Brookings Institution Press
Bryan J. MacDonald, Franklin R. Edwards, and Mustafa O. Caglayan - Comments and Discussion - Brookings-Wharton Papers on Financial Services 2000 Brookings-Wharton Papers on Financial Services 2000 (2000) 402-420

Comments and Discussion

[Do Hedge Funds Disrupt Emerging Markets?]

Comment by Bryan J. MacDonald: I would like to make a few points regarding this paper. I will not discuss the methodology, but I do think that there are several challenges in analyzing hedge funds in general. There certainly is a lack of data and of transparency, and both data and transparency are needed to allow someone to take a good look at the position of hedge funds.

Hedge funds are private funds, and they have limited disclosure. There is a tremendous amount of discussion in the hedge fund business about the issue of limited disclosure. Everyone is saying that these funds should be more transparent, but there are significant risks in transparency. We do not require mutual funds, which are highly regulated entities, to disclose their positions on anything more than a quarterly basis in financial statements.

In fact, the information that would be disclosed could be tremendously disadvantageous to the shareholders. If you knew, as someone on the other side of the transaction, that a particular fund had a large position in a particular market, you could use that to your advantage. I hesitate to use the word manipulation, but I will say that a tremendous amount of business is being done on the short side. Short squeezes are rampant in the marketplace. Information on what short positions are can be used. The street can be swept. Large traditional funds become very, very good at using information on other peoples' positions to their advantage. I am not an advocate of asking for more disclosure, unless it is to creditors who are going to extend you the margin and the credit to leverage your portfolio to invest in many different asset classes.

The bigger problem is the definition of a hedge fund. There is a tremendous amount of misunderstanding about the hedge fund industry, so I am [End Page 402] going to explain the hedge fund industry a bit more. The paper focuses only on the largest funds, which are the smallest number of funds. There are several thousand, and those funds are growing by the day. We continue to see huge growth in the hedge fund industry. Many people want to use the term hedge fund to explain a wide variety of strategies and approaches to investing in the world markets. There is a tendency to oversimplify.

What are hedge funds? Are we talking about large, leveraged, speculative pools of capital? If so, proprietary trading desks should be considered hedge funds. They are in many cases the predecessors to the hedge funds. The people who run hedge funds today, especially the large leveraged ones, typically are working for one of the large investment banks, and they have left the sell side to go to the buy side. That is the theater in which these funds get started.

Are we talking about specialized managers who invest long and short? That is probably a better use of the term hedge fund, in that it covers a lot of ground and encompasses many strategies. Are we talking about private partnerships that get paid incentive fees? Yes, private partnerships are paid incentive fees, but do private equity funds, real estate funds, and oil and gas partnerships? A variety of other vehicles are paid incentive fees. What about private investment funds that hedge their risks? The concept of hedge fund is dangerous, because many of these funds do not and cannot fully hedge the risk. The only perfect hedge that I have ever seen is long and short on the same security, and that can cost money.

What is the objective of a hedge fund? Is it absolute return? Some people would say that the objective is simply to get the biggest return possible in any market environment. They never want to be down; they want to always be up and always make money. Is the objective better risk-adjusted returns? That is probably a more reasonable expectation. These practitioners are simply trying to change the relationships between risk and return in the market. They are trying to reduce risks and improve return by using a variety of tools. It is yet to be fully determined whether they are successful or not.

Is the objective to be market neutral? I wish someone could explain to me why being market neutral is a good thing. Markets typically go up 75 percent of the time and go down 25 percent of the time. To be neutral to those movements is not something that I, as a long-term investor, necessarily want. I can understand if I am trying to extract return without market risk. Typically, I am trading one risk for another. I am trading the risk [End Page 403] of exposure to the market in return for counterparty risk in terms of the derivatives that I am using to hedge my portfolio or other risks, such as liquidity risks. I am not so sure that market neutrality is easily achievable or even a valid objective.

Is the objective to protect capital in down markets? Yes. The mathematics work. If you do not lose money, it is easier to have higher compound returns over time. That is a valid objective. Are we talking about speculation or investment? Some funds are speculators, and they play an important role in the marketplace. But not all funds in the hedge fund world are speculators.

What types of hedge funds are there? There are multiple-strategy macro-funds. The vast majority of the funds examined in the paper could be termed macro-funds. They are investing in a variety of disciplines from equities and currencies. They can go anywhere in the world. They can trade things like tax liens. You cannot believe the types of deals that come across my desk.

