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Rather than aid market functioning, hedge funds have been criticized for doing more harm than good. Firstly, rather than contrarian investing, hedge funds engage in “herding”. Notable examples include the 1992 ERM crisis and the 1997 Asian Currency Crisis.
Secondly, it was suggested that hedge funds provide much needed capital by investing in risky assets. Yet hedge funds have been blamed for exhausting liquidity in the market. Due to hedge funds typically taking large positions and the trading strategies they pursue, they are unable to make trades without causing a massive price moves due to illiquidity. Additionally, hedge funds usually heavily leverage, increasing the likelihood of illiquidity within the fund e.g. LTCM. However, while investigating capital adequacy using VaR (value at risk) measures, one concludes that most edge funds are adequately funded.
Thirdly, hedge funds can prevent efficient market functioning by causing market price distortions, rather than aiding price discovery. Large volume trades can cause significant price movements, rather than price movements occurring due to company/economic fundamentals.
The Hedge Fund as a viable alternative investment product has also been heavily disapproved. For instance some quotes from leading academics on hedge funds are as follows.
“If you want to invest in something where they steal your money and don’t tell you what they’re doing, be my guest.” – Eugene Fama.
“If there’s a license to steal, it’s in the hedge fund arena.” – Burton Malkiel.
“You would do better giving your money to a monkey” than investing in Hedge Funds.” – Bernard Condon.
As a managed investment product hedge funds command the highest management fees, typically around 20%, compared to mutual funds that normally charge around 1%. Addition-ally hedge fund investors have tougher withdrawal constraints. Secondly hedge funds have poor transparency. Regulatory bodies such as the SEC do not dictate the same strict rules for hedge funds that it does for mutual funds. There are no rules on publishing records on asset holdings and financial performance. Lack of transparency increases the chances of investors being unable to effectively assess risk of hedge funds. Finally, Hedge Funds have a higher failure rate than Mutual Funds and thus a higher credit risk. Hedge Fund face less regulation on leveraging and investment strategies, thus are susceptible to a higher probability of default e.g. LTCM. Consequently there is less likelihood of capital recovery.
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