Will Hedge Funds Bring A Global Financial Meltdown?

Hedge funds are secretive funds that use highly risky investing strategies to make a quick return. Nothing is unfair for them. A hedge fund manager sees an opportunity, he pounces on it and tries to make a return before the crowd does. Don’t know how a hedge fund operates? Watch the video below that explains how a hedge fund operates.

Recent example is Brexit. Hedge funds were the biggest winners. Hedge funds had figured out that in case of a yes vote there will be a huge financial outflow from UK which will force British Pound to fall like a rock. So the savvy hedge fund managers took massive short positions and profited handsomely. In a matter of 10-15 hours these hedge funds had made huge returns that most other funds will make in a whole year. Short selling has been blamed for bringing the market crash in 2008. Short sellers are the ones who are making money in today’s market. Watch the videos below that argue that hedge funds almost brought the global financial meltdown in 2008!

One can blame the hedge funds. But we believe the blame should be put on those who had changed the accounting rules that required the balance sheets to be marked to the market. When the stock of a company plummeted, it balance sheet became red instantaneously. This put a downward pressure on that stock that was exploited by the short sellers which were mostly hedge funds. Ordinary short sellers don’t have the power to bring down a company. This point has been argued by most financial experts that the old accounting rule that required assets to be priced in terms of historical costs is robust and more foolproof as compared to the new accounting rules that required marking the assets down to the market meaning pricing the assets according to the current market price.

Now we can blame the short sellers. In Europe a ban has been put on short selling in 2012. The financial crisis of 2007 led to strict European rules on hedge fund activity, which would be threatened if the UK left the EU. Hedge funds stand to save around $393 million if the rules are lifted. “There are quite a few hedge fund managers who are anti-EU,” said one Mayfair hedge fund boss, who declined to provide his name. “Many are generally opposed to it.”

So you can see hedge funds have got market power. If hedge funds don’t like a policy or a rule, they can manipulate the markets and achieve whatever they want. With huge funds at their disposal, hedge funds can make strategic investments that can tilt the market in their favor. Short selling is one of the favorite strategies that hedge funds love. When the words get out that a company is in its death spiral, short sellers start shorting the stocks of that company and the company dies earlier than its expected death.

You can understand now how a financial crisis is being snow balled by these hedge funds. When the markets panic and the stocks fall, short sellers start selling because everyone is expected to sell. Hedge funds can invest huge funds in short selling which brings so much pressure on the market that it only has one direction to go and that is down.

The best example of this hedge fund behavior was when it brought the currency crisis to a number of emerging Asian countries that included Thailand, Indonesia, South Korea, Malaysia etc. George Soros got the blame and was portrayed as a vulture trying to profit from the miseries of poor people in those countries. Hedge funds don’t like regulation and do their utmost to stay out of regulation. Hedge funds are having a tough time, making life much harder for everyone else in the market.

What is happening right now is that hedge funds have also learned from the markets. They have modified their vulture behavior that made them infamous in 1990s. Hedge funds are providing liquidity to the market and in most cases it is being argued that a big bank failure is much more risky for the global financial markets as compared to small hedge funds who fail often and nobody cares. When a big bank starts to show poor health it gets cash from the government regulatory authorities as it’s failure is considered to be more dangerous to the global financial system. So we believe big banks are far more dangerous to the health of the global financial system as compared to hedge funds. There are many big banks who are showing poor health so beware of their systemic risk. But still we cannot say hedge funds have no role in the systemic risk.

Do Hedge Funds Pose A Systemic Risk To The Economy?

It is important for investors to realize that the stock markets in the first years of the 21st century are not just down, but down in a particular way, as a result of the new forces at work in the market, the most important of which is the hedge fund. A hedge fund investor must have at least $1.5 million in net worth to invest. The funds are regulated little and do not report their activities, trades, and balances. The smaller investor cannot play this game successfully. He or she can only go long in the market, hoping for sustained rallies, while through the hedge fund a richer investor is free to go either long or short. The ordinary investor can make money in only one way—an up market—while the larger investor can make it coming or going, up or down.

Hedge funds are a much bigger part of the market than they used to be. They follow a herd mentality, as do most fund managers of any sort. When they all go long, the market rises—when they all go short, it falls. They tend to go one way, then the next—and the market experiences violent shifts from day to day, but in a narrow range without much of a trend….

Harvard Business School Professor argues in the above article that hedge funds have tilted the balance in favor of speculation as compared to investment as a result turning the markets into casinos.

Although hedge funds did not play a major role in the financial crisis, the researchers concluded that they can pose systemic risk to the financial system — that is, they can cause the initial failure of one or more financial firms or a segment of the financial system, disrupting a core function of the financial system…

This is a good scholarly discussion going on the Khan Academy on Are Hedge Funds Bad.

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