Reserve Bank warns against hedge funds

The Reserve Bank of India (RBI) today said hedge funds posed a risk to financial institutions through their credit exposures in securities transactions and derivatives trades.

On account of leverage, hedge funds might get into trouble if their assets experience a sharp drop and the market for these assets lacks liquidity so that funds cannot exit their positions.

The collapse of large hedge funds, in particular, may have serious implications for financial institutions having exposure to these funds.

The liquidity risk arises from the ability of hedge funds to move out of trades quickly when prices turn against them. The problem could be serious if too many funds have set up the same trade.

Hedge funds may also create excess volatility risks by making trades leading to overreaction of prices to diverge from fundamental values. These risk are crucial from the financial stability point of view, said RBI.

Though the hedge funds industry is smaller compared with mutual funds, it has increased in a significant manner.

The assets managed by hedge funds which were less than four per cent of the assets managed by mutual funds at the end of 1993, increased to 10 per cent by 2005. It is estimated that in 2006 more than US $ 1 trillion was invested in hedge funds (Stulz, 2007).

"Though hedge funds, on an average, have low return volatility compared with an investment in stock market, they can lose their money very rapidly. Around 10 per cent of hedge funds die every year (Stulz, 2007). Thus, the hedge funds are a source of concerns for regulators in terms of investor protection, risk to financial institutions, liquidity risks and excessive volatility risks,'' said RBI.