II International Symposium Engineering Management and Competitiveness 2012 (EMC 2012)

June 22-23, 2012, Zrenjanin, Serbia

HEDGE FUNDS IN CONTEMPORARY ECONOMY

Savina urin MSc*
Teaching Associate, Serbia
e-mail: savina@tfzr.uns.ac.rs
Jelena Stankovi MSc
PhD Student, Serbia
e-mail: jstankovic.ns@gmail.com
Edit Terek MSc
Teaching Associate, Serbia
e-mail: terekedita@gmail.com

ABSTRACT
Investment management can be defined as professional management of funds of individual and institutional
investors. Investment management includes: investment companies, hedge funds, venture capital funds, LBO funds
(funds of credit capital). In recent years, there are dynamic changes related to investment companies, which are
associated with emerging market changes in modern economies. There were hedge funds that control large amounts
of cash, with the present lower limits on use of funds investment strategies. Investment companies, as financial
intermediaries, stimulate economic development. Within the investment companies usually exists a number of
separate investment funds and hedge funds are private investment in the funds. They use financial instruments that
are not available to open-ended investment funds, and therefore they manage investment risk in a better way.
However, there are examples that indicate major failures in practice. Despite all the uncertainties and possible
crunches, hedge funds survive and develop very successfully.
Key words: hedge funds, investment, leverage, failure

INTRODUCTION
Hedge funds appeared in the early 1990s. They form a "pull" of funds to invest in securities. Business
activities of hedge funds include government securities, foreign exchange and financial derivatives.
In order to enter the hedge fund, an investor is obliged to pay the prescribed minimum amount. This
amount is different for individual investors. Investors who invest their capital in hedge funds become
limited partners who are not eligible to participate in managing the daily activities of hedge funds.
On the other hand, the general partner is usually the founder of hedge funds. He manages the fund,
performs all daily operations related to the fund and chooses the strategy of hedge fund.
The majority of investment strategies in hedge funds have a positive return from the investment as a goal,
regardless of whether the markets rise or fall. These funds' managers mainly invest their money in the
fund they manage, in order for their interests to be in concordance with the investors' interests [5]. Net
value of fund's asset can amount up to billions of dollars, due to the investments from the big institutions.
According to the data from 2009 [2], hedge funds are 1.1% of total funds and assets owned by financial
institutions. Estimated hedge fund industry value is 1.9 trillion dollars [1].

HEDGE FUND ATTRACTIVENESS

Since these funds do not belong to public and small investors, their advisors have never been constrained
as other investment funds' advisors in terms of fund structure and strategy use throughout history.
However, nowadays these funds have to be in compliance with a number of statute and regulatory
restrictions, just like other institutional market participants. This gains particular role after the credit crisis
from 2008, both in America and European Union, where the strive to increase the government's insight
into hedge funds and 'fix regulatory loopholes' [12].
By predicting growth of markets and companies and buying and selling complex financial derivatives,
hedge funds earn millions of dollars each year. They levy their revenue from their good judgement, but it
is questionable whether the growth they made profit on is actually based on existing goods.
Location and legal codes of hedge funds are determined by tax environment of potential fund investors, as
well as the legislature. A lot of hedge funds has been established in offshore financial centres, so the
investors (not the funds) pay the portfolio value increase tax. According to the 2010 data [3], around 60%
of hedge funds were registered offshore mainly on the Cayman islands (37%), British Virgin Islands
(7%) and Bermuda Islands (5%).When it comes to onshore funds, Delaware in USA carries 27% and
European leaders are Ireland and Luxembourg, with 5% of total capital.
Contrary to the funds themselves, investment managers are mainly located onshore. The reasons lie in
possibilities of having quality employees and the proximity of investors. Most hedge fund managers are
found on East American Coast, especially New York and Gold Coast area in Connecticut, since
investments in these funds are mainly from this stretch. In Europe, centre of hedge fund managers is
London, with 70% European investments in these funds (which amounted around 420 billion dollars by
the end of 2010 [3]). Asia, i.e. China takes increasingly more important role as the fund source in this
global industry, where America and Great Britain are main locations for investment managers in Asia,
with about 25% of share [3]. Hedge funds use a number of strategies to preserve capital, reduce volatility
in the market and minimize potential risks, so we call them fund management.

