Executive summary - Udo Bullmann

1.11. Tendency of crowdingDespite the differences of strategies among hedge funds, there are some common concernsto be taken into account. One key concern is related to similarities or correlations - even incases of different strategies! Where funds are pursuing similar strategies there is anincreasing risk that they will buy or sell their positions at the same time thereby disturbingliquidity. This so called herd behaviour could in turn leave hedge funds and third parties likebanks and institutional investors highly vulnerable to adverse market dynamics. And even incases of strategy-differences, there is still a strong correlation among hedge funds’ actions onthe financial markets.In its 2006 Financial Stability Report the ECB highlights this crowding problem:“The risks posed by the crowding of hedge fund trades were already highlighted in the June2005 FSR, as well as by the Counterparty Risk Management Policy Group, which recentlynoted that “the concept of crowded trades [has] entered the lexicon as one of the mostsignificant risks to be identified and mitigated”. The fact that correlations are trending highernot only within some strategies, but also among strategies, raises concerns that a triggeringevent could lead to highly correlated exits across large parts of the hedge fund industry” 18 .In other words, the systemic risks result from the combination of leverage, trading activityand strategy correlation. We have shown that the hedge fund industry has to generate veryhigh growth returns due to among others the generous pay-outs to the hedge fund managersthemselves and the high execution costs linked to the investment banks. We have shown thatonly leverage can ensure the necessary return.We know from several studies that around 60-70 percent of hedge funds’ AUM use somekind of long/short strategies. The importance of hedge funds in trading flows is alsosubstantial. The importance of hedge funds for asset pricing is thereby relatively higher thansuggested by their share of financial assets. All these factors together with the confirmed highcorrelation of returns within many hedge fund strategies and among strategies confirmconcerns about systemic risks. The capacity constraints and periods of diminishing returns,creating funds exploiting available arbitrage opportunities, are contributing to this risk.We will return to this issue in the chapter on financial stability.1.12. An imperfect market: Asymmetric information and no transparency or disclosureVirtually all accessible report or analyses on hedge funds published in the past two yearsunderline the lack of transparency and disclosure for the hedge fund industry.At the G7 meeting for finance ministers in Essen, February 2007, it was decided to promotegreater transparency in hedge fund industries. This theme has for long been an issue amongnational and international financial authority regulators. We have shown above that the vastmajority of all hedge funds are established in offshore centres for tax reasons. But this does18 ECB: Financial Stability Report 2006, p.136.28