The Global ManipulatorsDespite recent setbacks, hedge funds may still lead the world down the path to destruction By Allen T. Cheng When leaders of APEC converge on Kuala Lumpur this month, it's clear they will have their work cut out for them. The global community is facing its most crucial test in the post-Cold War era, and arguably the biggest challenge APEC must tackle can be summed up in two words: hedge funds. The unregulated flow of short-term capital has not only wreaked havoc in this region, causing severe political and social unrest, but rippled around the world with a devastating domino effect on the markets of Russia and Brazil. Today, even the specter of hunger hangs over communities that little more than a year ago were lifting themselves out of poverty and into an emerging middle class. It is now imperative that sweeping regulations be immediately set in place to mitigate future hedge fund onslaughts. Some governments, such as Hong Kong, Taiwan and Malaysia, have made a start. But concerted action is needed. The region's economic survival is at stake. Any delay could result in the first "Great Global Depression." Before we proceed further, let us make one thing clear. We aren't looking for scapegoats. Not all the region's woes have been caused by hedge funds. Many of us in business, government and the media have at times acted less than responsibly, freely committing, if nothing else, the sin of hubris. But that's no excuse for the terrible pain Asians have suffered at the hands of some hedge funds. We must also stress the word "some." We are not against all hedge funds. Some may serve a legitimate purpose in allowing investors to participate in futures markets and to "hedge" their investments. What we are appalled at are the unmitigated currency attacks of the multibillion-dollar "global macro funds" of the likes of financier George Soros, Julian Robertson, Paul Tudor Jones and Michael Steinhardt & Partners. Through the power of derivatives, such funds can "manipulate" markets by simultaneously "shorting" or "longing" stocks, stock indices and currencies. With huge reserves of billions - $23 billion under Soros and $20 billion under Robertson alone - these financiers can move markets in a way that no government can by leveraging or borrowing up to 30 times their capital from investment banks. Their power is magnified even greater - as much as 300 times - through global computer networks when the proprietary trading desks of investment banks and other smaller funds follow their lead and create a pile-on, snowball effect that results in utter panic. Witness the potentially disastrous downfall of the Long Term Capital Management fund. LTCM had an equity capital base of $4.7 billion at the beginning of this year. Yet on this capital base, it was allowed to borrow at least $125 billion, which it used to buy securities and bonds. In turn, these financial instruments were pledged as collateral to take various positions on all sorts of derivatives that had an underlying value of an astonishing $1.25 trillion. Taking the $1.25 trillion accumulated from a capital base of $4.7 billion, it would appear that Long Term Capital was leveraged up to an astounding 260 times, or in other words the fund had a debt-to-equity ratio of 260! What country seeking to defend its currency against speculators can compete against that massive war chest? Even Japan, the country with the world's largest currency reserves, has only $212 billion. The second-largest, China's, are $140 billion. The third-largest, Hong Kong's, are $87 billion and the fourth-largest, Taiwan's, $84 billion. Struggling Indonesia has only $17 billion, the Philippines $8 billion. Malaysian Prime Minister Mahathir Mohamad denounced these "rogue currency traders" last year at the World Bank/International Monetary Fund conference in Hong Kong, where he squared off against financier Soros. Though Mahathir received little international support then, it's clear that worldwide consensus is beginning to shift. Even regulators in the U.S. and Europe are looking at ways to rein in the hedge funds. Finally, they are beginning to admit what Asian leaders have said all along: Regulating the hedges funds is not "interfering" in free market forces. Had Mahathir's warning been taken seriously last year, the regional meltdown may have been mitigated. "These speculators can cause undue damage," admits Stephen Lonsdorf, president of U.S.-based Van Hedge Fund Advisors, one of the top hedge fund analysts in the world. "But at the end of the day, they'll only be successful if the economic fundamentals are there. They're like jackals. They're bottom feeders. They feed on a situation, but they don't create the situation." That may be true, but it still doesn't make hedge funds any less culpable for exacerbating Asia's sorrows, says Jerry Shum, deputy research head at New Japan Securities in Hong Kong. Hedge fund managers' rationale "are very easily said when you're the one watching - the one outside the fishbowl who is not taking the pain," he says. Shum's view hits it right on the button. And it's time world leaders take strong action to stanch the flow of unregulated capital flows. Global markets already are teetering on the precipice of a financial meltdown. Now is perhaps our last chance to pull them back, lest we all suffer irreparable damage - damage that may destroy the concept of global markets altogether as more and more nations are forced to turn inward for the sake of survival. Even Tiger Management's Julian Robertson admits there is a need for tighter regulations. Speaking to a hedge fund convention - appropriately held in the sunny tax haven of Bermuda - Robertson said: "I think there will be a lot of rules made to regulate or rules proffered to regulate the hedge fund industry. . . . Some sort of leveraged guideline in a particular currency might be helpful." Rather than outlawing hedge funds or shutting them out completely, the region's leaders might look at ways to make it both more expensive and more difficult for speculators to attack global markets. We'll discuss this further later, but first let us examine the "global macro" hedge funds.
