Financial Markets and Institutions (2-downloads)

Hedge funds are a special type of mutual fund that have received considerable

attention recently, due to the near collapse of Long Term Capital Management. In

Chapter 24 we discuss how financial markets can use hedges to reduce risk in a wide

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Part 6 The Financial Institutions Industry

Price

Time

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A

F I G U R E   2 0 . 8

The Price of Two Similar Securities

Hedge funds search for related securities that historically move in lockstep but have temporar-

ily diverted. In this example, the hedge fund would sell security A short and buy security B.

variety of situations. These risk-reducing strategies should not be confused with

hedge funds. Although hedge funds often attempt to be market-neutral, protected

from changes in the overall market, they are not riskless.

To illustrate a typical type of transaction conducted by hedge funds, consider a

trade made by Long Term Capital Management in 1994. The fund managers noted

that 29 -year U.S. Treasury bonds seemed cheap relative to 30-year Treasury secu-

rities. The managers figured that the value of the two bonds would converge over

time. After all, these securities have nearly identical risk since the maturity risk dif-

ference between 29 -year securities and 30-year securities is insignificant. To make

money from the temporary divergence of the bond prices, the fund bought $2 bil-

lion of the 29 -year bonds and sold short $2 billion of the 30-year bonds. (Selling short

means that the fund borrowed bonds it did not own and sold them. Later the fund

must cover its short position by buying the bonds back, hopefully at a lower price.)

The net investment by Long Term Capital was $12 million. Six months later, the

fund covered its short position by buying 30-year bonds and sold its 29 -year bonds.

This transaction yielded a $25 million profit.

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In the transaction, the managers did not care whether the overall bond market

rose or fell. In this sense, the transaction was market-neutral. All that was required

for a profit was that the prices of the bonds converge, an event that occurred as

predicted. Hedge fund managers scour the world in their search for pricing anom-

alies between related securities. Figure 20.8 shows a situation where hedge funds

could invest. Securities A and B move in lockstep over time. At some point they

diverge, creating an opportunity. The hedge fund would buy security B, because it

is expected to increase relative to A, and would sell A short. The fund managers hope

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Wall Street Journal, November 16, 1998, p. A18.

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Chapter 20 The Mutual Fund Industry

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that the gain on security B will be greater than the loss on security A. At times, the

search for opportunities leads hedge funds to adopt exotic approaches that are not

easily available elsewhere, from investing in distressed securities to participating in

venture-capital financing.

In addition to investing money contributed by individuals and institutions, hedge

funds often set up lines of credit to use to leverage their investments. For instance, in

our example, Long Term Capital earned $25 million on an investment of $12 million, a

108% return [($25 million – $12 million)/$12 million = 1.08 = 108%]. Suppose that half

of the $12 million had been borrowed funds. Ignoring interest cost, the return on

invested equity would then be 317% ($25 million – $6 million/$6 million = 3.17 = 317%).

Long Term Capital advertised that it was leveraged 20 to 1; however, by the time of

the crisis, the figure was actually closer to 50 to 1. The Mini-Case box discusses how

Long Term Capital eventually required a private rescue plan to prevent its failure.

Hedge funds accumulate money from many people and invest on their behalf, but

several features distinguish them from traditional mutual funds. First, hedge funds

have a minimum investment requirement of between $100,000 and $20 million, with

the typical minimum investment being $1 million. Long Term Capital Management

M I N I - C A S E