What is the curse of modern existence

Hedge Funds - Curse or Blessing of Modern Capitalism?

Table of Contents

1 Introduction

2 Classification of hedge funds in the financial market system

3 Definition of terms

4 Differentiation from private equity funds

5 investment strategies

6 Investors and Market Volume

7 spectacular hedge fund investments
7.1 Foreign exchange speculation in the 1990s
7.2 The LTCM collapse

8 The regulation of hedge funds

9 Dangers of Hedge Funds

10 Outlook


1 Introduction

In 2005, the then party and parliamentary group chairman of the SPD, Franz Müntefering, caused discussions with the metaphor “swarms of locusts”. In an interview with Bild am Sonntag he criticized the irresponsible behavior of private equity and hedge funds (cf. Kamp / Krieger 2005: 4). As early as November 2004, however, it was the CDU politician Heiner Geißler who expressed his lack of understanding of the existing financial market system in a guest article in the weekly newspaper Die Zeit: “Where is the outcry of the SPD, the CDU, the churches against an economic system in the big one? Corporations buy up healthy smaller companies like Kadus in the southern Black Forest with inventory and people as if they were slave ships from the 18th century, then shut them down for the purpose of market adjustment or to increase the return on capital and the stock market value and thus destroy the economic livelihoods of thousands and their families (Geißler, Heiner: Die Zeit from 11.11.2004, No. 47)? "

In Germany, a broad debate has gradually developed over the past few years about the opportunities and risks of speculative transactions and equity capital. This discussion is often very emotional. This may also be due to the fact that the financial sector appears alien and threatening to many people due to its abstract nature and ownership of capital is often associated with power and influence (cf. Kamp / Krieg 2005: 4). Many employees in particular are skeptical of the phenomenon of corporate participation. They see themselves helplessly at the mercy of the new owners and fear that they will lose their jobs. In contrast, medium-sized companies in particular hope to develop new sources of finance (cf. Böttger 2005: V).

The primary goal of this work, which arose in the context of the advanced seminar “Sociological Discourses and Core Issues of Globalization”, is to analyze the mechanisms of the financial market in a factual manner beyond emotions. The focus of this work is on hedge funds. The aim is to enable the reader to understand the systematics of these phenomena of financial capitalism and to shed light on the increasingly opaque financial world. It is also examined whether and, if so, what dangers hedge funds can pose.

For this purpose, it makes sense to first outline the overall system of the financial market and its tasks in order to be able to classify the subject of hedge funds in a logical manner. After an attempt at definition, it is differentiated from private equity companies. In a further step, the investment strategies and the market volume of the hedge fund industry are presented. Then, with the foreign exchange speculation of the 1990s and the collapse of the Long Term Capital Management Hedge Fund (LTCM), two of the most popular hedge fund investments are introduced. Following on from this, the currently existing regulatory mechanisms are outlined. The penultimate chapter deals with the dangers posed by hedge funds and the positive effects associated with them. The work ends with an outlook, which also includes a personal résumé.

2 Classification of hedge funds in the financial market system

The term “financial market” usually serves as a generic term for the two terms capital market and money market. Traditionally, the capital market is for the long term Financing used by private and public investments, the money market rather serves short term Securing liquidity, especially between banks (cf. Huffschmid 2002: 24).

Essentially, the financial market has two basic functions. On the one hand, there is the classic credit function, which enables companies, governments and banks to be solvent, e.g. for investments. On the other hand, capital can be stored and invested in the financial sector that is temporarily or permanently not required by its owners for payments. In recent years, however, the financial market has changed and has moved quite far from its original functions. In addition to the credit and custodian banks, new players have emerged. At the same time, the weights between the departments of the financial markets have shifted considerably. Huffschmid has clearly divided today's financial market into five sectors (cf. Huffschmid 2002: 24f). These are:

1. The Credit market, with the banks as creditors on the one hand; Corporations, governments and individuals as beneficiaries and debtors on the other hand.
2. The Primary market for securities financing. There, the actors raise funds directly from the “public” by issuing shares or issuing bonds. Shares securitize shares in the equity of companies (stock corporations), which enable the companies to receive capital from their shareholders at the beginning of their activity. Bonds, in turn, are securitized debt instruments, i.e. a company is given a certain amount of capital that is repaid after an agreed time and at a fixed interest rate. This sector is the classic capital market, which is mainly settled on the stock exchange. Financial companies do not act as lenders, but as intermediaries between lenders and borrowers.
3. The Secondary market for securities trading. Existing securities, whose financing function has already been fulfilled, are traded there. The investor's interest in high interest yields and rising prices comes to the fore over the interest in financing.
4. The Market for currencies. It is required for handling cross-border investments. In addition, however, it has also developed into a preferred speculative market.
5. The Derivative Financial Instruments Marketthat are based on claims or obligations in the future. On the one hand, the security function against price fluctuations for trading partners and, on the other hand, speculation are in the foreground (cf. Huffschmid 2002: 24f).

Equities and bonds are still considered to be the classic forms of investment. Accordingly, other investments are also referred to as "alternative assets". The most important asset classes within this category are private equity and hedge funds. If you take Huffschmid's classification, hedge funds operate in a large number of the markets listed. They invest primarily in the secondary market for securities (3.), in the market for currencies (4.) and in the market for derivative financial instruments (5.) (cf. Nitschke 2006: 1; Böttger 2005: 3). What exactly is hidden behind the term hedge fund is the subject of the next chapter.

