Are hedge funds the new bird flu?

That's certainly how some of the media have reported the ECB's latest analysis. For example, Friday's Financial Times ran with the front page headline: ECB warns of hedge funds risk to stability: Collapse compared to bird flu pandemic. Here is an excerpt from Ralph Atkins and Chris Giles' page one piece:

Hedge funds have created a "major risk" to global financial stability for which there are no obvious remedies, the European Central Bank warned yesterday in one of the bluntest official statements yet on the rapidly growing sector.

In a clear hint of rising official nervousness about the multi-billion-dollar industry, the ECB ranked an "idiosyncratic collapse of a key hedge fund or a cluster of smaller funds" in the same category as a possible bird flu pandemic as the type of shock that could trigger fresh disruption in financial markets.

The ECB's remarks will play to the hostility felt by some European political leaders over the growing influence of hedge funds. Last year, they were described as "locusts" by Franz Müntefering, now the German deputy chancellor. They come amid a debate among financial regulators around the world over the regulation of hedge funds.

The ECB's concern contrasts with a more relaxed attitude at the International Monetary Fund and the Bank of England, both of which have stressed the positive role of hedge funds while acknowledging possible dangers.

The ECB's comments came in the Frankfurt-based central bank's latest "financial stability review", which, for the first time, included a special section on hedge funds. The review highlighted an increasing tendency by funds to mimic strategies followed by others. It noted that the correlation of hedge fund returns had "surpassed levels seen just before the near collapse of Long Term Capital Management in 1998".

...Presenting the report, Lucas Papademos, ECB vice-president, said that if business conditions changed and many hedge funds reacted in a similar way, "because of the similarity of strategies, the implications for asset prices are going to be more pronounced". He stepped up ECB demands for greater transparency.

Here is the ECB media release for the report, and a link to the June 2006 Financial Stability Review (2.5Mb PDF). The section on hedge funds starts at page 133. Here is the 'overall assessment' from that section. It's quite a stark warning, accompanied by some compelling analysis:

As the hedge fund industry keeps on growing, its expansion continues to raise questions about capacity constraints and the impact of hedge funds’ largely unconstrained investment strategies on financial markets. In addition to potentially high leverage, the increasingly similar positioning of individual hedge funds within broad hedge fund investment strategies is another major risk for financial stability which warrants close monitoring despite the essential lack of any possible remedies. This risk is further magnified by evidence that broad hedge fund investment strategies have also become increasingly correlated, thereby further increasing the potential adverse effects of disorderly exits from crowded trades.

It is difficult to gauge what could cause correlated sell-offs and how damaging these could be, but one possible trigger could be an abrupt end of the recent global search for yield possibly induced by the tightening of global liquidity conditions. A further slowdown of inflows into hedge funds or even widespread redemptions could also exert pressures on individual hedge funds to liquidate increasingly less liquid holdings, as more hedge funds seem to be venturing into less liquid markets in order to earn the associated liquidity premium. Since the valuation of such investments is often arbitrary, investors may not always be presented with an accurate picture of fund positions and performance.

Comments

[banks]

correctomundo!!!! hedge funds are the scurge of the world, and wnen left-brain individuals look at the overall finance "globally" situation now, this is an era that no one in the world has experienced, and truly to take profits quarterly and not reinvest it, but align with a hedge fund, that really is only for the "fat cats", that's aggregious and demonstrates poor economic dealings. All countries are only use to "existing within their "shaky" economic state, but now, the lession will be learned, if we are smart, we will use our bartering skills and hope CHINA won't make us unpaid slaves. Hey, what goes around comes around.... Great Britian and the U.S. for the most part folks are right-brainers!! It's time for the world to be guided by the scientist, humanists, and philosophiers, and people who want to keep their heritage without being "subliminally induced to settle for what they feel is the "goodl ife"and be culturally raped. Quick example: India, the major auto makers are looking to sale their "atomospheric killing" cars there, can you imaging if 2 in 5 folks had cars!!!!

[retro jordan 5]

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