"Hedge funds employ active, opportunistic and sometimes leveraged trading strategies. They turn their portfolios over far more frequently than traditional funds, so their short-term influence on markets can be larger than the capital under management would indicate [NB: Currently, only about two percent of the liquid financial assets are managed by hedge funds]. Hedge funds generally prefer liquid and “anonymous” markets, i.e. ones that can be entered and exited swiftly at low cost. Their actions tend to be sporadic and, in contrast to traditional funds, they do not need to be fully invested all the time. Efforts to estimate the impact of hedge funds on financial markets are hampered by the lack of good data. Past episodes where hedge funds were reportedly involved are numerous, most of which relate to macro hedge funds trying to exploit doubts about the sustainability of unsound macroeconomic policies or probing shaky currency pegs.

Under normal conditions, hedge funds contribute to the liquidity and eff icient functioning of financial markets, but in certain cases, especially in small or medium-sized markets, their actions can be destabilising. Concentration information on OTC derivatives and other less transparent markets can provide an early warning signal on the build-up of concentrated positions in certain markets and can alert market participants to the risks involved.
Another question that often arises is whether hedge funds – through their daily activity– stabilise or destabilise f inancial markets. In this context, two forms of trading can be distinguished: positive and negative feedback trading. The former refers to the buying of financial instruments after price increases, and selling them after price decreases. Such practice can amplify price swings and lead to overshooting or bubbles. Positive feedback or momentum trading can be generated by dynamic hedging, stop-loss orders, similar position-taking by other market participants, forced liquidations related to margin calls or just by simple trend-following strategies. By contrast, negative feedback or contrarian trading can have a stabilising influence on markets. Intuitively, hedge funds should be more contrarian, as only trading against the crowd can be expected to generate persistent excess profits. However, markets are not completely efficient and trend following can, at times, be lucrative. Managed futures hedge funds (5% of total single hedge fund capital under management) are reportedly cited as utilising trend-following approaches, and this is probably the main factor explaining the negative year-to-date performance in rather range-bounded markets. Other directional strategies – global macro (11%), emerging markets (4%), long/short equity (33%) – can be on both sides of the spectrum, while dedicated short sellers (less than 1%) are probably more contrarians. Event driven (17%), market neutral (relative value and arbitrage) (20%) strategies probably also involve the taking of more contrarian views. Hence, it is very difficult to determine whether hedge funds, on average, are momentum traders or contrarians. Furthermore, there are concerns that as the
number of new hedge funds increases, they may be increasingly attempting to exploit the same market opportunities, possibly relying on similar models. The so-called crowding of positions in this way is another form of momentum trading and could have a destabilising impact on both rising and, especially, falling markets. There are indications that certain strategies, such as convertible arbitrage, have reached capacity limits related to market size. Only funds with new ideas or dealing in fledgling sophisticated markets can continue to deliver alpha. According to market reports, the capacity limits of certain strategies or markets makes essentially limitless foreign exchange markets attractive to hedge funds once again. There are indications, however, that the prevailing concentration in the hedge fund industry is not very high, with currently no hedge fund in the market comparable to the size of LTCM in its heyday. This, together with the fact that there are a larger number of active hedge funds, could also mean that the probability and risks of large crowded trades are lower."

Source: ECB Financial Stability Review 2004 (pdf)