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Despite the possibilities, the evidence on whether other investors engage in such copy-cat behavior is mixed or even negative. Analysis of reported large transactions gives no evidence that other traders are guided by the positions taken by hedge funds in prior periods. When big moves are under way, the data shows that hedge funds often act as contrarians, leaning against the wind, and therefore, often serve as stabilizing speculators.

Feedback Trading

Although hedge funds have the flexibility to take short positions (that is, be on the selling side), they can also be the first to take long positions (buying side) in currencies that have depreciated in the wake of a speculative attack, providing liquidity to illiquid markets and helping the currency establish a bottom. Clients' expectations that hedge funds will make above-normal returns - as they often do - will discourage managers from buying the same assets being purchased by other investors since these asset prices already reflect others' moves. Hedge funds' greater flexibility makes them less inclined than other investors to buy and sell in the same direction as the market. Hedge funds are not bound by their prospectuses, as mutual funds often are, to invest new inflows of capital in the same manner as existing capital. When a market is falling, hedge funds can wait it out, while mutual funds may be required by their internal controls to liquidate positions, or they may have to pay off withdrawals by their investors. Hedge funds - except for those with very high amounts of leverage - are often able to await a market reversal, either because they may have credit lines to draw on to put up more margin or collateral, or because their investors are locked in for substantial periods.

Risk Management

Regulatory policies seek to avert systemic threats to the financial system by limiting imprudent extensions of credit. These regulations include margin requirements, collateral requirements, and limits on the exposure of financial intermediaries to individual customers. All of them affect hedge funds' business with banks, brokers and other intermediaries.

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* Contributed by -
Swetha Narayanaswamy,
M.B.A. II year (Finance),
ICFAI Business School, Mumbai.