"Significant numbers of trading strategies are already destined to prove disappointing, a point that recent data on the distribution of hedge fund returns seem to be confirming." So said Fed Chairman Alan Greenspan in his satellite-delivered speech to the International Monetary Conference in Beijing. Here's the full hedge fund related section from his speech:
Note: full text of Mr Greenspan's talk is here.
Whatever the underlying causes, low risk-free long-term rates worldwide seem to be one factor driving investors to reach for higher returns, thereby lowering the compensation for bearing credit risk and many other financial risks over recent years. The search for yield is particularly manifest in the massive inflows of funds to private equity firms and hedge funds. These entities have been able to raise significant resources from investors who are apparently seeking above-average risk-adjusted rates of return, which, of course, can be achieved by only a minority of investors. To meet this demand, hedge fund managers are devising increasingly more complex trading strategies to exploit perceived arbitrage opportunities, which are judged--in many cases erroneously--to offer excess rates of return. This effort is particularly evident in the pronounced growth and increasing complexity of collateralized debt obligations. Although collateralized debt obligations are a powerful tool for enhancing risk management by separating idiosyncratic risks from systematic risks, the models used to price and hedge these instruments are just beginning to be tested.
I have no doubt that many of the new hedge fund entrepreneurs are embracing a strategy of pinpointing temporary market inefficiencies, the exploitation of which is expected to yield above-average rates of return. For the time being, most of the low-hanging fruit of readily available profits has already been picked by the managers of the massive influx of hedge fund capital, leaving as a byproduct much-more-efficient markets and normal returns.
But continuing efforts to seek above-average returns could create risks for which compensation is inadequate. Significant numbers of trading strategies are already destined to prove disappointing, a point that recent data on the distribution of hedge fund returns seem to be confirming.
Consequently, after its recent very rapid advance, the hedge fund industry could temporarily shrink, and many wealthy fund managers and investors could become less wealthy. But so long as banks and other lenders to these ventures are managing their credit risks effectively, this necessary adjustment should not pose a threat to financial stability.
I trust such an episode would not induce us to lose sight of the very important contributions hedge funds and new financial products have made to financial stability by increasing market liquidity and spreading financial risk, and thereby enhancing economic flexibility and resilience.