We have many arbitrage strategies: convertible arbitrage, fixed-income arbitrage, market-neutral strategies, and long and short equities in the developed markets, which are the vast majority in terms of numbers. Sector funds, technology funds, banking funds, and specialized funds run by specialized people with specialized experience use their experience to exploit inefficiencies in the market. Many distressed securities funds are done as locked-up vehicles. They are long term, but there are a number of distressed securities hedge funds. Emerging-market funds, both debt and equity, have been lumped into the hedge fund world. There is an important reason why they are in hedge funds and why emerging-market investments will be viewed as a hedge fund-type function for at least the foreseeable future.

And last but not least, there is a whole community of commodity traders. The biggest are functioning just like large hedge funds. The only difference is that, in addition to trading the financial markets, they may trade agricultural commodities and metals. And many times, they gained their experience in the commodity trading market.

There is an overlap between the Commodity Futures Trading Commission and the Securities and Exchange Commission in their jurisdiction over futures. This ought to be rationalized at some level because we are really dealing with two communities in two worlds that are growing together over time. [End Page 404]

All too often, people view hedge funds as a ticking time bomb. The vast majority of hedge funds are very responsible investors. And they are our best and brightest. The best and brightest people in the financial markets in the world are going into the hedge fund business, not just in the United States, but all over the world. Europe is the largest area of growth today. People are leaving large European financial institutions, which was unheard of ten years ago. Massive changes are occurring. These people are starting investment boutiques, and this is going to occur on a global scale.

Why are the best and brightest migrating to this format? What motivates the hedge fund? The first is economics. It is possible to make a lot of money running a hedge fund, and there are cultural benefits as well. You go into most hedge funds, and the workers do not dress up in suits any longer. They work near their homes.

Technology has freed hedge fund managers to run these operations from anywhere they want. Funds no longer need to have a bevy of eighty analysts. They can get the information on the Internet. It is possible to pull tremendous amounts of information from the Internet and to harness computer horsepower to cull through the information.

Entrepreneurial activities are the driving force in hedge funds, which is why the United States has been such a leader in the business. It is important not to underestimate the role of entrepreneurship in developing these creative enterprises. At some point, the best and brightest people get tired of sitting in meetings and spending their time dealing with organizations. They are not necessarily good organizational beasts. In order to succeed in large corporations, you have to understand organizational dynamics and be good at it.

Global consolidation of financial institutions is displacing some of the best and the brightest. One of the biggest risks that we have in these large mergers is the displacement of intellectual capital. One of the greatest challenges in merging globally is retaining the best and brightest. Typically, the first people to leave are the ones who can, and you are left behind with people who are not necessarily your best performers. Ego drives a lot of this, too. You have to have an ego to run one of these funds.

I would like to run through what the hedge fund business looks like, because I think that it is important in the context of the paper's analysis. I used one source, and these are probably understated numbers. An estimated $205 billion is in hedge funds globally, and the number is probably closer to $300 billion today. Not everyone reports to this source. There [End Page 405] are about 2,000 to 3,000 hedge fund firms. Each firm tends to have three funds: an onshore fund, an offshore fund, and a qualifier purchaser or QIB-type structure, a 337 vehicle.

The distribution of assets is more fascinating. There are twenty firms with more than $1 billion in assets in this particular data set. There are only fourteen firms with between $500 million and $1 billion in assets. Thousands of people are not counted in the top group. Buyers are migrating to the largest funds, giving them the most creditworthiness and access to the greatest amounts of leverage. As a result, these large funds are taking particularly large bets that can influence and affect markets.

The top twenty-five managers control almost 25 percent of the assets in the entire industry. And 40 percent is controlled by the top 100 firms. In addition to the number of firms in the distribution, the control of assets indicates that a lot of new participants may not be growing. It is hard to break into that club. It is very hard.

The growth of assets is huge, running at about a 20 to 25 percent growth rate over time. Even after last year, when hedge funds had significant net outflows as a result of disappointing performance in 1997 and 1998, we still saw an increase in assets, with an estimated 17 percent growth rate year over year between 1998 and 1999.

