Hedge Funds Risk Takers or Gamblers

Abstract

This research proposal's aim is to describe the phenomenon of hedging funds from the perspective of gambling. Hedge funds remain a center of attention and a magnet of attraction for almost all of the investors since last few decades. However, not all of the returns that it get turned to be positive. In spite of being a villain in the recent global financial crisis, hedge funds are also considered as victims, similar to the way like other segments of the market are considered so. Moreover, it is also one of the reasons for marketing hedge funds to most of the investors because they are often considered as good tools in increasing returns and reducing the risks. This reduction in risks results because of the low correlation between numerous other assets in the diversified portfolio of investors and the returns of hedge funds. But last few years have witnessed the poor performance of hedge funds that have surprised most of the investors. During the global financial crisis, hedge funds resulted in faring worse than investors' expectations mainly because of the reason that their risk is often underestimated like numerous other instruments of alternative assets by traditional risk analysis. Therefore, hedge funds are riskier than they generally seem, and the returns obtained from them may not match the promise of their reputation. In short, one of the greater dangers of a financial crash today is that most of the people do not believe in economics now; rather they actually believe in 'gambling', and the financial system today is more like a gambling system.

Introduction

The last three decades have witnessed two most significant evolutions in global financial markets. First evolution has occurred in the areas of managing large amounts of capital, which has been now handed over to agents, like hedge funds. These agents are subject to very less number of trading restrictions and need to disclose much little about the strategies that they use in trading. Moreover, as a result of this entrustment on agents, investors today have to rely mainly on the history of realized returns to evaluate future performance in order to allocate their funds across such mediums. Secondly, it is now possible to combine and slice a large variety of risks because of a rapid pace of financial innovation, and by trading a rich set of financial instruments (Levinson, 2010, pp. 37).

However, these two major evolutions have also created room for a particular type of agency problem. This has resulted in allowing those managers who run out of genuine arbitrage opportunities to take secret exposure to unusual or exotic risk factors or get involved in gambling for the purpose of improving their reputation temporarily. In this regard, numerous strategies that aims to generate small but frequent positive returns, and minimize the probability of experiencing very large and huge losses are becoming increasingly appealing because of the reason that they disguise luck as skill. The spectacular collapse of Amaranth, LTCM, and numerous other large hedge funds have ...