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December 09, 2005
Hedge Fund Failure – A real concern
Even as high strung investor community pours in billions of dollars into hedge funds, there are eminent risks that could have a far reaching impact than acknowledged. Wealthy investors in expectation of huge returns bet big on loosely regulated hedge fund strategies.
However, some financial experts and analysts opine that, in the event of a surprise market tremor, such funds could potential shake up the financial markets. Although, hedge funds usually cater to large institutions and the super-wealthy investors, a shake up of the hedge funds market could have ramification on the banking system as well as on the retail investors owning to the sheer magnitude of the hedge fund investments.
The very fact that regulations are relatively easy on hedge fund investment pools, further adds to the fear of a spiral down. Unlike mutual funds, hedge funds can potentially bet on everything from real estate to energy futures. In order to garner the sky-rocketing returns that investors expect from hedge funds, fund managers usually engage in risky strategies, such as loading up on debt and engaging in unlimited short-selling (betting that an asset will fall rather than rise in value).
Such risky strategies might bring about amazing returns, but a failure leads to heavy losses too. The risks of hedge funds were highlighted back in 1998, when the Long-Term Capital Management fund collapsed. In spite of being driven by two Nobel-Prize-winning economists and some of the smartest Wall Street experts, Long-Term Capital Management fund made enormous bet on bonds that lost. And in order to prevent a financial chaos, a coalition of Wall Street banks had to come to the rescue of the fund.
Although, the severity of the consequence in case of Long-Term Capital Management brought about a sense of caution into the industry – the number of hedge funds is growing at an alarming rate.
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