Why Hedge Funds Matter

It is impossible to stay abreast of what is happening on Wall Street (and, ultimately, on Main Street) without knowing what hedge funds are up to.

Some might wonder why. After all, this group of lightly regulated money managers caters to the needs of wealthy investors and has little interaction with ordinary Americans.

That is anything but true. Hedge funds exert a tremendous influence on stock, bond, currency, commodity, and other markets, and they have been major players in virtually all aspects of modern finance, including mortgage lending.

Although there are many factors involved, two stand out: as a group, hedge funds have a substantial measure of assets under their control, and they are not afraid to aggressively deploy these funds in trading venues around the world.

In "Hedge Fund Assets Rise," Reuters gives us the latest data on the size of the industry.

Investors poured $41.1 billion (20.5 billion pounds) into hedge funds in the 2007 second quarter, which combined with performance gains, swelled industry assets to an estimated $1.67 trillion by the end of June, fund tracker Lipper TASS said on Tuesday.

The gains, which marked the second biggest quarterly inflow since 1994, came mostly before recent turmoil struck many hedge fund strategies due to market volatility due to the subprime lending market meltdown.

Still, the turmoil that escalated during the summer isn't having a significant impact on investors' resurgent appetite for hedge fund strategies, Lipper said.

"Today the big bulk of inflows are coming from institutional investors who have a longer-term horizon," said Ferenc Sanderson, senior hedge fund analyst for Lipper, a unit of Reuters Group. "The inflows may take a knock, but will still remain firm. There's no panic and running for the doors."

During previous periods of outflows, such as after the Long-Term Capital Management collapse in 1998, hedge fund investment was largely from high net worth investors, who tend to pull back quicker during market changes than institutions, said Sanderson.

The second quarter inflows, which were the second highest since the same period in 1994, came amid "relatively strong performance" for hedge funds of 5.19 percent by June 30, according to the Credit Suisse/Tremont Hedge Fund Index.

The aggregate hedge fund performance didn't exceed market indices for the period, however. The S&P 500, for instance, returned 6.28 percent, while the MSCI World TR returned 6.71 percent.

The biggest inflows, according to Lipper, were for long-short equity strategies, which gained $14.9 billion, followed by event-driven funds, which gained $12.2 billion. Multi-strategy funds gained $6.1 billion during the period.

Strategies that posted net outflows included global macro funds, which bet on world currencies and sovereign debt and were down by $848 million, and managed futures, which were down by 686.7 million, Lipper said.

In "Hedge Funds Do About 30% Of Bond Trading, Study Says," the Wall Street Journal reports on a survey that details the scale of their involvement in today's markets.

There was a time when debt was considered a boring investment, held primarily by institutions seeking predictable returns or a steady stream of interest payments. A recent study by the consulting firm Greenwich Associates shows how much that's changed.

Hedge funds have quickly become a dominant player in the world of debt. In some corners of the market -- often among the most complex areas -- they are the biggest force by far. Hedge funds are responsible for nearly 30% of all U.S. fixed-income trading, according to the survey.

That level, which reflected activity over a 12-month period through April, was double the amount of trading hedge funds accounted for the previous year. Greenwich found hedge-fund trading comprises 55% of U.S. activity in derivatives with investment-grade ratings, and also 55% of the trading volume for emerging-market bonds.

The rapid rise in hedge-fund trading underscores the changing nature of the debt markets. Unlike many mutual funds that look for stable returns or pensions and insurers that want steady, long-term holdings, hedge funds frequently seek short-term gains through numerous trades they can amplify with borrowed money.

"We've seen over the past 10 years a proliferation of products created to meet the needs of hedge funds," says Tim Sangston, a managing director at Greenwich Associates. "More and more of the growth in bond trading is coming from these kind of professional traders and investors."

In some corners of the U.S. debt market, hedge funds practically are the market. For instance, hedge funds generated more than 80% of the trading for derivatives with high-yield ratings, and more than 85% of volume in distressed debt, Greenwich found.

Hedge funds also accounted for a good portion of the trading in mortgage-backed securities, asset-backed securities, collateralized debt obligations and other parts of the debt market that have suffered recently as worries over subprime loans have spread.

Analysts say these debt instruments were developed primarily for sophisticated investors like hedge funds, which sometimes use these products to protect themselves. But the debt securities have also been peddled to pension funds and other institutions that may not completely understand them.

The survey involved responses from 1,333 institutions in North America, including mutual funds, insurance companies, pension funds, banks, brokerage firms' proprietary trading desks and federal agencies, Greenwich said. These investors were polled about their trading in 15 kinds of debt instruments. Overall, debt-market trading volume among the participants increased by 10% in the period, to $25 trillion, from the previous year.