How Do Hedge Funds Affect the U.S. Economy?

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Hedge funds have an outsized, and largely hidden, impact on the economy. Since they aren't as regulated as the stock, bond, or commodities markets, it's difficult to find out what they actually buy or sell. It's estimated they own between 10%-50% of some stock exchanges, and make up half of daily trading volume. Their growth has accelerated since 2000, and so has volatility in many investment classes.

 

What makes them so influential? First, their use of leverage allows them to control more securities than if they were simply buying long.  they use derivatives means that, with little actual money invested, they have the capability to create large swings in the market.  These include options contracts that allow them to put down a small fee to buy or sell a stock at an agreed-upon price on or before a specified date. They can short sell stocks, which means they borrow the stock from the broker to sell it, and promise to give it back in the future. They buy futures contracts that obligate them to either buy or sell a security, commodity, or currency, at an agreed-upon price on a certain date in the future. 

Second, they use computer trading programs that accentuate any trend. This is really the only way anyone can outperform the market. They are basically betting that their sophisticated computer programs and analysis will allow them to be right more often than not.

Third, hedge funds rely heavily on short-term funding through money market instruments. These are normally very safe ways to raise cash, such as money market funds, commercial paper issued by high-credit corporations, and CDs. The hedge funds purchase and resell bundles of these instruments to investors to generate enough cash to keep their margin accounts active.

The bundles are derivatives, such as asset-backed commercial paper.

Usually, this works fine. However, during the financial crisis, many investors were so panicked they sold even these safe instruments to buy 100% guaranteed Treasury Bills. As a result, the hedge funds couldn't maintain their margin accounts, and were forced to sell securities at bargain-basement prices, thus worsening the stock market crash.  For more, see September 17, 2008 Run on Money Markets.

Fifth, hedge funds are still largely unregulated. They can make investments without scrutiny by the SEC. Unlike mutual funds, they don’t have to report quarterly on their holdings. This means no one really knows what they are invested in. 

How They Create Asset Bubbles

The world's richest hedge fund owner, George Soros, said that hedge funds actually influence markets in a feedback loop. If a few of their trading programs reach similar conclusions about investment opportunities, it triggers the others to react.

For example, say funds start buying U.S. dollars in the forex market, driving the dollar's value up a percent or two. Other programs pick up on the trend, and alert their analysts to buy. This trend can be accentuated if the computer models also pick up on supporting macro-economic trends, such as war in Ukraine, an election in Greece, and sanction on Russian oligarchs.

The model takes all these things into account, and further alerts the analysts to sell euros and buy dollars. Although no one knows for certain, the dollar index did rise 15% in 2014, while the euro fell to a 12-year low.  

Other recent asset bubbles were just as sudden and ferocious. The stock market rose nearly 30% in 2013, Treasury yields fell to a 200-year low in 2012, and gold rose to nearly $1,900 an ounce in 2011. Oil prices rose to an all-time high of $145 a barrel in 2008, even though demand had fallen thanks to the recession. The most damaging asset bubble of all was hedge fund trade in mortgage-backed securities in 2005. 

How They Affect You

If you own any publicly-traded securities, either outright or through your 401(k), IRA, or pension plan, you are affected by hedge funds. Hedge fund traders have dramatically lowered the cost of oil.

That's had a huge impact on the economy. Oil prices are a component of inflation, which affects consumers ability to purchase. Since consumer products are nearly 70% of the U.S. economy, the expansion of consumer buying power has boosted domestic growth. On the other hand, the U.S. manufacturers are being hit by the strong dollar. That's lowered export growth. 

Hedge funds have also affected the banking industry. Large banks are focusing more and more on the largest hedge fund customers. For example, Citi receives its biggest trading commissions from the "Focus Five." These are the largest hedge fund companies: Millennium Management, Citadel, Surveyor Capital, Point72 Asset Management, and Carlson Capital. Smaller businesses are having a more difficult time getting financing. (Source: "You Paid Us Only $1 Million? Get in Line," Bloomberg, March 23, 2016.) 

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