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Recent Developments in Hedge Funds *1

June 13, 2006
Financial Systems and Bank Examination Department *2
Financial Markets Department
Bank of Japan

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Summary

Definition of Hedge Funds

Hedge funds are becoming increasingly prominent in global financial markets. Although hedge funds and investment trusts are both forms of pooled investment vehicles, hedge funds are characterized by greater freedom for investment managers in terms of investment strategies. This is because hedge funds' investor base is limited to institutional investors and high net worth individuals, exempting them from the constraints of various regulations, and because they commonly place restrictions on investors' withdrawal of funds.

Growth of the Hedge Fund Industry and Changes in Risk Characteristics

Since the 1990s, the hedge fund industry has grown both in asset size and in number of funds. Investments in hedge funds by institutional investors have increased markedly since 2002. In Japan, pension funds and financial institutions, in particular, have increased investments in hedge funds. Such increase in investments into hedge funds has been supported by a low interest rate environment in major economies and by an increase in demand from investors to diversify their assets. Analyses using publicly available data, although there are some data constraints, reveal that in recent years (1) hedge funds produced positive returns regardless of stock and bond market performance; (2) volatility of hedge fund returns was lower than that of stocks; and (3) portfolio diversification could be expected from investing in hedge funds, as the correlation of returns between hedge funds and traditional assets was low. Such risk-return properties of hedge funds may have matched investor demand.

Hedge funds have become increasingly active in a variety of markets, exploiting new investment strategies as they grow in size and investor base, and have contributed to enhancing efficiency and liquidity in global financial markets. Accordingly, the risk characteristics of hedge funds have changed. Data show that in the few years after 2002, compared to the late 1990s, which coincided with the Long-Term Capital Management (LTCM) crisis, (1) returns of hedge funds and their volatility were lower and (2) incidents where hedge funds incurred large losses that exceeded maximum losses calculated by Value at Risk (VaR) were fewer. Meanwhile, investors have become more conscious of risk management and less keen on investing in hedge funds that use extraordinary levels of leverage, and leverage levels taken by hedge funds seem to have declined. Investors are also more careful to avoid concentrating their investments in certain hedge funds because hedge funds tend to be quickly weeded out in terms of "survival of the fittest."

Regulatory Environment in the Hedge Fund Industry

In the United States, the Securities and Exchange Commission (SEC) amended regulations to place tighter restrictions on investment managers. In the United Kingdom, a new collective investment vehicle that has the characteristics of hedge funds, called the Qualified Investor Schemes, was introduced for institutional investors. In some European and Asian countries, building a legal environment to allow hedge funds to target retail investors has been contemplated in recent years. Although the directions of changes are not uniform, legal developments with respect to hedge funds have been noted. These changes are all being made to find the appropriate balance between ensuring a wide range of investment options for investors and protecting investors.

Recent Issues concerning Hedge Funds

Hedge funds, on the whole, seem to be taking less risk in recent years. However, there are some that take high risk, and when the global financial environment permits, more funds may be inclined to do so in seeking higher returns. Given their growing presence in the global financial markets recently, it cannot be denied that large losses by or default of hedge funds may not only affect their counterparties and investors, but also have wide-ranging external effects on liquidity and the price discovery process in global financial markets. Therefore, it is vital to pay close attention to hedge fund activities and their effects.

In the discussion of hedge fund developments in global financial markets, two issues come to the fore: (1) exploring ways to enhance information disclosure on hedge funds and risk management by counterparties and investors of hedge funds; and (2) understanding the influences that hedge fund activities or default have on global financial markets and systems.

While there are outstanding issues to be addressed, much progress has been noted in risk management by counterparties of hedge funds since the LTCM crisis. However, it is necessary to continuously check counterparties' risk management standards so that they will not be lowered when the environment becomes more competitive. The widely held view in regard to information disclosure on hedge fund activities is that having counterparties and investors obtain necessary information to manage risk from hedge funds is more efficient and effective than uniformly imposing statutory requirements on hedge funds.

Hedge fund activities and their influences need to be monitored, even though there are data constraints, with a focus on the following two issues in particular. One is whether there is a risk that hedge fund activities might destabilize markets if hedge fund transactions become concentrated on similar strategies or pressured to use high-risk strategies in market environments where profit opportunities are few. The second is whether there is a risk that market liquidity might dry up with the exit of hedge funds.

In these circumstances, financial authorities including central banks have been examining risk management systems of financial institutions including banks and securities firms, from the perspective that these market players are counterparties and investors of hedge funds. Furthermore, financial authorities have been discussing ways to adequately monitor market developments in hedge funds, such as enhancing information exchange in international fora and supporting efforts to improve databases on hedge funds.