THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 337

CHAPTER 12

Nonbank Financial Institutions

305

Money Market
Mutual Funds

An important addition to the family of mutual funds resulting from the financial
innovation process described in earlier chapters is the money market mutual fund.
Recall that this type of mutual fund invests in short-term debt (money market)
instruments of very high quality, such as treasury bills, commercial paper, and
bank certificates of deposit. There is some fluctuation in the market value of these
securities, but because their maturity is typically less than six months, the change
in the market value is small enough that these funds allow their shares to be
redeemed at a fixed value. Changes in the market value of the securities are figured into the interest paid out by the fund.
In the United States, many money market mutual funds allow their shareholders to redeem shares by writing cheques on the funds account at a commercial
bank. In this way, shares in money market mutual funds effectively function as
chequable deposits that earn market interest rates on short-term debt securities.
For this reason, in the United States the share of money market mutual funds in
total financial intermediary assets has increased to nearly 6% and currently money
market mutual funds account for around one-quarter of the asset value of all
mutual funds.

Hedge Funds

Hedge funds are a special type of investment fund, with estimated assets of more
than $1 trillion. Hedge funds have received considerable attention recently due to
the shock to the financial system resulting from the near collapse of Long-Term
Capital Management, once one of the most important hedge funds (see the FYI

box, The Long-Term Capital Management Debacle). Well-known hedge funds in
the United States include Moore Capital Management and the Quantum group of
funds associated with George Soros. Investors in hedge funds, who are limited
partners, give their money to managing (general) partners to invest on their behalf.
Several features distinguish hedge funds from mutual funds. Hedge funds have a
minimum investment requirement between $100 000 and $20 million, with the typical minimum investment being $1 million. Long-Term Capital Management
required a $10 million minimum investment. In the United States, federal law limits hedge funds to have no more than 99 investors (limited partners) who must
have steady annual incomes of $200 000 or more or a net worth of $1 million,
excluding their homes. These restrictions are aimed at allowing hedge funds to be
largely unregulated, on the theory that the rich can look out for themselves. Many
of the 4000 U.S. hedge funds are located offshore to escape regulatory restrictions.
Hedge funds also differ from traditional mutual funds in that they usually
require that investors commit their money for long periods of time, often several
years. The purpose of this requirement is to give managers breathing room to pursue long-run strategies. Hedge funds also typically charge large fees to investors.
The typical fund charges a 2% annual fee on the assets it manages plus 20% of
profits.
The term hedge fund is highly misleading because the word hedge typically
is used to indicate strategies to avoid risk. As the near failure of Long-Term Capital
illustrates, despite their name, these funds can and do take big risks. Many hedge
funds engage in what are called market-neutral strategies where they buy a
security, such as a bond, that seems cheap and sell an equivalent amount of a
similar security that appears to be overvalued. If interest rates as a whole go up
or down, the fund is hedged because the decline in value of one security is
matched by the rise in value of the other. However, the fund is speculating on
whether the spread between the prices on the two securities moves in the direction predicted by the fund managers. If the fund bets wrong, it can lose a lot of