Invented in 1949 by ex-Fortune magazine editor and part-time sociologist Alfred Winslow Jones, hedge funds have been a part of the global landscape for decades. Most are based in the U.S. but domiciled in Caribbean tax havens, where they're free from U.S. regulators. Since 1988 there's been an explosion of such funds from 1,300 with $42 billion under management to 4,000 with more than $300 billion, according to Van Hedge Fund Advisors. What distinguishes hedge funds from mutual funds is that hedge funds do not assume that markets always go up. They have the flexibility of dealing in futures and can "long" or "short" stocks or stock indexes - borrowing from a broker and taking bets that a particular share's value or index will go up or down. A common technique involves pairs trading: shorting one stock (because it's overvalued) and longing a related stock (because it's undervalued) in the same industry or belonging to the same investment group. For example, a hedge fund manager can "short" Hutchison Whampoa Ltd. because it's perceived to be overvalued and "long" Cheung Kong Holdings because it's perceived to be undervalued. Both companies are controlled by Hong Kong property tycoon Li Ka-shing. By using this technique, most hedge funds can produce a profit even when share values fall. Most hedge funds also use "arbitrage" - profiting from differences in prices when the same security, currency, or commodity is traded on two or more markets. Such techniques are a legitimate part of futures trading, says Winston Van, 36, a Hong Kong hedge fund manager, who adds that he never attacked Asian currencies. "Why did I not attack the Hong Kong dollar or other Asian currencies?" says Van. "That's not what I do best. I do not take markets risks." Global macro funds, however, specialize in currency or bond arbitrage: using a variety of techniques to short or long stocks, indexes, currencies or bonds in multiple markets simultaneously. The most famous of the "global macro" managers are Soros of the Quantum Fund and Robertson of Tiger Management. Most global macros control billions of dollars worth of assets. Through the use of derivatives and their good relationships with investment banks, they can leverage up to 30 times their pledged capital, an equivalent to a debt-to-equity ratio of 30. Most companies with a debt-to-equity ratio exceeding 1.0 are considered by analysts as being over-leveraged. Such exceedingly high leverage is even dangerous for the brightest financial minds. Through the prestige of its investors, the recently bailed out Long Term Capital Management fund was able to borrow extensively from investment banks, accumulating a debt-to-equity ratio of 260 arbitraging Russian bonds. Despite the fact that its economic modeling was created by the sharpest mathematicians around -including shareholders Myron Scholes and Robert Merton, both Nobel Prize winners in economics, and David Mullins, a former vice chairman of the U.S. Federal Reserve Board - the fund lost $4 billion in August. There's something wrong with the world's investment-banking industry when so much credit is handed out so liberally to a few individuals. It's clear that even Nobel Prize-winning economists can make mistakes. This is only one fund among many that has access to huge amounts of capital leveraged through investment banks. Countries that are defending their currencies or equities have to play with real money, money that otherwise might be used for their people's welfare. In August, Hong Kong - which has the third-largest reserves in the world - spent an astounding $8.8 billion or 10 percent of its reserves defending its currency's peg to the U.S. dollar. We believe that some global macro hedge funds are in effect creating "false markets" when they simultaneously attack currencies and stock indices, comparable to insider trading or securities manipulation. Such criminal acts are punishable by fines and potentially jail terms. Why shouldn't currency and stock-index manipulators be punished in the same way as those convicted of insider trading and securities fraud? Both create victims. For securities fraud, the victims are other investors. For currency manipulation, the victims are countries and their peoples.
