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Changes in Hedge Fund Investment Behavior and the Impact on Financial Markets

Position Concentration, Expanded Scope, and Market Liquidity Risk

December 2006
Naoto Higashio
Tai Terada
Tokiko Shimizu

Click on rev06e06.pdf to download the full text.

Hedge funds have changed their investment behavior in recent years stimulated, among other things, by large inflows of money and rising stock prices around the world. Database1 analyses indicate that they are expanding their long positions in equity markets, increasing their investments in emerging markets and commodities markets, and exhibiting higher degrees of correlation between strategies. Hedge funds have an influential presence in the financial markets as suppliers of liquidity, and they contribute to improving efficiency of markets. On the other hand, they also have the potential to amplify market price fluctuations if their investment behavior becomes one-sided or if they concentrate on specific markets, especially small-sized and low-liquidity markets. Bias in investment behavior or concentration on specific markets has the potential to impact investors investing in hedge funds such as reducing risk-diversification benefits. In this perspective, central banks need to appropriately monitor changes in hedge fund investment behavior and keep close contact with market participants in order to fulfill their roles, which include to support adequate market liquidity during market distress.

  1. "Database" in this review means Lipper TASS Database, which contains 4,310 hedge funds as of August 2006.

Notice

This series explains recent economic and financial topics in a plain and concise manner for a wide range of readers. The views expressed in the report are those of the authors and do not necessarily reflect the views of the Bank of Japan.

Comments and questions as well as requests for hard copies should be addressed to Naohiko Baba, Director, Financial Markets Department (naohiko.baba@boj.or.jp).