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Learning To Love Hedge Funds

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics and Director of the Maurice R. Greenberg Center for Geoeconomic Studies
June 11, 2010
Wall Street Journal

The first hedge-fund manager, Alfred Winslow Jones, did not go to business school. He did not possess a Ph.D. in quantitative finance. He did not spend his formative years at Morgan Stanley, Goldman Sachs or any other incubator for masters of the universe. Instead, he studied at the Marxist Workers School in Berlin, ran secret missions for a clandestine anti-Nazi group called the Leninist Organization and reported on the civil war in Spain, where he hitch-hiked to the front lines in the company of Dorothy Parker. It was only at the advanced age of 48 that Mr. Jones raked together $100,000 to launch a "hedged fund," setting himself up in 1949 in a shabby office on Broad Street. Almost by accident, Mr. Jones improvised an investment structure that will survive for years to come.

Hedge funds account for a huge share of trading in financial markets, and have grown to a scale that would have astonished Mr. Jones, amassing roughly $2 trillion in assets. Success has come with notoriety: the Securities and Exchange Commission is suspicious of hedge funds' fast trading algorithms, which some blame for last month's "flash crash" in U.S. stocks. Reformers in Congress are threatening to bring hedge funds to heel by forcing them to register with the SEC and perhaps to hold more capital. Hedge-fund managers such as Raj Rajaratnam of the Galleon Group are being investigated for insider trading, and recently Art Samberg and his late firm, Pequot Capital Management, settled a complaint with the SEC, agreeing to a fine of $28 million. But although hedge funds are often blamed for excesses, Mr. Jones's investment structure holds the key to a more stable finance, to an extent that Washington's reformers fail to understand.

After the 1929 crash, investors had fled the market in droves, and the bustling brokerages had fallen quiet; it was said that you could walk the famous canyons near the stock exchange and hear only the rattle of backgammon dice through the open windows. The few obstinate souls who opted to work in money management joined firms such as Fidelity and Prudential, which behaved as conservatively as their names implied. But Mr. Jones was cut from different cloth and he reinvented capitalism on Wall Street.

Mr. Jones's hedge fund, like most later hedge funds, embraced four features. To begin with, there was a performance fee. Mr. Jones reserved 20% of the fund's investment gains for himself and his team, invoking the Phoenician sea captains who kept a fifth of the profits from successful voyages. Mr. Jones's portfolio managers hustled harder than rivals at traditional money-management firms: They called more people, crunched more numbers and made decisions faster. At the same time, the Jones men were deterred from taking crazy risks. They were required to keep their own capital in the fund, so that mistakes would cost them personally.

Mr. Jones's second distinguishing feature was a conscious avoidance of regulation. In his previous life as an anti-Nazi agent, Mr. Jones had kept a low profile. As a hedge-fund manager, likewise, Mr. Jones escaped the attention of regulators by never advertizing his fund; he raised capital by word of mouth, which sometimes meant a word between mouthfuls at his dinner table. Unhindered by the government, Mr. Jones expected no help from it either. The Jones men knew that if they mismanaged their risks, their fund would blow up—and nobody would save them.

Thirdly, Mr. Jones embraced short selling. In the 1950s as now, speculating on the prospect of corporate failure was seen as almost un-American. But Mr. Jones described it as "a little known procedure that scares away users for no good reason." By being "short" some stocks, he hedged his "long" investment in others.

By insulating his fund from market swings, Mr. Jones cleared the way for his fourth distinctive practice, which was later to become the most controversial one. Because he had hedged out market risk, he felt free to embrace more stock-specific risk, and so he magnified, or "leveraged," his bets with borrowed money. Between 1949 and 1968, Mr. Jones's partnership earned a cumulative return of just under 5,000%.

Mr. Jones inspired a wave of imitators in the late 1960s, including the compulsive trader Michael Steinhardt, who opened a small operation in 1967, and the Hungarian philosopher-financier George Soros, who started his own Jones-style fund two years later. As the successor hedge funds grew, they ad-libbed their own variations on Mr. Jones's original model. Mr. Steinhardt started out as a long/short stock investor, but he found his niche as a gun-slinging market maker for outsized blocks of stock. He was a human version of today's fast-trading computerized hedge funds—those "flash traders" that excite the SEC's suspicion. Mr. Soros evolved too, triggering a decline in value of foreign currencies from Britain to Thailand by selling them short.