Now let me address the subject of emerging markets. What sources of capital do emerging markets have available to them? When they need money, where do they go? They can go to governments and get foreign aid. They can go to central banks. They can go to multilateral organizations like the International Monetary Fund, the World Bank, and the development banks like the International Finance Corporation that have been long-time investors in private investments, well before the private sector.

They can go to foreign financial institutions, commercial banks, investment banks, and insurance companies. Or they can go to the private market, meaning institutional investors. Both pension funds and endowment funds have been big investors here, as have private investors, high-net-worth individuals, and very wealthy families. And they can go to domestic financial institutions and domestic financial markets. We could help the emerging markets to develop their own domestic financial markets by giving them incentives. Do not underestimate the power of the 401-K in driving our bull market forward; 3 percent of U.S. salaries go into 401-Ks like clockwork, and very few individuals look at their 401-K statement more than quarterly. [End Page 406]

Liquidity is being fueled into the markets. If we could help other countries create that kind of engine over time, that would be a positive force, and it would help them not to rely so much on foreign capital for growth.

Hedge funds have an important role to play in emerging markets. They are the risk-based capital portion of the liquid markets. These people are paid to take risks. They are compensated for it, and they play an important role. Without something like the hedge fund, there would be times when no capital would be available, and the volatility would be worse.

The natural evolution is that the investment banks make money for a period of time, and then they do not. They decide that they no longer want to perform that function, and the people leave, and they start a hedge fund. They bring in other investors, who then reenter the markets, recapitalize, and reliquefy those markets, and the next cycle begins. They play a very, very important role. When somebody asks whether hedge funds disrupt markets, I answer that perhaps they do. Do they affect markets? Absolutely. There are two sides to the coin. Some things are good, and some things are bad.

They are successors to the proprietary trading desk. They are pioneers. I have a difficult time accepting the concept that they are late into trades, which is presented in the paper. Hedge funds often are the first to trade, not the last. There are times when they have to reverse, and perhaps that occurred in the currency crisis. Hedge funds provide liquidity, and they fill capital voids.

Now let me address the dangers. Hedge funds are tactical in nature. They are not strategic investors. They are not compensated to stay in for a long time, because their base of investors demands much shorter results. They are focused on the short term. They are leveraged, and leverage has risks.

I am amazed at how many asset allocation models do not factor in liquidity. Liquidity is assumed to be a free good in our world. It is great that the academic world focuses on ways of quantifying liquidity. Every time we have a liquidity disruption, people seem surprised.

Hedge funds are driven by incentives, and their base of capital is unstable. Most hedge funds have quarterly redemptions, annual redemptions, or monthly redemptions. The investors would like daily redemptions. Managers would like a 999-year lock-up.

So the challenges facing the emerging markets are an excessive dependence on foreign capital; a lack of a developed fiscal monetary infrastructure, [End Page 407] good banking systems, regulatory infrastructures, and so forth; and a need to manage change. The reality is that effecting change through a market-driven economy is a messy process. It is not simple and neat and tidy. It takes time, and investors need to understand that it is a long-term process.

Hedge funds are unable to attract additional investors. Traditional investors are not going to invest in the emerging markets until the risk-reward relationship changes. Since 1992 the average annual rate of return for emerging-market debt has been about 12 percent with a standard deviation of 17 percent. Equities have performed even worse, realizing a 4 percent return with a 23 percent standard deviation. Standard & Poor's (S&P) has had a much more positive relationship between risk and return. High-yield bonds have constituted a wonderfully efficient use of capital. Until this relationship changes, it is hard for any traditional investor to say that hedge funds are a good trade. Once those relationships start to normalize, it will be possible to say that these markets have emerged. Until that happens, they are not going to be seen as an extension of normal debt and equity investing. So the hedge funds are the only ones with the tools to manage that relationship. Until that changes, the hedge funds will continue to attract capital.

The correlations of emerging-market bonds are very high with their stock markets and reasonably high with the S&P. Since 1992 the S&P has been a big driver of world liquidity and wealth creation. It does not surprise me that those correlations exist.

The one that is quite telling is the correlation of emerging-market bonds to the U.S. Treasury market. It would seem to make sense that investing in emerging-market debt would help to diversify a U.S. fixed-income portfolio quite effectively. If you can manage the risk-return relationship, you may have a good investment.

