Changes in Hedge Fund Investment Behavior and the Impact on Financial Markets: Position Concentration, Expanded Scope, and Market Liquidity Risk

Naoto Higashio, Tai Terada and Tokiko Shimizu
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Naoto Higashio: Bank of Japan
Tai Terada: Bank of Japan
Tokiko Shimizu: Bank of Japan

No 06-E-6, Bank of Japan Review Series from Bank of Japan

Abstract: 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. Database 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.

Date: 2006-12
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