What is the role of “hedge funds” in the financial market?
“Hedge fund” is a term used to describe a diverse group of financial institutions, which play an important role in our financial system. There is a wide variety of definitions given for a hedge fund. Money Central Investor defines it as “a risky investment pool…that seeks very high returns by taking very great risks”, and Goldman Sachs & Co. adds that they “use of investment and risk management skills to seek positive returns regardless of market direction.” (Lhabitant, 2002: p14) There has been rapid growth in the number of hedge funds and their assets under management, suggesting they provide economic value to investors that ...view middle of the document...
” The purpose of regulation is to protect investors. Although an element of secrecy between funds is kept in order to keep investment strategies to themselves, they can’t do whatever they like with other peoples’ money, so regulation had to be introduced.
Markets function best when investors use different information and strategies to manage, or hedge against, risk. Private investment companies provide valuable liquidity to financial markets in normal market conditions. In “Hands Off Hedge Funds”, Sebastian Mallaby states that “by buying irrationally cheap assets and selling irrationally expensive ones, they shift market prices until the irrationalities disappear, thus ultimately facilitating the efficient allocation of the world’s capital.” (Mallaby, 2007). Consequently, hedge funds can be less volatile than individual stocks or mutual funds.
With the freedom to invest wherever the managers believe they can perform better than the market, hedge funds broaden the use of investment strategies, increasing the number of investors, and enlarging the capital pools available and strengthening capital markets. Through flexibility, they are able to trade different securities in several markets at once, so opportunities for returns are maximised, improving risk management and encouraging innovation of strategies, as well as financial products and services.
There is also a competitive advantage as hedge funds attract human and financial capital, contributing to a stronger economy. They can act as an incentive for businesses and individuals to invest because they offer the chance for money to be invested in a range of products, free from fraud and over-regulation, and increases in investment can influence economic growth and stability.
Hedge funds also improve the efficiency of capital markets by helping to price securities more accurately. This minimizes market distortions, which in turn leads to better allocation of capital, financing growth, innovation and job creation. Short selling, for example, may be a technique used by hedge funds and is sometimes seen as playing an essential part of the price discovery mechanism. Some researchers believe short interest is an indicator of poor stock performance, and that short sellers exploit market mistakes.
Hedge funds have many different benefits such as diversification, flexibility and liquidity, but to the larger financial system they can provide innovation,...