Hedge Funds — the very name is surrounded by either an aura of big bucks or downright market manipulation for hedge fund detractors. However, when even super rich rock-band stars such as Bono decide to invest in hedge funds, one really has to sit up and take notice. Could there be, just that little bit of something more, than the instinctive fear that they seem to generate amongst many investors?
For many, hedge funds seem to be epitomized by mega-deal Wall Street Hollywood blockbusters, relishing in the thrill of taking markets to the edge, as one macho hedge fund manger tried to outdo the ego of another. Some blew it in a grand manner, such as the collapse of the $130 billion Long Term Capital Management (LTCM) hedge fund in 1998, which found itself on the wrong side of the Asian currency and Russian debt crises of the period. It is not that hedge fund managers are outright gamblers — LTCM employed the services of no less than two Nobel Prize winning economists as its founders. And yet, amongst the blood letting of the recent global equity markets triggered by a fall in China’s stocks, we are now told that some hedge fund managers made a killing for their investors.
The secret it seems, was in placing strategic bets on a string of different markets around the world, on the premise that not everyone loses money in all markets at all times. The bets might be on currency movements or fixed income instruments. The hedge funds that made it when the equity markets were seeing red ,seemed to have got it right on the Japanese yen (which rose against the dollar) ,and on US government bonds (which rose as equity investors moved out of the markets).
In the end it is a matter of leverage, right betting on market movements and timing luck. When LMTC collapsed, the hedge fund had borrowed 125 times its capital to maximize on its position bets, and when the crash came its losses were 125 times more than they would otherwise have been compared to more conservative portfolio managers. Why then the sudden found favor of hedge funds?
The answer is investor greed. For years, there has been a torrent of cash pouring into hedge funds as well as private equity companies, who apparently have been promising better returns than the highest grade corporate or government debt. In a period of relatively low inflation and low interest rates, similar to those witnessed over the past few years, the demand from investors has been for a so-called “search for yield”. Hedge funds seemed to be their dreams come true, as they offered super-normal returns. Globalization has helped hedge funds, for it spawned the cross-border financial practice known as the “carry trade”, which is basically borrowing from a low interest environment in say countries like Japan, and investing in higher interest and yield markets, whether in emerging economies or in corporate just bonds.
Globalization has also ushered in swifter communication and information flows across borders, and this has helped to reduce the time limit for “carry trade” premiums. Hedge funds operate on the basis of under-pricing of substantial risks; with managers of such funds sometimes behaving as through they lived in a risk-free world. This is fine as long as the status quo and the basis of the hedge bet remains stable. If risk is under-priced, it only takes a very small rise in expectations of risk, for volatile sales to begin and the whole leveraged structure to crumble. If this scenario takes hold, then hedge fund managers will try to liquidate their portfolios of high yielding assets — whether it is emerging markets or junk bonds, which in turn will drive down better quality buy lower yielding assets. In a panic selling situation, hedge funds will quickly find out that their high yield assets have suddenly become relatively illiquid.
In the Middle East, we have began to observe a move towards private equity funds, but not yet the emergence of true blue-blood hedge funds of the size, diversity or sheer speculative underpinning that has characterized Western capital markets hedge funds. Middle East or more specifically, Gulf based private equity funds, are playing a more valuable role of intermediating between savers and investors by identifying relatively under-priced investment opportunities in high quality tangible projects as opposed to junk bonds. Interest and yield differentials are relatively a secondary issue, as most Gulf economies’ interest rates and currency parities are roughly in line with each other, and to their US currency pegs.
The drive for investment in private equity funds is not only relegated to the Middle East, as they are a popular investment vehicle in western markets. Some of these private equity funds are truly large, such as the US Blackstone Group with assets of $55 billion and plans for an IPO. The private equity markets in the US have generally outperformed the stock market indexes, but they are also less regulated by the Securities and Exchange Commission, giving them the freedom to try some novel financial engineering and leverage.
The danger here is that Middle East private equity funds might be tempted to bundle their “second-tier” assets and issue junk-bonds, or higher yielding so called “toxic-bonds” to fund their purchases. These are potentially poisonous financial instruments issued by private equity fund mangers and which end up infecting safer blue chip investments. Let us hope that Gulf regulators are keeping a close eye on developments, as investors in the region cannot afford another shock to their system following the disastrous bear run on national stock markets.
(Dr. Mohamed Ramady is visiting associate professor, finance and economics at King Fahd University of Petroleum and Minerals, Dhahran.)