Should hedge funds be subject to greater regulation? I am not a big fan of regulation; I have always been a fan of deregulation. But if we are going to subject funds to regulation, we should first define the objectives. Are we trying to protect the system against risk, or are we trying to protect the consumer? The only people who can invest in hedge funds are sophisticated investors, people with money that they are able to lose and, in some cases, with the experience to be in these investments. Buyer beware has always been a better driver than regulation overall.

We should deal with the source of the problem, not the results. The issue here is leverage and its impact on liquidity. Leverage in illiquid markets [End Page 408] or nascent markets can be highly dangerous. That is true not just in the currency markets, but also in small cap stocks and in convertible markets. It is true wherever the volume of trading is low relative to the amount of capital poured into the area.

We should look to the industry for greater regulation. This industry should take note of what the mutual funds have done. We need to have a body of hedge funds saying that they are going to regulate themselves. That should happen in the next ten years.

We also should educate investors more and more about the true risk associated with certain strategies. What surprised people with regard to Long-Term Capital Management (LTCM) was the amount of leverage, and therefore the amount of risk that was being taken, not the type of trades. We need to make sure that investors understand the risks to letting managers do anything they want.

Finally, I wish to address the capital requirements of high-level transactions. If we want to regulate hedge funds, let us start with the people who lend the money. A regulatory structure is in place with banks, and the capital requirements for highly leveraged transactions were changed back in the early 1990s. Hedge funds are highly leveraged portfolios, and we ought to look at ways of applying similar requirements to them. We need close monitoring of borrowing by sophisticated creditors, meaning banks. Banks have the responsibility to ask for information in return for credit.

The bailout of LTCM could be viewed not as a bailout but as the Federal Reserve doing its job. The greatest disasters in the last five years have occurred in fixed-income and credit-related instruments. In 1994 it was in mortgage backs. Last year, it was in a variety of credit spread issues from high-yield debt to distressed securities to emerging-market debt. The establishment of global standards for banks will address all of these problems, and that perhaps is a better way to regulate an industry requiring a great deal of credit to function.

Do I think that hedge funds disrupt markets? Perhaps. But other, bigger, speculative positions of participants also may have a great impact. Hedge funds play a very important role and should continue to play a very important role in the future.

Comment by Franklin R. Edwards and Mustafa O. Caglayan: Fung, Hsieh, and Tsatsaronis address the controversial issue of whether speculation [End Page 409] by hedge funds caused or exacerbated the Asian currency crisis during the last half of 1997, when most Asian currencies lost between 44 and 56 percent of their value against the U.S. dollar. The sharp devaluation of these currencies resulted in the bankruptcies of many Asian corporations and banks and was a major factor in the subsequent economic contraction in Asian economies.

After the fact, hedge funds came under attack as a major cause of the collapse of the Asian currencies. The prime minister of Malaysia, Mahathir Mohammad, for example, accused them of being the modern equivalent of "highwaymen" in breaking the Asian currencies. 1 He argued that, by accumulating huge short speculative positions, hedge funds made it impossible for the Thai central bank to maintain the baht at a fixed rate versus the U.S. dollar. Further, he contended that when the value of the baht plummeted on July 2, 1997, this precipitated the sharp devaluations of the Malaysian ringgit, the Indonesian rupiah, and the Korean won. Prime Minister Mohammad is not alone in this view. Prominent economists, such as Joseph Stiglitz, have also singled out volatile international capital flows as a major cause of the economic instability that rocked the economies of many East Asian countries in 1997. 2

The policy issue that underlies this controversy, of course, is whether trading by hedge funds and other international speculators should be curbed, perhaps by regulatory restrictions on hedge funds or by explicit capital controls. At the very minimum, critics contend, hedge funds should have to report their portfolio positions and trading activities either publicly or to specified regulators, who, knowing these positions, could presumably act to head off the kind of market turmoil experienced by Asian countries in 1997.

The controversy about the role of speculators and in particular hedge funds in the Asian currency crisis is difficult to resolve empirically because of the difficulty of directly observing the position of hedge funds. Hedge funds are largely unregulated and therefore do not have to disclose their portfolio positions publicly. Hedge funds consider position information to be proprietary and are reluctant to disclose it for fear of losing their competitive advantage. Indeed, even highly regulated financial institutions, such as mutual funds, [End Page 410] are required to report their portfolio positions only semi-annually, so that information in the kind of detail necessary to evaluate even their role in the collapse of the Asian currencies is typically not available.