HEDGE FUND RISKS AND LEVERAGE

Numerous hedge funds use leverage lend money or trade the financial margin, additionally to
investment capital. Although this practice can increase potential income, the chance for greater profit is
proportional to chance for greater loss. Hedge funds using this strategy use extensive practices of risk
management. However, compared to investment banks, hedge funds' practice is relatively low; according
to National Bureau for Economic Research [4], average leverage in investment banks amounts 14.2, while
in hedge funds it is 1.5-2.5.
Hedge funds are fairly prone to risk, with the intention to maximise their profit. This is the reason why the
investors' and managers' tolerance to risk is greater there. However, since investment in hedge funds can
add diversification to investment portfolios, investors can use them as a means of lowering their total risk
exposure. Hedge fund managers use individual strategies as trade techniques so as to create risk-adjusted
profit, consistent to investor's desired risk level. Ideally, these funds create profit relatively uncorrelated to
market indices. While hedging can be a way to lower risk from investment, hedge funds, like all other
investment types, are not immune to risk.
Since hedge funds are private entities, there are really few requirements for public transparency in fact,
they are frequently believed to be almost not transparent at all. The other problem is the fact that their

managers are not controlled so strictly as other financial investments' managers. Thus, they are more
prone to manager-specific risks, like style changes, bad decisions or frauds. However, a new regulation
from 2010 obliges hedge fund managers to give more information, i.e. make their funds more transparent
[6]. Apart from that, investors, especially the institutional ones, encourage further risk management
development in hedge funds through internal practice and external regulations [13]. Increased influence
STATISTICS OF THE BEST HEDGE FUNDS
To indicate the size of hedge funds, the last two places in the top10 in the U.S. have nearly $20 billion in
assets under management each. Even more amazing is the fact that the funds individual size is the size of
the hedge fund world. U.S. funds that had $1 billion or more in assets cumulatively had assets under
management of more than $1.3 trillion. Well over $1 trillion of those assets tracked were distributed in
New York, Connecticut and Massachusetts.
Although the industry is very large, it is not rescued by the unstable situation. Many funds take such
outsized risk to grow more rapidly than their competitors. After the fall of Lehman Bros in 2008,
thousands of funds were closed. That was probably the worst quarter in the industrys history. Hedge
Fund Research reported that 700 U.S. funds closed in the third quarter of that year. The hedge funds lost
their money on investment and couldnt repay loans taken from banks that gave them leverage to help
increase their asset bases.
Last year, the hedge fund industry was lifted by the surge in the stock market and improvement in the
economy, when number of new funds rose to 1113 from 935 in 2010. In the Table 1 below, there is a
display of the top 5 hedge funds, which is the result of Wall Street research, and present their strategies
and business importance.
Table 1. Top 5 hedge funds

Assets under
management
Year founded
Location

Strategies:

Baupost Group

BlackRock

Och-Ziff
Capital
Management
Group

$25.0 billion

$25.5 billion

$28.4 billion

$45.0 billion

$76.6 billion

1983
Boston

1988
New York

1994
New York
Varied. Primary:
convertible and
derivative
arbitrage,
merger
arbitrage,
private
investments and
structured credit
via mortgagebacked and
asset-backed
securities

1984
New York
Multiple
strategies
crossing
multiple asset
classes via a
fund of funds
approach and
through its
direct hedge
funds under
Highbridge
Capital
Management

1975
Westport, Conn.

Can use debt and

equity, often has a
substantial
position in cash
rather than being
long or short

HEDGE FUND FAILURES

Manages multiple
asset
classes through
various absolute
return strategies
around the globe

JP Morgan
Asset
Management

Bridgewater
Associates

Take large
macro-bets
using
currencies,
commodities,
bonds and other
instruments.

There are many examples of failures of small and large hedge funds in practice. Essentially, this is not a
big surprise for someone who knows the financial service industry, but certainly attracts the attention.
However, this is a disaster when a large hedge fund loses a huge amount of money, for example 20% or
more in several months or even weeks. Usually, investors may recover about 80% of their investments,
but most of hedge funds are designed on the promise that they will make a profit regardless of market
condition. A fact that must be accepted is that hedge funds always have a significant failure rate. As
already mentioned, the factor which can also lead to hedge fund failure when the market moves toward an
unfavorable direction is high leverage.
The following examples show fatalities in contemporary economies which were related to a strategy that
involves the use of leverage and derivates to trade securities that the trader does not actually own:

