Bank for International Settlements 2010

¶ … Bank for International Settlements 2010 Triennial Survey of Foreign Exchange and Derivative Markets reports that big banks (reporting dealers) are undertaking a steadily diminishing share of derivative trade and other financial institutions - prevalent amongst them hedge funds and pension funds are undertaking a steadily larger share. Why might this trend be occurring, and what is its potential significance

Over the last several years, the total number of hedge funds has been rising dramatically. Part of the reason for this, is because of the strategies that they are using to achieve a higher return in the markets. The most notable include: selling short, put buying and becoming involved in arbitrage situations. as, each of these different areas is designed to: provide these funds with the ability to see a larger return. This has caused to total amount of money flowing into hedge funds to significantly increase. A good example of this can be seen with the number of funds that existed in 1994, as just below 200 were accounted for. However, by 2007, this number jumped to over 10 thousand. This is important, because it showing how the underlying trends have been changing in the world of investing. To understand what is taking place requires conducting an analysis of the trend and it significance. Together, these different elements will provide the greatest insights as to how hedge funds are reshaping the financial industry. (Hedge and Pension Funds 2011)

In general, hedge funds utilize management skills, to provide higher than expected total returns. Moreover, two aspects of hedge funds make them compelling investments include: the absolute return and leverage funds. Absolute return funds are focused on the total profit of the portfolio (which are used to compensate investors for the risks). Conversely, it exhibits low correlations with fixed relative return assets and it does not providing any kind of consistent interest or dividends to shareholders.

Leverage, on the other hand, is used to increase the returns on positions through: borrowing money with the use of margin. As they are purchasing fixed assets and utilizing derivatives to achieve these objectives (Brigham 1995). As a result, the most common type of leverage used is the derivatives. These are financial instruments, whose underlying values depend on variables such as: indices, interest rates, assets, and volatility (Hull 2006).

In 1999, Brown, Goetzmann, and Ibbotzon conducted a study on the performance of offshore hedge funds. They found that its operation depends on the style effects, instead of its management skills. Furthermore, these investments and market assets produced returns that varied significantly. As a result, researchers found that hedge funds were consistently outperforming mutual funds in the financial markets (Ackermann, McEnally & Ravenscraft 1999).

In United Kingdom and United States, hedge funds are imperative in financial markets, where it accounts to approximately 50% of the transactions on the stock exchanges (Anderson 2006). In 2005, Ibbotson and Chen assessed that hedge funds will continue to develop and increase in value of up to 3 to 4% per year. Later on, the financial industry increased its size through: hedge funds and managers who control these assets.

It is difficult to acquire data on the different dimensions of hedge funds, but Liang (1999) estimated that the amount total amount of these assets reached almost $190 billion. This based on the data that was provided by Hedge Fund Research, Inc. (HFR). Moreover, the Zurich database had 1,115 hedge funds with assets of $110 million. Whilst, Vermont Housing Finance Agency has: 1,990 funds with assets of $146 billion under management (Eichengreen & Mattieson 1998). In general, HFR reported that in the last decade, there were 3,000 hedge funds created annually, with $370 to $400 billion in profits. In Europe, the annual estimated values of hedge funds consist of $28 billion in assets. Overall, the industry makes up a tenth of the size of the global financial services sector (HFR 1997).

In 2000, Fung and Hsieh reported that hedge funds demonstrated a survivorship rate of not less than 0.3% performance monthly. Where, they exhibited constant performance statistics and unchanged conclusions. Hence, hedge funds grew dramatically in number compared to: the standard equities and bond indices from 1990 to 2000.

Between 1988 to 1995, a large sample of hedge fund data showed exemplary performance, where it surpassed the standard market indicators and exhibited less volatility (Ackermann et. Al 1999). In the same year, Edwards proposed three explanations on why hedge funds produce high risk-adjusted returns, and how it has become a pivotal player in terms of its role in the financial markets. The first explanation is that, hedge funds make use of: price inefficiencies and it aims to address cost irregularities (no matter what the technique is) to always produce a larger return. Conversely, arbitrage returns decrease as the financial markets develop. This analysis shows that as the number and value of hedge funds increased the arbitrage profits will decrease in terms of total revenues. This in turn, produces larger profits in the assets coming from hedge funds.