Fung, Hsieh, and Tsatsaronis attempt to overcome this data deficiency by inferring from data on hedge fund returns during the Asian currency crisis the speculative positions the funds must have held in Asian currencies. In particular, they use data on the monthly returns of twenty-seven large hedge funds and data on the weekly returns of ten of these twenty-seven hedge funds to infer the positions that these funds must have had in Asian currencies during the last six months of 1997. They then compare those inferred positions with the total capital flows for the Asian countries (from balance-of-payments accounts) to determine if the hedge funds' positions were large enough, in their opinion, to have caused the collapse of the Asian currencies.

The authors conclude that hedge funds were not the main culprits in the 1997 Asian crisis and that their speculative bets against the Asian currencies were small. Nevertheless, they identify excessive speculation as a factor and believe that all financial institutions, including hedge funds, should be required to report their positions on a timely basis to an impartial regulating body that could use this information to assess the market's exposure and signal impending trouble. Thus Fung, Hsieh, and Tsatsaronis envision regulators as standing ready to impose additional constraints on financial institutions should they believe that either a currency crisis is fomenting or some other financial crisis is, in their view, impending.

Some of these conclusions and policy recommendations go well beyond the empirical work in this paper and, in our opinion, are highly controversial. What do Fung, Hsieh, and Tsatsaronis mean by excessive speculation? How do they determine that speculation is excessive? How would a regulator use the information they believe should be reported, and in what circumstances would a regulator act? The authors do not address any of these questions. We believe their paper would be improved either by omitting any discussion of these policy issues or by discussing the pros and cons of adopting such policies.

There are several problems with the methodology that Fung, Hsieh, and Tsatsaronis use to infer the portfolio positions of hedge funds from their return data. First, reported hedge fund returns are the returns on a hedge fund's entire portfolio. Thus to isolate the impact of changes in Asian currency values on a particular hedge fund's returns, as Fung, Hsieh, and [End Page 411] Tsatsaronis attempt to do, it may be important to account for other factors that may affect a hedge fund's returns. In particular, if the fund is holding other assets (or positions) that also change in value when the Asian currencies change in value, it is not possible to estimate the impact of the change in these currency values on the hedge fund's returns without controlling for the effects of changes in the other asset values on returns. But since information on hedge funds' portfolios is not available, it is not possible to do this directly. Fung, Hsieh, and Tsatsaronis attempt to address this problem by including returns on the S&P 500 index as an explanatory variable in their estimating equations, but this simple procedure is unlikely to capture the complexity of the returns-generating process for hedge funds. In our empirical work, we show that estimates of the relationship between hedge fund returns and Asian currency values are quite sensitive to the returns-generating factors included in the estimating equation.

Second, Fung, Hsieh, and Tsatsaronis examine only twenty-seven hedge funds and estimate separate equations for each of these funds over the six-month period from July 1, 1997, through December 31, 1997. This procedure leaves them with very few degrees of freedom, so that they are not able to include other explanatory factors in their estimating equations.

To demonstrate the instability of estimates of the relationship between hedge fund returns and changes in Asian currency values depending on which explanatory factors are included in the estimating equations, we estimate new pooled, time-series, cross-section returns equations for the July-December 1997 period using monthly returns for 827 hedge funds (including Commodity Trading Advisors). The hedge funds in our sample employed four different trading strategies: global macro, global, market neutral, and currency funds. Monthly returns equations are estimated using two models: one using only the four Asian currencies used by Fung, Hsieh, and Tsatsaronis as the explanatory variables and one employing a six-factor return model and regressing six-factor return residuals on the same four Asian currencies. 3 The estimates for the first model, using time-series, cross-section, pooled regressions for the last six months of 1997, are reported in table 1. Estimates are shown for each of the four investment styles of hedge funds as well as for all hedge funds taken together. [End Page 412] [Begin Page 414]

Estimates for the second model are derived as follows. First, we estimate the following pooled, time-series, cross-section, six-factor regression model to account for the effect of other factors on hedge fund returns:

where Ri is monthly hedge fund returns; Rf is the thirty-day Treasury bill rate; HML is monthly returns on a portfolio of high book-to-market stocks minus the monthly returns on a portfolio of low book-to-market stocks; SMB is the monthly returns on a portfolio of small stocks minus the monthly returns on a portfolio of large stocks; WML is the monthly returns on a stock portfolio of past year's winners minus the monthly returns on a portfolio of past year's losers; TERM is the monthly returns on long-term government bond portfolio minus the monthly returns on thirty-day Treasury bills, measured at the end of the previous month; DEF is monthly returns on a portfolio of long-term corporate bonds minus the monthly returns on long-term government bonds; and ei is the usual error term (or residual return). This equation is estimated separately for each of the four hedge fund styles as well as for all hedge funds for the nine-year period 1990:01 through 1998:08. All hedge funds in existence for at least twelve months during this period are included in the sample. The estimates for this equation are reported in table 2.

