HEDGE FUNDS AND THEIR IMPLICATIONS FOR FINANCIAL STABILITY by Tomas Garbaravicius and Frank Dierick

HEDGE FUNDS AND THEIR IMPLICATIONS FOR FINANCIAL STABILITY by Tomas Garbaravicius and Frank Dierick

1 INTRODUCTION
Hedge funds first came to prominence with
the near-collapse of Long-Term Capital
Management (LTCM) in September 1998.
Recently, they have again started to attract the
attention of the global financial community –
this time for their impressive growth and
increasing proliferation as a mainstream
alternative investment vehicle. Although the
hedge fund industry is still relatively modest in
size, the pace of growth indicates that hedge
funds are heading towards becoming important
non-bank financial intermediaries. However,
while the role of other major institutional
investors is well established, analysed and
understood, the same is not true with regard to
hedge funds, their activities, their impact on
financial markets, and their implications for
financial stability, all of which remain
relatively less explored.
The purpose of this paper is to provide an
overview of the hedge fund industry from a

financial stability perspective, with some
emphasis on the European Union (EU)
dimension. The paper starts in Section 2 by
providing a working definition of a hedge fund
and by examining some of the key features of
hedge funds. Hedge funds differ from each
other in many respects, but their most notable
distinguishing feature is the investment
strategy they pursue. Section 3 accordingly
provides a classification of such strategies.
Section 4 reviews the basic characteristics of
the hedge fund industry, and includes a
synopsis of the different institutional
relationships involved in hedge fund
operations. Quantitative estimates of the recent
expansion in hedge funds are provided in
Section 5, along with a number of factors that
could explain this evolution. Section 6 assesses
the impact of hedge funds on financial
stability. Section 7 addresses the supervisory
concerns related to hedge fund activity and
the various initiatives taken so far to address
these concerns. Finally, Section 8 concludes by
summarising the main issues and provides an
outlook for the future.
2 THE CONCEPT OF HEDGE FUNDS
Strictly speaking, the term “hedge fund” is not
a correct definition of the institutions under
consideration. The term has historical
significance, as in the beginning of the second
half of the last century the first institutions of
this kind were engaged in buying and short-

selling equities with the aim of eliminating
(hedging) the risk of market-wide fluctuations.
However, the possibility of using short-selling
and other types of hedging is not unique to
hedge funds. Moreover, over time hedge funds
have started to use a wide variety of other
investment strategies that do not necessarily
involve hedging.
There is no legal or even generally accepted
definition of a hedge fund, although the
US President’s Working Group on Financial
Markets (1999) characterised such entities
as “any pooled investment vehicle that

is privately organised, administered by
professional investment managers, and not
widely available to the public”.
 While this
definition distinguishes hedge funds from
public investment companies, it does not
capture many of the distinctive features of
hedge funds and is so broad that it includes
many other alternative investment vehicles,
such as venture capital firms, private equity
funds, real estate funds and commodity pools.
In contrast to other pooled investment vehicles,
hedge funds make extensive use of short-

selling, leverage and derivatives.
Nevertheless, it would be inaccurate to assign
these attributes exclusively to hedge funds, as
other financial companies, including banks and
other registered and unregistered investment
companies, also engage in such operations. The
key difference is that hedge funds do not have
any restrictions on the type of instruments or
strategies they can use owing to their
unregulated or lightly regulated nature. A
summary of some key hedge fund
characteristics is presented in Table 1, which

demonstrates that hedge funds represent a
flexible business model and investment
process rather than an alternative asset class.
In addition to single hedge funds, there are
funds of hedge funds (FOHFs), i.e. funds that
invest in a number of other hedge funds. In this
way diversification and selection services are
provided to investors that are not able to
perform adequate due diligence, lack the
required expertise or do not meet high
minimum investment requirements. FOHFs
usually charge less than single hedge funds
 and
often offer monthly or quarterly redemption to

HEDGE FUNDS AND THEIR IMPLICATIONS FOR FINANCIAL STABILITY by Tomas Garbaravicius and Frank Dierick