Brought closer by the Internet and financial-news wires like Reuters and Bloomberg, the world's markets are inextricably linked. That linkage has forged a double-edged sword, says Lonsdorf of Van Hedge Fund Advisors, mainly fast gains and fast declines as traders around the world play stocks and futures 24 hours a day in constant pursuit of profit. Such inter-linkage transcends nation states, and the implications are clear: No single nation in the world today has true economic sovereignty or control of its own economic destiny. All are at the whims of market forces. "The world has changed dramatically in the past 20 years," says Lonsdorf. "The price we pay for a global economy is we all have to play by the same rules." Jerry Shum of New Japan Securities finds fault with that logic: "Our benchmark economy is the U.S. and anything that is less efficient than the U.S. is considered weak. The fact is Asian countries are different than the U.S. If we bring it down to the individual level, people on the face of the Earth do not have the same circumstances or opportunities as the people in the U.S. The States is the most powerful country in the world, and it's not burdened by all the history and culture of other countries." Hedge fund managers do have a point when they say that some of the region's leaders are making all hedge funds scapegoats. Investment banks in the region also bear a part of the responsibility for the volatility, says Lisa Hintz, another Hong Kong-based hedge fund manager. In fact, the proprietary trading desks of major investment banks have far more leverage than hedge funds, she says. "At least someone like me, I have to go out and borrow money from someone like them. When they blame young kids behind computer screens screwing up Asia, they should blame the banks. People doing those trades may not really understand the risks they're taking on. Their bosses may not either." Hintz's argument is relevant. The proprietary trading desks of investment banks need to be reined in, for they, too, can act irresponsibly. The Australian Securities and Investments Commission is currently awaiting a court decision on whether Nomura Securities created a "false market" involving the sale of A$587 million worth of stocks in the last 30 minutes of trading on March 29, 1996. Nomura stands accused of trying to force the index to fall as much as 10 percent so the bank could profit from an arbitrage position on futures contracts on Australia's All Ordinaries Index. The commission alleges that several Nomura traders in London and Hong Kong conspired to mount the attack. Thanks to the rules of the London and Hong Kong stock exchanges, which require brokers' phone lines to be recorded, a tape of conversations involving three Nomura executives was presented at court. The brains behind the operation, Gary "Fatty" Channon, then 28, was in charge of equities derivatives for Nomura in London. His minion, Duncan Moss, just 23 years old, was a trader who managed $800 million of other people's money. The tapes of their phone conversations the night before the coordinated attack show the contempt with which they held regulating authorities. But in this case the regulators may get the last laugh. In certain developing countries where there aren't the same policing resources as in Australia and Hong Kong, such alleged scams could be going on every day. In a public statement, Nomura refused to acknowledge any wrongdoing: "If the Court finds it to be wrong, we will then be good corporate citizens and modify our behavior, but until then we give no undertakings."
