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Myth #5: Hedge Funds Are a Source of Systemic Risk There are two ways hedge funds could
increase systemic risk: First, they could reinforce asset bubbles, thus increasing the size of the losses and the damage to the financial system when the bubble
bursts. Two pieces of evidence contradict this. First, as negative-volatility traders, hedge fund managers make their
money by betting against unsustainable movements in security prices. Hence, not only do hedge funds not reinforce asset bubbles, they may in fact prevent
them in the first place. Second, a recent study by William Fung and David Hsieh finds that hedge fund returns are largely uncorrelated with those of mutual funds
and other asset classes—a finding that is also inconsistent with this definition of systemic risk.11 A second way that hedge funds could
increase systemic risk is by increasing the risk exposure of counterparties, especially in the derivatives market. In this scenario, a hedge fund’s failure could
impose losses on its counterparties large enough to seriously impair their capital, or even cause them to fail. This is the
“domino effect” variety of systemic risk. However, counterparty risk might also be posed by other investments. Furthermore, the transmission of a loss sizeable
enough to impair an institution’s capital is the result of poor credit policy and control by that institution. Thus, the risk
posed by hedge funds might be dealt with through improved regulation of counterparties. In fact, regulatory
authorities have identified several areas where improvement might be warranted.
- posted by Mark Pane @ 11:55 AM