3 Definition of terms

Hardly any other term in finance is as misleading as that of the hedge fund. It is suggested that the investments are risk-free, since the word “hedge” is generally understood to mean “secure” (cf. Pichl 2001: 5). Originally, hedge funds actually concentrated on low-risk, secured investments (cf. Böttger 2005: 60). The first hedge fund was founded in 1949 by Alfred Winslow Jones, a journalist and sociologist who later became a fund manager (cf. Agarwal / Naik 2006: 129). The historical investment idea was to take advantage of small price differences between low-risk and hedged investments at different trading venues or to hedge against price fluctuations. Since certain fluctuations follow fixed patterns, this “arbitrage business” is in principle very low-risk (cf. Böttger 2005: 60). However, the modern hedge fund landscape has very little to do with classic "hedging". Contrary to their name, hedge funds no longer serve to hedge against risks, but are independent investment instruments with very different strategies and risk profiles. The core concern is to make profits when prices are rising as well as falling. The focus is on speculation with the aim of profiting from price fluctuations on the financial markets (cf. Kamp / Krieger 2005: 27).

In practice, hedge funds can be defined using the following criteria:

- The aim is to generate income regardless of general market developments.
- There are basically no restrictions with regard to the investment instruments. Often derivative financial instruments are used.
- The fund fees depend on the success of the fund. However, compared to standard mutual fund fees, they are extraordinarily high.
- Fund management often has a financial stake in the success of the hedge fund.
- As a rule, the investor pays a high minimum investment and is tied to the commitment for a longer period of time (holding period).
- Hedge funds often use short sales and a high level of leverage to leverage returns.[1]
- There are only a small number of information and disclosure obligations (cf. www.fondsinformation.de/Hedgefonds/Hedgefonds.htm, as of: May 18, 2005, quoted from Kamp / Krieger 2005: 27f)).

Internationally, investment funds are strictly regulated. Hedge funds are therefore usually not organized as investment funds, but as a "limited partnership", comparable to the German GmbH & Co. KG. In order to avoid further regulations, the hedge funds are often registered in low-regulation Caribbean countries and tax havens (cf. Böttger 2005, p. 60). The most important centers of the hedge fund industry include the Channel Islands, the Cayman Islands, the Bahamas, but also states with liberal capital market legislation such as Luxembourg, Ireland or Monaco (cf. Kamp / Krieger 2005, p. 29f). In the fourth chapter that follows, there is a distinction between hedge funds and private equity funds.

4 Differentiation from private equity funds

At its core, private equity funds involve investing in unlisted companies via equity. Its counterpart by definition is “public equity”, ie equity stakes in listed companies. In Europe, the term private equity is used very imprecisely and is often equated with venture capital - the “venture capital participation” of mostly very young companies. However, the venture capital market area is only a sub-segment of the extensive private equity market (cf. Pichl 2001: 19). In contrast to public equity, there is no organized, public market for private equity funds. For this reason, the market structures and investment strategies are more difficult to see and more complex (cf. Kamp / Krieger 2005: 21).

The classic function of equity participation is the self-financing of a company, in contrast to self-financing, in which the company generates funds from external sources such as loans (cf. Kamp / Krieger: 22ff).

Private equity is therefore a pure equity financing. The new shareholders thus become legal co-owners of the company. Unlike lenders, you do not receive any fixed interest payments, but as a partner in the company you participate equally in profits and losses. The actual goal of private equity funds, however, is not dividends and profit distributions, but rather to increase the value of the acquired company within a limited period of time in order to then sell the company at a higher price (exit) (cf. Böttger 2005: 16) .

In the meantime, the boundaries between private equity and hedge funds with regard to their business goals are becoming more and more blurred. However, the following differences can be summarized:

Hedge funds are mostly registered in countries where they are not subject to financial supervision and where their income is largely untaxed. Private equity funds, on the other hand, are registered in the country where the management is predominantly active. So here, at least in principle, taxation of the income generated is possible. The core strategies can also be distinguished. Hedge funds invest in a wide variety of financial assets. In some cases, they also invest in companies through shares, although rarely in majority. The primary goal of private equity funds, on the other hand, is to acquire the majority of company shares. Both alternative assets are largely financed by outside capital. (See Jarass / Obermair 2007: 14ff).

There is a wide-ranging debate in the literature about the benefits of private equity firms to economies. Proponents argue that companies rely on cash to invest and create jobs. Private equity companies could make a necessary contribution to this. In the dispute, it is shown by the other side that the financial strength of the large corporations has grown significantly in recent years and the increased need for liquid funds cannot be confirmed in this way (e.g. Bundesbank 2006: 66). Furthermore, the private equity companies would indeed be able to develop positive effects in the short term, but empirical evidence shows that they develop harmful effects in the longer term (over-indebtedness, job cuts, insolvencies, instability) (e.g. Kamp / Krieger 2005: 21ff). The debate should not be continued at this point. The lines of argument, however, are also similar in the discussion of hedge funds, which will be discussed later. The next chapter focuses on which investment strategies are pursued by hedge funds.


[1] What exactly is hidden behind the terms short selling and leverage is explicitly explained in Chapter 5.

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