The best way to defend against hedge funds, says a Filipino-American banker, is to come up with correct policies to cure one's country's ills. In fact, Japan's recent announcement of a set of determined policies to overhaul its banks sent the yen soaring against the U.S. dollar, causing some hedge funds to lose bundles because they'd been shorting the yen. Many of these hedge funds are suffering a double-whammy because they also borrowed yen to buy dollars for investments globally. With Japanese interest rates hovering just barely above zero, the yen has been the cheapest currency to finance global transactions for several years. However, we still believe world leaders should outlaw currency and stock-index manipulation. (See Recommendations below) Any group found deliberately manipulating a currency or index, by starting rumors of devaluation or appreciation and then taking large positions in either direction, should be prosecuted. We also wholeheartedly agree with the World Economic Forum's recent call for reforming the global financial system. The G-7 economies should establish new regulatory regimes for the monitoring, disclosure and regulation of highly leveraged short-term financial flows, as well as off-balance sheet commitments and derivative transactions. APEC leaders looking for a solution would find it worthwhile examining Hong Kong's approach of tightening regulations. By increasing margins by 50 percent on positions with 10,000 or more contracts, Hong Kong has made it much more difficult - and expensive - for hedge funds to speculate in index futures. Hong Kong regulators also have decreed that buyers of futures contracts must settle the payment within two days after the trade, that brokers must reveal to authorities anytime a position of 250 contracts has been taken, down from 500 contracts, and also identify the holders of such contracts. (See The Hong Kong Initiative below) The new rules have been effective - at least for Hong Kong. Hedge fund manager Winston Van says that he's stopped playing the Hong Kong futures market since the rules were imposed at the end of August and instead is focusing on Japan and the U.S. Another example worth examining is Taiwan, where regulators have all but banned Soros's funds from soliciting investments. Taiwan's Securities & Futures Commission also has launched an official investigation into whether any local firms are helping Soros gain access to the stock market. In addition, Taiwan's Central Bank has slapped new controls on the island's foreign exchange trade, in effect limiting speculators' ability to attack the New Taiwan dollar. (See Taiwan's New Forex Rules below) The only way to completely protect an economy from hedge funds is to do what Malaysia did - impose exchange controls - or to wipe out futures trading, says hedge fund manager Hintz, 35, who has a master's degree in business administration from Harvard University and whose father is a hedge fund manager in New York. Neither option is feasible for the long term if Asian countries want to be part of global capital markets, she asserts. "Countries think they can be part of the international capital market without following the discipline of the markets," says Hintz. "You can't. You've got to choose." However, one can't help but notice that hedge fund advocates often use the terms "discipline of the markets" and "free market forces" as an excuse in defending hedge fund attacks on global markets. Dealing with the hedge funds is like a chess game, says one banker. "Tactics backed up by sound policies are everything," he says. Before setting any new policies, says another banker, the region's leaders should realize that all the tactics needed to defeat the likes of Soros lie in the Quantum chief's book, The Alchemy of Finance. They could take advice from another hedge fund "star," Paul Tudor Jones, who wrote the following in recommending Soros's treatise: "In the World War II movie Patton, my favorite scene is when U.S. General George S. Patton has just spent weeks studying the writing of his German adversary Field Marshall Erwin Rommel and is crushing him in an epic tank battle in Tunisia. Patton, sensing victory as he peers onto the battlefield from his command post, growls, ÔRommel, you magnificent bastard. I read your book!' Enough said." Whether Asian leaders decide to adopt Hong Kong's or Taiwan's regulatory fine-tuning, Malaysia's exchange controls or Japan's new determined policy of shutting down insolvent banks will depend on the politics and situation of each country. But one thing is for sure: They must act wisely and decisively, lest they want more unwanted house guests. The "jackals" are waiting to feed.
RECOMMENDATIONS Here's what we believe should be done to neutralize the global macro menace:
THE HONG KONG INITIATIVE This is what Hong Kong did:
TAIWAN'S NEW FOREX RULES Here are Taiwan's Central Bank's new curbs on forex trading:
COMMENT
How the Hedge Fund Mutation OccurredBy P.Y. Chin Global macro hedge funds could be described as mutants of sorts. Through loopholes in the global financial system, they have grown from offshoots of the prestigious U.S. institution of mutual funds to become a mutable form of investment vehicle that can be extremely risky, mischievous in many cases, and monstrous both in cause and effect. The most virulent are called "global macro" hedge funds. They specialize in taking speculative macro-economic positions on countries and their currencies. Such funds used to be little-known creatures. It wasn't until recent years that, through a system of loopholes, they grew into such formidable economic entities. Just as healthy cells in the human body can become cancerous, global macro hedge funds have grown from well-regulated investment vehicles to economic powers that pay obeisance