Easy pickings for hedge funds could be over

WASHINGTON - US Federal Reserve chairman Alan Greenspan has warned that hedge funds had picked the "low-hanging fruit" of easy profits and may be set for a fall as they assume more risks in a quest for high returns.

He said, however, that the financial system should escape widespread damage from hedge fund woes as long as banks lending to them managed risks effectively.

"After its recent rapid advance, the hedge fund industry could temporarily shrink, and many wealthy fund managers and investors could become less wealthy," he said via satellite to a bankers conference in Beijing.

"Continuing efforts to seek above-average returns could create risks for which compensation is inadequate.

"Significant numbers of trading strategies are already destined to prove disappointing, a point that recent data on the distribution of hedge fund returns seem to be confirming."

Hedge funds are largely unregulated entities that cater to wealthy and institutional investors. Their assets are estimated to have doubled over the last five years to about US$1 trillion ($1.4 trillion), although observers think funds suffered perhaps the heaviest redemptions in a decade in the second quarter of this year.

In his remarks, Greenspan tied the big risks hedge funds have taken on with the unusually low long-term interest rates prevailing around the globe.

As in February, when he termed the low level of long-term interest rates "a conundrum", the Fed chief wrestled with a number of potential explanations for the atypical environment - but again found them all inadequate.

"One prominent hypothesis is that the markets are signalling economic weakness," he said.

"This is certainly a credible notion. But periodic signs of buoyancy in some areas of the global economy have not arrested the fall in rates."

He said stepped-up demand by pension funds for long-term assets was likely no more than "a small part" of the cause.

Greenspan said while foreign central bank purchases of US Government debt may have lowered long-term borrowing costs in the United States, Fed staff estimates suggested only a modest impact.

Further, he said this would fail to explain the lower long-term rates elsewhere around the globe.

He said the integration of low-cost producers like China and India into global markets had possibly lowered the inflation compensation investors had previously demanded for holding long-term debt.

But he said that more readily explained trends of the past decade, rather than of the past year.

The Fed has raised overnight borrowing costs by 2 percentage points since June last year, taking the benchmark federal funds rate to 3 per cent. Long-term rates, however, are lower now than when the Fed started.

Greenspan said the abnormal behaviour of interest rates had encouraged greater risk-taking.

"Whatever the underlying causes, low risk-free long-term rates worldwide seem to be one factor driving investors to reach for higher returns, thereby lowering the compensation for bearing credit risk and many other financial risks over recent years," he said.

And for high-flying hedge funds, the increased appetite for risk seemed likely to lead to losses, Greenspan said.

"But so long as banks and other lenders to these ventures are managing their credit risks effectively, this necessary adjustment should not pose a threat to financial stability."

Although warning of hedge fund troubles ahead, Greenspan urged countries not to become resistant to free trade because it would lessen their economic flexibility.

- REUTERS