Second, we regress the monthly residuals of equation 1 for the six months from July through December 1997 on the four Asian currency variables used in model 1, once again for each style of hedge fund and for all hedge funds together, using time-series, cross-section, pooled data:

where currency variables are expressed in units per U.S. dollar. This procedure controls for other factors that may affect hedge fund returns other than changes in the values of Asian currencies, isolating the relationship between hedge fund returns and the Asian currencies. The estimates for this equation are reported in table 3.

The results in table 1 show a significant relationship between the Asian currencies and returns for all hedge funds. In particular, the coefficients for all four currencies are significant at the 1 percent level. However, only two [End Page 414] of the coefficients (Thailand and Malaysia) are positive, indicating the presence of a net short hedge fund position in those currencies. The negative coefficients for Indonesia and Korea indicate that hedge funds were net long in those currencies and therefore lost money when the currencies devalued. These results, therefore, present a mixed picture of the effects of hedge fund trading on the currencies: they may have destabilized the currencies of Thailand and Malaysia but may have stabilized those of Indonesia and Korea.

After controlling for other factors, however, these results change significantly. Table 3 shows that for all hedge funds there is a significantly positive coefficient only for Indonesia and a significantly negative coefficient only for Korea. Further, the coefficients are quite different for different styles of hedge funds. For example, for the Malaysian currency, global macro and currency funds have significantly positive coefficients, while market-neutral funds have significantly negative coefficients.

Without laboring our results any further, two things seem clear. First, the estimated relationship between the Asian currencies and hedge fund returns are highly sensitive to what other returns factors are included in the [End Page 415] [Begin Page 417] estimating equations and, second, the estimated relationships are very different for different styles of hedge funds. Thus attempting to infer the Asian currency positions of hedge funds from a very small sample of selected hedge funds, as Fung, Hsieh, and Tsatsaronis do, seems highly risky and may lead to erroneous policy implications.

Even presuming that it can be unambiguously inferred from hedge fund returns that hedge funds had net short positions in the Asian currencies, it is a leap of faith to conclude that hedge funds "caused" the collapse of the Asian currencies. The Asian currency crisis was first and foremost the result of problems in the real economy: excess capacity and increasing costs that led to a sharp fall in profitability. The Asian currencies were pegged principally to the dollar, despite the fact that a substantial proportion of their external trade was with countries in the Asian region. These currency pegs became unsustainable for real economic reasons: the sharp fall in the growth of exports from the region--caused in part by an appreciation in the real exchange rate of the Asian countries relative to that of other Asian countries and to Japan, the weak Japanese economy, increasing competition in export markets from China and Mexico, and excess capacity in many exporting industries. By 1996 the current account deficit in the five most affected Asian countries had reached $55 billion. 4

It was the crisis in the real economies of the Asian countries that precipitated the flight of capital by investors, causing asset prices to fall and financial institutions to fail. The financial effects of the capital outflows were particularly severe for the Asian countries because both the governments and most of the banks in these countries had borrowed heavily in short-term dollars to invest in longer-term domestic currency loans, creating currency and interest rate risks that they could not support. In summary, the economic policies and the financial structures of the Asian countries were fundamentally incompatible with the policy of pegging their currencies to the U.S. dollar.

To the extent that hedge funds and other financial institutions bet on the depreciation of the Asian currencies, these institutions were the messengers rather than the cause of the Asian currency crisis. They merely exposed the weaknesses in the Asian economies. In today's world of nearly uninhibited international capital flows, it is far-fetched to think [End Page 417] that speculators will not bet against countries that fix their exchange rates but then pursue economic policies that are unsustainable under fixed- rate regimes. Thus it is not as clear to us as it is to Fung, Hsieh, and Tsatsaronis that excessive speculation led to the Asian currency crisis of 1997. Indeed, we might even argue that the substantial capital outflows from Asian countries in 1997 have forced these countries to make the policy and structural changes that they eventually would have had to make in any case. It is not obvious that putting off these changes to a later time would have enhanced international financial stability.

