Hedge funds are largely unregulated, private funds for pooling investors' money and investing in a variety of assets. They're more flexible than mutual funds in their inevstment strategies. Hedge funds typically use leverage and other aggressive methods to maximize returns, and this also maximizes risk. They were particularly popular in the years leading up to the 2008 crisis, and they played a major role in what unfolded.
- Hedge funds are private funds designed to pool investors' money for investing in a wide range of assets.
- Hedge funds are inherently more flexible and risky than mutual funds.
- Because they are largely unregulated, risky hedge fund strategies were allowed to proliferate leading up to the financial crisis of 2008.
- Hedge funds and their derivative investments were one of the major factors behind the housing market's eventual crash.
What Makes Hedge Funds Risky?
Hedge funds don't only mitigate risk. In some ways, they can increase it. There are several reasons for this.
Leverage Magnifies Losses
Their use of leverage allows them to control more securities than if they were simply buying long. Hedge funds use sophisticated derivatives to borrow money to make investments. That creates higher returns in a good market and greater losses in a bad one. As a result, the impact of any downturn is magnified.
Hedge fund derivatives 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 Control the Market Through Futures
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.
As a result, hedge funds' impact on the stock market has grown substantially in the last decade. According to some estimates, they control 10% of shares on U.S. stock exchanges. That includes the New York Stock Exchange (NYSE), Nasdaq, and BATS. Since they trade often, they are responsible for one-third of the total daily volume on the NYSE alone.
An estimated 10,000 hedge funds are operating globally.
Hedge Funds All Focus on the Same Products
All hedge funds use similar quantitative strategies. Their computer programs can reach similar conclusions about investment opportunities, so they affect the market by all buying the same product, such as mortgage-backed securities, at the same time. As prices rise, other programs get triggered and create buying orders for the same product.
They Rely on Short-Term Funding
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 certificates of deposit. 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% 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. This helped create the September 17, 2008, run on money markets.
They Are Unregulated Products
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.
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.
How Hedge Funds Create Asset Bubbles
The world's richest hedge fund owner, George Soros, said that hedge funds 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 macroeconomic trends, such as war in Ukraine, an election in Greece, and sanctions on Russian oligarchs. The model takes all these things into account, then alerts the analysts to sell euros and buy dollars, rapidly inflating the value of the dollar.
Events like these can create sudden and ferocious asset bubbles. For instance, Treasury yields fell to an all-time low in March 2020. The U.S. dollar rose sharply in 2014 and 2015. The stock market rose rapidly in 2013, and gold rose to nearly $1,900 an ounce in 2011. Oil prices rose to an all-time high in 2008. The most damaging asset bubble of all, however, was hedge fund trades in mortgage-backed securities in 2005.
How They Helped Cause the Financial Crisis
In 2001, the Federal Reserve lowered the Fed funds rate to 1.82% to fight the recession. During the stock market downturn, investors sought out hedge funds to gain higher returns. Low interest rates meant bonds delivered lower results to pension fund managers. They were desperate to earn enough to cover their expected future payments. As a result, massive amounts of money poured into hedge funds.
As the economy improved in 2003 and 2004, more money flowed into these funds. Managers created riskier investments to gain an edge in a very competitive market. They increased their use of exotic derivatives, such as mortgage-backed securities. These were based on bundles of mortgages and were highly profitable.
Low interest rates also made payments on interest-only loans affordable to many new homeowners. Many families who couldn't afford conventional mortgages flooded the housing markets. As demand for the mortgage-backed securities rose, so did demand for the underlying mortgages. Banks had become big investors in hedge funds with their customers' deposits.
Large banks even created their own hedge funds. That had been illegal until Congress revoked the Glass-Steagall Act in 1999. As a result, banks put pressure on their mortgage departments to lend to anyone and everyone. They didn't care if the loans defaulted because they sold the mortgages to Fannie Mae and Freddie Mac.
As the number of reasonable investment alternatives decreased, fund managers started piling into similar types of risky investments. That meant they were more likely to all fail together. Nervous investors were more likely to withdraw funds quickly at the first sign of trouble. As a result, many hedge funds were launched, and just as many failed.
By 2004, the industry was unstable with high levels of volatility. A National Bureau of Economic Research study of the hedge fund industry revealed higher levels of risk. Those findings were supported with more research in 2005 and 2006.
Also in 2004, the Federal Reserve raised rates to fight inflation. In 2005, rates rose to 4.16%, then to 4.99% by June 2006. As rates increased, demand for housing slowed. By 2006, prices started to decline. That affected homeowners who held subprime mortgages the most. They soon found their homes were worth less than what they paid for them.
Higher interest rates meant that payments rose on interest-only loans. Homeowners could not pay the mortgage, nor sell the home for a profit, so they defaulted.
No one really knew how that would affect the value of the derivatives based on these mortgages. As a result, banks that held these derivatives didn't know if they were holding good investments or bad ones. They tried to sell them as good ones, but other banks didn't want them. They also tried using them as collateral for loans. As a result, banks soon became reluctant to lend to each other.
Banks and Bankruptcies
In the first half of 2007, several prominent multibillion-dollar hedge funds started to falter. They had invested in mortgage-backed securities. Their failure came because of desperate attempts by investors to reduce risk and raise cash to meet margin calls.
Bear Stearns was a bank brought down by two of its own hedge funds. In 2007, Bear Stearns was told to write down the value billions in collateralized debt obligations (CDOs). They were, in turn, based on mortgage-backed securities. They had begun to lose value in September 2006 when housing prices fell. By the end of 2007, Bear wrote down $1.9 billion. By March 2008, it couldn't raise enough capital to survive. The Federal Reserve lent JPMorgan Chase the funds to purchase Bear and save it from bankruptcy. But that signaled markets that the hedge fund risk could destroy reputable banks.
In September 2008, Lehman Brothers went bankrupt for the same reason—its investments in derivatives. No buyer could be found.
The failure of these banks caused the Dow Jones Industrial Average to plummet. A market decline alone is enough to cause an economic downturn by reducing the value of companies and their ability to raise new funds on the financial markets. Even worse, the fear of further defaults caused banks to refrain from loaning to each other, causing a liquidity crisis. It almost stopped businesses from raising short-term capital needed to keep their businesses running.
The Bottom Line
No single factor caused the financial meltdown that came to a head in 2008. There were a slew of aggressive investing strategies at play, and hedge funds played a significant part in the crisis. Regulations have been expanded since then, but it remains to be seen how effective they will be at heading off a future crisis.