to no government or legal jurisdiction. In appearance, global macros seem like mutual funds, well regulated and in full compliance with laws overseeing the investment and finance industry. Most are managed from the U.S. but, in fact, live in a no-man's land where they can hide from all financial regulations. Based in tax havens in the Caribbean, global macros can ignore U.S. authorities and yet attract investments from all over the world through the Internet, unwittingly supported by rating agencies and the news media. Traditionally, all hedge funds have been investment clubs for the wealthy. Although many are based in foreign tax havens, funds that operate in the U.S. are required by the the U.S. Securities and Exchange Commission to have more than 65 investors, but no more than 99 investors, each with a minimum investment of $1 million. Aside from that, U.S. authorities place few restrictions on hedge funds. A "general partner," or in other words, the fund manager, typically earns a 20 percent commission on the profits generated by the fund. On top of that, the fund manager earns a 1 percent management fee. Such high fees give additional incentives to the fund manager to seek the highest rate of return on investments. For the nine and half years ended June 30, 1997, hedge funds - across all investment strategies - consistently performed at the top of the financial world. During the period, hedge funds returned an annual average of 17.6 percent net compared with 9.6 percent for the Morgan Stanley World Equity Index, 14.5 percent for the average U.S. equity mutual fund, and 9 percent for the Lehman Brothers Bond Index. Only individual U.S. stocks could compete during that period, with the Standard & Poor's 500 earning an annual average of 17.9 percent net. However, top performing hedge funds can produce triple-digit annual earnings. According to U.S.-based Van Hedge Fund Advisors, the average net return of the five highest-returning hedge funds was 137.4 percent in 1997. Even when global equities plunge, hedge funds can earn good money. In the six quarters since 1989 in which the S&P 500 has been negative, the net returns of the average hedge fund exceeded those of the average mutual fund. While investors in the average equity mutual fund lost 24 percent in those six losing quarters, investors in the average hedge fund gained 1 percent. Even though they were mauled in 1994, global macro funds, such as Soros's Quantum and Robertson's Tiger, achieved an annual compounded return of 16.9 percent over the past five years. Their financial power is tremendous, due to the leverage from both their investors' capital and finance facilities of major investment banks around the world. With virtually no laws to rule them, global macro funds in particular can move ubiquitously and with the speed of light to prey upon any market they see as economically vulnerable: moving currencies, securities indices and entire economies, often in the guise of being champions of "free-market forces" and providing "discipline to the markets" around the world. Their profit can be huge as even the smallest difference in arbitrage can make them billions. Likewise, their losses can be huge. Despite the word "hedge" being a part of their name, global macro funds are volatile beasts. What drove investors to hedge funds in recent years can be summed up as one word: greed. Before the early 1980s, mutual funds that earned a 10 percent or greater return were considered fantastic. By the mid-1980s, however, private investors began earning 30 percent to 50 percent a year from a new breed of investment vehicles called "leveraged buyout funds." Such funds borrowed heavily from banks and through the use of junk bonds accumulated huge war chests. They specialized in taking over undervalued companies, breaking them apart and then selling individual divisions for huge profits. Such LBO funds whetted the appetite of both the institutional and privileged investors. When LBO candidates dried up in the early 1990s as good undervalued companies became more scarce, investors were seduced by a new investment creature. Thus "global macro" hedge funds were born. Rather than taking undervalued companies apart, however, global macro funds have come to specialize in taking countries and their economies apart. In this new game, in order to feed on the addiction of 30 percent to 50 percent yields, funds exploited a country's economic ambiguities. In global markets, the trading of currencies and stock index futures has been largely unregulated. As a result, many economies become prime targets, easy to exploit for their vulnerabilities by the often brilliant economic minds that the top global macro hedge funds can hire from U.S. Ivy League business schools. With no regulatory oversight, global macro funds often gamble - and gamble big - earning huge profits from the volatile ups and downs of emerging markets, betting large sums on currencies, derivatives and indices. In contrast, in mature markets, where volatility is relatively subdued, earnings are subdued as well. Their positions are comparable to a game of roulette, where you can bet on black or red, odd or even, hedging your bets while playing other numbers. While some may think the Long Term Capital Management affair was a localized problem, it is just the tip of the iceberg. What the Sunday Times of London said in late September was frighteningly clear: "The global financial system came perilously close to total collapse over the failure of LTCM." The world is on a precipice of a global financial meltdown. If safeguards aren't put in place, the losses and volatility triggered by hedge funds could spark an unstoppable global depression far greater than the 1929 Great Depression.
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