General Discussion: Bryan MacDonald opened a general discussion of hedge funds by asserting that as hedge funds get larger, they tend to migrate to global markets for currencies, fixed-income instruments, and other credit instruments because the markets in which they traditionally operated have become less liquid. Franklin Edwards agreed with the paper's conclusion that the problems surrounding the Asian financial crisis were due not to hedge fund activity, but instead to excessive lending by foreign banks in foreign currency or, conversely, to excessive borrowing by banks and corporations in the region. Edwards added that the pegged, but adjustable, exchange rate regimes being used by the affected countries also encouraged unwise lending and borrowing. Indeed, Edwards asked why some countries, knowing this to be the case, persist in maintaining fixed exchange rates.

Litan answered that the conventional answer to that question is that pegging exchange rates is generally justified as a means to control domestic inflation. However, as all nations should have learned from the Asian crisis, potentially very large costs also are associated with maintaining fixed exchanges.

Daniel Tarullo asked MacDonald whether the disclosure concern addressed in his presentation refers to a type of disclosure that is close to real time and reveals a particular trade or whether it refers to a significantly lagging disclosure that reveals a fund's overall trading strategy. MacDonald responded by asserting that a one-time snapshot of a fund's positions may not reveal much and that a stream of complex data is probably necessary to produce full disclosure. However, he cautioned that such data may be difficult to analyze within a reasonable time period. [End Page 418]

More broadly, MacDonald argued that too much disclosure may not necessarily be in the best interest of investors. Information is power in the capital markets. Disclosure of sizably leveraged positions to other market participants, such as banks with similar positions, can be dangerous. For instance, it is not necessarily advantageous to shareholders of these funds for the public to know that their fund is short 4 million shares of a stock traded at 10,000 shares a day, because such information can be extracted and manipulated in the marketplace.

David Hsieh explained that the kind of disclosure suggested in his paper is not a full public disclosure of the positions held by an individual fund, but rather some measure of aggregate exposure of all institutions to a particular kind of trade. He acknowledged, however, that the question of to whom the hedge funds should report is a difficult and sensitive one to answer.

Robert Litan questioned whether Hsieh's suggested disclosures would be effective in markets that are as dynamic as those in which hedge funds participate and where the amounts at risk change frequently on a daily basis. In addition, he noted that there most likely would be a huge lag in whatever disclosures the investors get. Litan argued that the real problem posed by hedge funds lies in excessive leverage by a few (such as LTCM) and that the best approach to handling excessive leverage is through effective regulation of banks that provide credit to the funds. Franklin Edwards agreed.

Calomiris also argued that the key variables triggering the economic downfalls in the 1980s and 1990s in Chile, Mexico, Russia, and Brazil and the problem with LTCM were not the hedge funds, but rather weaknesses in domestic financial systems and improper incentives for foreign banks to lend excessively in foreign currencies. Accordingly, in his view, establishing effective market discipline--perhaps through a subordinated debt requirement for large banks--is key to preventing financial crises in the future. Indeed, with a subordinated debt requirement, banks should have greater solutions to obtain more adequate disclosure from hedge funds. Alternatively, in the absence of such a requirement, it might be appropriate to prohibit banks from lending at all to hedge funds unless those funds provide banks with sufficiently transparent information that can be evaluated. Still another alternative would be for banks to establish hedge fund operations themselves, but to operate them as separately capitalized subsidiaries. [End Page 419]

One participant observed that some banks are beginning to put credit ratings on hedge funds, not only because they finance the funds themselves, but also because many foreign banks have actually extended credit using the hedge fund investments as collateral. Credit ratings help managers at all these lending institutions to establish an appropriate level of capital.


1. Mahathir Mohammad, "Highwaymen of the Global Economy," Wall Street Journal, September 23, 1997, p. C1.

2. Joseph Stiglitz, "Boats, Planes, and Capital Flows," Financial Times, March 25, 1998, p. 32.

3. For a discussion of our multifactor returns models, see Edwards and Caglayan (2000). See also Fama and French (1995, 1996) for a discussion of multifactor returns models.

4. Brealey (1999).

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