Edwards' second explanation is that the managers of hedge funds hold a variety of important skills in finance and management (as they earn a considerable amount of income). Moreover, the outcome of adverse selection lessens as fund managers put their money into these areas. This is despite the difficulty that this comes with a theoretical point-of-view in: the lack of data surrounding their fees, as suggested by Fung and Hsieh (1997). Lastly, Edwards' reports, that the case of risk adjusted return measures are significant issues to consider. The reason why is because, it is not accurately accounted for by Sharpe ratios. Moreover, the risks in: liquidity and leverage are also vital in controlling hedge funds. This significant, because it helps to explain why some of the underlying trends are occurring in the industry.

What all of this is showing is that hedge funds have been used to provide investors with a larger return. Part of the reason why this is happening, is because there was a shift in the financial markets. Where, technology and globalization had a major impact upon how quickly trades were executed. This caused the total amounts of volatility to increase. To address these challenges, many hedge funds became attractive to investors. This is because they can use: different tools and strategies to provide investors with a larger return. As a result, this flexibility and the higher profit potential have lead to an increase in the number of hedge funds.

Recently, hedge funds have been playing an essential role in the financial markets, particularly when it comes to: the price and volatility. Nevertheless, the hedge fund transactions are still in need of more details in terms of: empirical analysis and its management activities (Kodres 1998).

On the other hand, hedge funds have destabilizing management practices that feature feedback trading. as, they are determining the following to include: 1) dynamic hedge fund techniques, 2) effects of stop-loss orders / margin calls, and 3) herd trading in financial instruments.

In 1996, Kodres and Prisker detailed empirical evidence on: hedge funds and trades in business transactions from 1992 to 1994. as, Kodres concluded that the herding was determined in the study to be: improbable causes of systematic risk in the financial markets (no matter how destabilizing it may be). After this, an analysis on the managerial and trading techniques used in hedge funds showed that there were: a wide range of approaches that are dissimilar to those embraced by traditional investors (Fung & Hsieh 1997).

In 2001, Lo documented that non- linearity, one of the risks that come with hedge funds, that can produce non-linear as well as non-normal payoffs due to: its 1) dynamically traded derivatives, 2) execution of option-like trading strategies, 3) investment techniques that greatly affect returns during market sell offs and 4) incentive fees (Agarwal & Naik 2004). Empirical studies on hedge funds demonstrated an averagely negative return and rejection rate in its test for normality (Cremers, Kritzman & Page 2005).

From 1990 to 2000, the performance of hedge funds in the business world experienced a significant returns compared to the traditional asset categories like: bonds and equities. In 1998, hedge funds exhibited great amounts of profits for the whole year. Even though, this was the only time in the sample (where the majority of fund categories) exceeded bonds and equities throughout the year (in terms of the Sharpe ratio).

In 1998, particularly the period of August to October, the techniques on fixed income turned out to be inferior (in terms of performance) compared to the strategies used on equities, with the set of fixed income funds having losses of: 10 to 15% in that same period.

In terms of the facets of bonds, cash, equities and hedge funds, there were noticeable changes in the techniques used to make the system functional during the period of 1990 to 2000. However, in other times, only cash and hedge funds managed to develop as well as increase in terms of size and value. The increase in profits (at certain points) highlights the overall risks vs. rewards, as they can see substantial growth of 5% each year. Moreover, the performance of various strategies used in management of hedge funds experienced a greater feat, despite having less asset classes to choose from.

Over the years, the hedge fund industry has shown consistent growth and increase in its regulatory issues. This is because managers are using strategies that: increase the overall amounts of risk, while offering the possibility of greater financial rewards. As a result, the odds improve that investors could experience significant losses in these areas (which increases the overall amounts of regulatory scrutiny).

Hedge funds will experience more changes that will lessen its variance in comparison with mutual funds. Where, it will determine its investors and techniques of management without being greatly influenced by: institutionalization or regulation of the finance industry. In 2005, Ibbotson and Chen estimated that the growth in the hedge funds over the next few years would be approximately 3%.

The annual size of the sector is $262 billion, and the skills of hedge fund managers contribute on an average of $10 billion to investors (in terms of the total return). The finance industry is now three times as large in comparison with what it was a decade ago, and the performance of hedge funds had successfully generated 3 to 4% of fees for shareholders. Moreover, the strategies used by hedge fund managers made a supplementary $20 billion worth of alpha.