Alternative investments and financial markets

Published: 01 June 2016

Alternative investment funds such as hedge funds provide useful liquidity to markets and their activities can help to prevent investment bubbles, sell-offs and fire-sales, thereby supporting financial stability.

1. By providing liquidity and taking on risks that others may avoid, hedge funds help to drive the engine of financial services, ensuring that needed capital reaches companies and borrowers.

Without interest rate derivatives trading by macro hedge funds, to name one example, banks and other lenders would find it more difficult or riskier to offer fixed-rate mortgages to their customers. Without commodity derivatives trading by hedge funds, airlines would not be able to control the costs related to their fuel consumption. Without credit derivatives trading by hedge funds, banks would have to liquidate wholesale portfolios of SME loans and severely restrict finance to an already cash starved sector.

More generally, by providing “liquidity”, alternative investment funds help to ensure that capital goes to the most productive companies and the most credit-worthy borrowers, which in turn generates new jobs and tax revenues.

2. Alternative investment funds help to reduce the concentration of dangerous risks in the financial system. Notably, no hedge fund has ever been bailed out by the taxpayer.

Alternative investment funds contribute to financial stability in their role as sceptics acting in a counter-cyclical, contrarian manner, which can help to deflate bubbles before they become dangerous or volatile. There are no hedge funds operating today that are sufficiently large, leveraged, complex or interconnected that their failure or financial stress would cause severe disruption to markets or the economy.

The attention some hedge funds attract can sometimes be out of proportion to their true size and influence over the market. The hedge fund industry remains diverse and small in scale relative to the overall asset management industry or the banking sector. Individual hedge fund firms are comparatively small businesses – often with fewer than 20 staff – and the funds they manage usually have little or no ability to move markets on their own or even as a group. This is desirable from a policy perspective as financial markets are arguably less unstable with diverse participants that have different capacities to take on particular risks.  

3. Short selling helps hedge funds to reduce risk across the spectrum of their investments. The practice can add useful liquidity to financial markets, thereby reducing the cost of capital to ordinary investors, and even can be the financial market equivalent of a ‘canary in a coalmine’ – a warning of mismanagement at stock market-listed businesses.

IOSCO, the association of financial regulators, says that “short selling plays an important role in capital markets for a variety of reasons, including more efficient price discovery, mitigating price bubbles, increasing market liquidity, facilitating hedging and other risk management activities”.

Typically, short sellers devote considerable time, effort and resources to establishing the reality behind corporate rhetoric. Short selling is a powerful incentive for investors to find out what is wrong with individual companies. It is a way of expressing a view that a stock is over-valued. 

In past years, some governments have made quick decisions to ban short selling, usually when their local stock markets were in sharp decline. Subsequent academic research has shown that this approach is misguided and in fact harmful to markets. Research examining the consequences of short-sale bans around the world during the 2007-2009 crisis found that bans had negative effects on liquidity, especially for small cap stocks and stocks without listed options. Moreover, the bans were found to have slowed down price discovery, especially in bear markets, and failed to support prices in the vast majority of markets.

4. The restrictions that many alternative investment funds impose on their investors’ ability to withdraw capital at short notice can help to prevent damaging runs and fire sales. 

Hedge funds have a set of tools at their disposal to restrict or prohibit withdrawals under certain conditions. These are often designed to ensure that investment strategies are capable of being carried out as intended. Certain restrictions are designed to avoid mismatches between liquidity offered to investors and that of the underlying assets in the fund. Others exist to allow managers to withstand periods of significant market stress. 

These tools include lock-ups, gates and side pockets. Gates put restrictions on how an investor may withdraw at any one time. Lock-ups prohibit withdrawals during a defined period after the initial investment is made - generally between one and two years but can be longer in duration. During the global financial crisis, the liquidity that some hedge funds had been able to offer to investors under normal conditions was not available in times of severe market stress. Unable to meet a wave of redemption orders, some hedge funds imposed gates or separated hard-to-value assets into so-called side pockets - a type of account used by hedge funds to separate illiquid assets from more liquid investments.

Some critics believe that, on balance, gates and side pockets restrict investors too much and are not in investors’ interests. However, such tools actually can protect the interests of many investors, including those who choose not to redeem, given that a fund may have been forced into a fire-sale of its assets if a run for the exit had been allowed. Similarly, side pockets can help to ensure that illiquid assets are sold at their rightful value and in an orderly fashion once markets have stabilised.

Further reading

AIMA/State Street: Let’s Talk Liquidity - Opportunities in a New Market Environment


AIMA/CAIA: The Way Ahead - Helping trustees navigate the hedge fund sector