How Do Hedge Funds Impact the Stock Market?
Pros and Cons
Hedge funds' impact on the stock market has grown substantially in the last decade. According to some estimates, they control 10 percent of shares on U.S. stock exchanges. That includes the New York Stock Exchange, the NASDAQ and BATS. Credit Suisse estimates their impact could be even higher. They may control half of the New York and London Stock Exchanges. (Source: "U.S. Regulators Grow Alarmed Over Hedge Fund Hotels,” International Herald Tribune, January 1, 2007.)
Since they trade often, they are responsible for one-third of the total daily volume on the NYSE alone. An estimated 8,000 hedge funds are operating globally. Most are in the United States. There is a high concentration in the state of Connecticut.
Researchers found that hedge funds contribute positively to the stock market. But when their sources of capital dry up, they can have a devastating negative impact. (Source: Charles Cao, Bing Liang, Andrew Lo, Lubomir Petrasek, "Hedge Fund Holdings and Stock Market Efficiency," Federal Reserve Board, May 2014.)
Hedge funds make the stock market less risky. That's because they use sophisticated, data-based investing strategies. It allows their analysts to find out more about individual companies than an average investor could. They exploit and take advantage of any unfairly priced stocks. That makes share prices more fairly valued.
By reducing risk, hedge funds lower stock market volatility.
Many hedge funds are very active investors. They buy enough shares to get a vote on the company's board. They have such an influence on that company's stock that they can force the company to buy back stock and improve share prices. They can also make the company sell off low-producing assets or businesses, becoming more efficient and profitable.
Hedge funds also increase risk. That's because they use similar quantitative strategies. Their computer programs can reach similar conclusions about investment opportunities. They affect the market by buying the same product, like mortgage-backed securities, at the same time. As prices rise, other programs get triggered and create buying orders for the same product. That's how they create asset bubbles. Just look at the prices of housing in 2005, oil in 2008, gold in 2011, Treasuries in 2012, the stock market in 2013, and the U.S. dollar in 2014.
Second, hedge funds' use of 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 specified date in the future.
Third, hedge funds rely heavily on short-term funding through money market instruments.
These are usually 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. But during the financial crisis, many investors were so panicked they sold even these safe instruments to buy 100 percent 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.
Fourth, they use this short-term debt as leverage to buy the risky derivatives.
That's the only way anyone can outperform the market. They are betting that their sophisticated computer programs and analysis will allow them to be right more often than not.
Fifth, hedge funds are still largely unregulated. They can make investments without scrutiny by the Securities and Exchange Commission. Unlike mutual funds, they don’t have to report quarterly on their holdings. That means no one knows what their investments are.
How They Affect You
If you own stocks, either outright or through your 401(k), IRA, or pension plan, you are impacted by hedge funds.