Hedge Funds and Systemic Risk
Report

Hedge Funds and Systemic Risk

Lloyd Dixon, Noreen Clancy and Krishna B. Kumar
Rand Corporation, 2012
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Editorial Rating

8

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  • Analytical
  • Innovative
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Recommendation

Investors, analysts and other market observers often point to hedge fund managers as market mavericks with little regard for the overall health of the financial system. However, while short selling, leverage and other common hedge fund practices may have contributed to the collapse of Long-Term Capital Management (LTCM) in 1998 and to the financial crisis 10 years later, missteps by banks, credit rating agencies and other market participants appear to have played a far greater role. Recent regulatory reform seeks to impose greater oversight on certain hedge fund practices that may add systemic risk to the financial system, but hedge funds’ lack of transparency makes that oversight difficult. This RAND Corporation report draws from interviews with hedge fund managers, industry attorneys, regulators and independent researchers to highlight the part that hedge funds played in the financial crisis and to discuss the potential pitfalls of federal regulators’ direct supervision of hedge funds. getAbstract finds that this paper’s observations provide a refreshing break from the simplistic hedge fund bashing that usually makes headlines. It offers a more nuanced and balanced view of these still-secretive but highly influential financial entities.

Summary

Hedge Funds in the Financial System

A hedge fund is a type of private investment fund available only to “qualified investors”: individuals with a minimum of $5 million in investments or companies with investable assets of at least $25 million. Hedge funds can be independent entities or can form part of a larger organization, such as an investment bank. These funds have a broad investment menu, including equities, derivatives, currencies and commodities.

Unlike mutual funds, hedge funds aren’t limited in terms of leverage, short selling or concentrated positions. One research firm estimates that between 9,200 and 10,100 hedge funds were in business worldwide in 2010, three times the number that existed in 1998. Fewer than 10% of these funds manage more than 70% of the industry’s assets under management (AUM).

Hedge funds are an important part of the financial system because their creative approaches to investing offer profit opportunities as well as market dynamism. Yet they accounted for only $2.5 trillion in AUM in 2010, compared to $23.7 trillion for the mutual fund industry. However, because many hedge fund strategies involve arbitrage, they generate 25% to...

About the Authors

Lloyd Dixon and Krishna B. Kumar are senior economists at the RAND Corporation, where Noreen Clancy is a senior project associate and environmental scientist.

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