Hedge Funds : What Do We Know ?

hile hedge funds have been around since at least the 1940s, it has been only in the last decade or so that they have attracted widespread attention. Investors—mainly well understood by their own investors, much less by their bankers and derivatives counterparties. LTCM had managed to build up so much leverage both onand off-balance sheet that when their investments soured they were unable to meet the demands of their creditors and counterparties. The result could have been a “firesale” of LTCM’s positions and a systemic liquidity shortage, with sharp changes in asset prices and uncertain consequences for the stability of financial markets. But the Federal Reserve did not wait for this to happen. It arranged a bailout by LTCM’s largest creditors and derivatives counterparties, preventing a “run” on the hedge fund. Over the course of the following year, a creditor committee managed LTCM’s positions and effected an orderly liquidation. This event was a catalyst to regulators throughout the world. Studies were undertaken by nearly every major central bank, regulatory agency, and international “regulatory” committee (including the Basle Committee and the International Organization of Securities Commissions) to determine if hedge funds posed a risk to the global financial system. Many of these studies concluded that there was a need for greater disclosure by hedge funds to increase transparency and enhance market discipline. In the fall of 1999, two bills were introduced before the U.S. Congress directed at increasing hedge fund disclosure—the “Hedge Fund Disclosure Act” (also called the “Baker Bill”) and the “Markey/Dorgan Bill”—although neither was enacted. Our aim in writing this article is to provide an overview of the structure and operation of the hedge fund industry, the various investment strategies pursued by hedge funds, the existing research on the returns and overall performance of hedge funds, and the key questions that remain to be answered. W