereby causing instability. This is especially the case in smaller illiquid markets. Yet, it
is also not unlikely that it could happen in larger and more liquid markets.
In some cases there were suspicions that hedge funds – for instance by applying short selling
strategies – have been engaging in manipulation, collusion or other possibly unfair trading practices.
However, it is difficult to draw the line between seemingly manipulative trades and rational
economic behaviour. Furthermore, it is even more difficult to obtain information about whether
such a line has been crossed. For instance, the Financial Stability Forum has declined to
conclude that hedge funds had compromised market integrity in the cases analysed in a report
on highly leveraged institutions. Thus, the true motives were very difficult to prove. In addition,
quite often it was traditional financial institutions and investors, and not hedge funds, which
seemed to lead or precipitate market crisis and crashes. 68
5.4 Increasing correlations
A key concern regarding hedge fund and financial market stability is related to increasing similarities
or correlation among hedge fund strategies. Where hedge funds are pursuing similar
strategies there is an increasing risk that they will buy or sell their positions at the same time
thereby disturbing liquidity, i.e. the normal fundamentally driven supply and demand. 69 This could
in turn leave hedge funds and third parties like banks and institutional investors highly vulnerable
to adverse market dynamics.
The current empirical evidence as to whether hedge funds and institutional investors engage in
such “copy-cat” behaviour is alarming. According to ECB calculations, the recent increasing
competition in hedge fund markets has come along with increasing correlations among hedge
fund strategies. In this connection, the ECB has stated that “... the correlations among hedge
fund strategies tended to increase more or less continuously after mid-2003, reaching an all-
66 Wall Street Journal (2006): Double trouble valuing the hedge-fund industry, July 8/9, 2006, p. B3.
67 FSA (2005): ibid., item 3.29.
68 Financial Stability Forum (2000): Report of the Working Group on Highly Leveraged Institutions,
http://www.fsforum.org/publications/Rep_WG_HLI00.pdf (02.12.2006)
69 E.g. Counterparty Risk Management Policy Group (2005): Toward greater financial stability: A private sector perspective, July, p. 48.