June 22, 2006

Hedge Funds Still a Threat to Global Financial System

Hedge funds, though a $1.5 trillion industry worldwide, have come to be associated with the following negative aspects:

  • They pose substantial threats to the global financial system.
  • They result in heavy losses for investors.
  • They are largely unregulated.
  • They use complicated stress tests and scenario planning techniques to compensate the fact that they may be forced to liquidate positions in an unplanned and sudden manner.
  • They risk disrupting the market and causing a structural collapse in the event of a multiple funds offloading positions simultaneously, triggered by the occurrence of a market event.

The high risks linked with hedge funds arise largely due to the fact that these funds invest in a wide variety of asset classes in businesses that are often supported by leverage, derivatives, or debt. A study of this rapidly evolving industry conducted by consultants Mercer Oliver Wyman (MOW) has revealed that though hedge fund managers and banks that service these funds have improved their risk-management practices, there is still a long way to go before they can keep pace with market innovations. Though stress tests and scenario planning reduce the risks to a certain extent, they are still qualitative methods, and so, not very reliable. The survey also found that hedge funds are increasing their transparency so that investors and pension funds can calculate their risk more effectively.

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June 22, 2006 in Research | Permalink




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