The fall of Amaranth Advisors marked the most significant loss of value, after its attracting 9
billion $ worth of assets. They lost 6 bilion $ on natural gas futures in 2006, because the energy
trading strategy failed. Due to unfavorable conditions, gas prices did not rebound to the required
level to generate profits for the firm, so 5 bilion dollars were lost within one week.
Marin Capital is a high-flying California-based hedge fund wich attracted 1.7 bilion $ of capital.
They put it all to work using credit arbitrage, which they invested in debt, and convertible
arbitrage to make a large bet on General Motors. Mainly, when one of companys customers may
not be able to repay a loan, the company can protect itself against loss by transfering the credit
risk to another part, and that is a hedge fund. In this case, the share price went down substantially,
General Motors bonds were downgraded and the fund was crushed.
Aman Capital was founded in 2003, by top derivate traders at one of the largest bank in Europe,
UBS. The plan was to become Singapores 'flagship' in the hedge fund business, but leverage
trades in credit derivates resulted in an estimated loss of hundreds of milions of dollars. After that,
the fund stopped trading, and what remains from capital would be distributed to investors.
One of the most succesuful hedge fund, Tiger Management, has also experienced the failure.
Despite raising 6 billion $ in assets, Julian Robertson, a value investor, placed big bets on stocks
through a strategy that involved buying what he believed to be the most promising stocks in the
markets and short selling what he viewed as the worst stocks. During the bull market in
technology, this strategy failed. Tech stocks continued to soar, while he overestimated the tech
shares that have only inflated price in order to make the difference, but profit was not certain.
They suffered huge losses, and Robertson overthrew the Tiger Management from the throne.
Long-Term Capital Management began trading with more then 1 bilion $ of investor capital,
attracting investors with the promise of an arbitrage strategy that could take advantage of
temporary changes in market behavior and reduce the risk level. They operated so well during the
1990s, that they made a big bet, when the Russian financial markets entered a period of turmoil,
which said that the situation would quickly revert back to normal. They were so sure this would
happen that they invested the money that didnt actually have available if the markets moved
against it. That didnt happen. Losses approached 4 bilion $ and the federal government of the
United States feared that the imminent collapse of LTCM would tumble in a larger crisis. A loan
of 3.65 bilion $ was created by fund, which enabled LTCM to survive and be liquidate in
early2000s.

HEDGE FUNDS AND GLOBAL ECONOMIC CRISIS

In the mid-third trimester of 2007, global financial markets saw a large-scale crisis. Before that, a large
financial crisis has been noted in Asian and Russian market, in the end of previous decade. This time, the
crisis starts from the American mortgage market, where borrowers with suspicious credit history find
themselves in a situation of being unable to repay their obligations, due to rise of interest rates.
Contemporary financial instruments enable creditor banks to transform their claims into other forms of
asset through securitization and make considerable profit by trading these new securities.
However, when this chain broke, due to inability to repay the debtors loans, U.S. mortgage market sees a
liquidity crisis, interest rate rise in interbank lending, as well as the general distrust between the mortgage
market participants.
Due to global financial interdependence, this liquidity crisis soon transfers to developed countries
markets of Western Europe and Asia, which banks have been buying American mortgage securities. An
increase in interbank lending and a sudden drop in stock market indices in Europe and America were
next, caused by stock sale. A kind of panic emerges in financial markets in developed countries. Central
banks intervene so as to stabilise the situation as much as possible, and they succeed in a way, through
interest decrease and restoring of confidence. Financial markets slowly recover, stock market indices rise
again and normal lending flows establish again. However, what were the long-term effects of these
panicked interventions? The future remains to show.
CONCLUSION
Despite all the failures and their public disclosure, the global hedge fund assets continued to grow in the
trillions of dollars and continue to attract investors. Some of them fulfill the promise, others offer
diversified investment that is not associated with traditional financial markets, and of course there are
some hedge funds that fail.
Hedge funds are more flexible in their investment options, compared to other investment funds. They use
financial instruments that are not available in other funds. Their flexibility means using the best hedge
strategy in a given market, because it provides the same ability to manage the fund in the best way to
avoid investment risks.
Hedge funds are particularly attractive because they offer specific strategies, but wise investors treat
hedge funds the same way they treat any other investment carefully, not putting any money into one
investment and devote a great attention to risk. Before investing should conduct research, should beware
of investments promising something too good to be true and never put more into a speculative investment
than you can comfortably afford to lose.
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