Hedge funds came under heightened examination as a result of the failure of Long-Term Capital Management (LTCM) in 1998, which necessitated a rescue coordinated (but not financed) by the U.S. Federal Reserve. Critics have charged that hedge funds create systemic risks highlighted by the LTCM disaster. The excessive leverage (through derivatives) that can be used by hedge funds to achieve their return is outlined as one of the major factors of the hedge funds' contribution to the systemic risk.
The ECB (European Central Bank) issued a word of warning in June 2006 on hedge fund risk for financial stability and systemic risk: "... the increasingly comparable positioning of individual hedge funds within broad hedge fund investment strategies is another chief risk for financial stability which warrants close monitoring despite the essential lack of any possible remedies. This risk is additional magnified by evidence that broad hedge fund investment strategies have also become increasingly interrelated, so further increasing the potential adverse effects of disorderly exits from crowded trades." Nevertheless the ECB statement has been disputed by parts of the financial industry.
The potential for systemic risk was tinted by the near-collapse of two Bear Stearns hedge funds in June 2007. The funds are invested in mortgage-backed securities. The funds' financial problems necessitated a combination of cash into one of the funds from Bear Stearns but no outside assistance. It was one of the largest fund bailout since Long Term Capital Management's collapse in 1998. The U.S. Securities and Exchange Commission is investigating on this bailout.
As private, lightly regulated entities, hedge funds are not appreciative to disclose their activities to third parties. This is in distinction to a regulated mutual fund (or unit trust) which will typically have to meet regulatory necessities for disclosure. An investor in a hedge fund generally has direct access to the investment advisor of the fund, and may have the benefit of more personalized reporting than investors in retail investment funds. This may include detailed deliberations of risks assumed and significant positions. Nevertheless, this high level of disclosure is not available to non-investors, contributing to hedge funds' reputation for secrecy, though several hedge funds are offer very limited transparency even to investors.
Some hedge funds, principally American, do not use third parties either as the custodian of their assets nor as their administrator (who will calculate the NAV of the fund). This can lead to conflicts of interest, and in severe cases can assist fraud. In a recent illustration, Kirk Wright of International Management Associates has been accused of mail fraud and other securities violations which supposedly defrauded clients of close to $180 million. In December 2008, Bernard Madoff was in prison for running a $50 billion Ponzi scheme.
The rather disappointing hedge fund performance of the past five years calls into question the substitute investment industry's value proposition. Alpha had appeared as becoming rarer for two related reasons. First is to be, the increase in traded volume may have been reducing the market anomalies that are a source of hedge fund performance. Second one is to be, the remuneration model is attracting more managers, which may dilute the talent available in the industry, though these causes are disputed.
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