2.2.4 Hedge funds – are they market manipulators?
Hedge funds have attracted considerable attention and, on occasion, criticism in recent years – but what are they, and how are they different from other types of investment funds? The term relates to an array of funds with a variety of structures and investment strategies. However, there are some common features:
- some are targeted at wealthy individuals (those of ‘high net worth’) who may be prepared to take greater risks with their investments than ‘ordinary’ investors
- the managers of hedge funds charge high fees for their services, often linked to the performance of their funds
- the funds tend to adopt riskier investment strategies than ‘ordinary’ investment funds, often building up their positions by borrowing money from the wholesale markets to finance their investments.
The main criticism levied at the hedge funds is that there is evidence that they target firms they perceive to be in difficulties and engage in strategies to profit from a fall in their share prices. They do this by ‘short-selling’ – entering into agreements to sell shares they do not possess for settlement at a future date. The intention is that between the transaction date and the settlement date, the market price of the shares in question will fall, enabling the hedge fund to buy them at the lower market prices to deliver them as required under the terms of the original transaction. The profits arise from having originally sold the shares at a higher price than the one at which they were ultimately acquired for delivery to the customer. If this strategy pays off, it is often to the disadvantage of the affected firms, who may find that their share price has been driven downwards – or, at worst, that the fall in the price has provoked panic selling by other investors, thereby jeopardising the firm’s existence. Hedge funds were widely criticised for their role in pushing down bank share prices during the 2007/08 financial crisis.
Ironically, the term ‘hedge’ is widely used in the financial markets to describe a method for reducing risk. Hedge funds, by contrast, are widely viewed as seeking to increase risk in the search for higher investment returns.
However, to be fair, there is a huge variation of styles and risk profiles within the hedge fund sector. Consequently, recent years have seen the rise of the ‘fund of hedge funds’ (FOHF): investors buy into a FOHF and leave the manager of the FOHF to use their skill and judgement to decide which hedge funds to buy into. This can provide greater investment diversification and thus help to reduce the overall risk to the investor.