As hedge funds improvised new ways of getting rich, they didn't always need the tools that Mr. Jones had relied on. Julian Robertson's storied Tiger Fund, launched in 1980, began as a faithful imitator of Mr. Jones; but when Tiger negotiated the purchase of the Russian government's entire stock of nongold precious metals in 1998, leverage mattered less than the security around the train that was to bring the palladium from Siberia. Four years later, a swashbuckling West Coast fund named Farallon swooped into Indonesia and bought the controlling stake of the country's largest bank. The chief ingredient for this trade was neither hedging nor leverage but nerves—Indonesia had recently experienced a currency collapse and a political revolution.

Light regulation has allowed Mr. Jones's descendants to seize opportunities as they arise—when Farallon was not buying a bank in Indonesia, it was speculating on corporate mergers, distressed debt or a water project in Colorado. Equally, the freedom to go long and short has permitted hedge funds to express investment views with precision. Rather than simply buying a stock or a bond whose performance will reflect currency shifts, interest rates, trends in the broad market, and so on, a hedge fund can hedge out the risks on which it has no view, isolating the particular risk on which it has a real insight.

In the 1960s, the Jones men would show up at the office of the Securities and Exchange Commission to read key releases the moment they came out, stealing a march on sleepier rivals who waited for the information to arrive in the mail. In the 1980s, likewise, Julian Robertson maintained two giant Rolodexes; when compromised Wall Street salesmen pitched a buy recommendation his way, he would pump information out of his network to get the real story on the company. Once, when a Robertson lieutenant heard that a car maker's latest model was prone to break down, he bought two of the suspect vehicles and had them independently tested. When the mechanic confirmed there was an engine flaw, Tiger took a short position in the manufacturer.

Other hedge-fund innovations have been bracingly complicated. James Simons, who emerged as the industry's top earner in the past decade, built his fortune on mathematics, particularly the sort used in military cryptography. By discerning patterns in price movements that were invisible to others, his team constructed a black box that earns billions of dollars annually.

Because they are largely free of regulatory impediments, and because their reward structure has attracted the best brains, hedge funds have continued in the Jones tradition of outperforming rivals. Whereas mutual-fund managers, as a group, do not beat the market, the best analysis suggests that hedge funds deliver value to their clients. In a series of papers, Roger Ibbotson of the Yale School of Management has examined the performance of 8,400 hedge funds between 1995 and 2009. After correcting for various biases in the data, and after subtracting hedge funds' large fees, Mr. Ibbotson and his co-authors conclude that the average fund generates positive "alpha"—that is, profits that could not be earned from exposure to a market index. In the United States, only rich individuals and institutions are allowed to reap the benefits of hedge funds. But in Europe and Asia, they are increasingly marketed to ordinary savers.

Of course, neither endowments nor individuals should put all their money in hedge funds; like any investment, they can blow up spectacularly. The most famous hedge-fund collapse came in 1998, when Long-Term Capital Management lost almost $6 billion. Eight years later, a Ferrari-driving 32-year-old trader at a fund called Amaranth lost $6 billion on disastrous gas bets; a year after that, several quantitative funds hit trouble all at once, setting off a panic known as the "quant quake."

But even these exceptions to hedge funds' generally good performance serve to underline one of their virtues. When Amaranth failed, another hedge fund named Citadel swooped in to buy the remains of its portfolio—one hedge fund had caught fire, but a second stabilized markets by acting as the fireman, and taxpayers did not have to cover any of the losses. Likewise, the quant quake of 2007 was over even before the public realized it had begun. The one partial exception was Long-Term Capital, whose failure was destabilizing enough to cause the New York Fed to broker a $3.6 billion rescue. But even in this case, public resources played no part in the bailout: The Fed convened Long-Term's bankers and told them to cough up the money to stabilize the fund.

The independent culture of hedge funds stood them in good stead during the recent mortgage bust. Spurred by the carrot of the performance fee, a then-obscure manager named John Paulson created a $2 million budget to buy the largest mortgage database in the country and hire extra analysts to figure out patterns in default rates. Meanwhile, because of the stick of having their own savings at risk, hedge funds that did not undertake similar research at least had the wit to avoid buying subprime paper. Lazier investors piled into collateralized debt obligations on the strength of their triple-A seal of approval. But most hedge funds were too careful to rely on the advice of ratings agencies.

In 2007, the year the mortgage bubble burst, hedge funds were up 10%—not bad for a crisis. Even more remarkably, the subgroup of hedge funds specializing in mortgages and other asset-backed securities was flat for the year—in other words, the hedge funds that might have been expected to get hit generally dodged the bullet. In 2008, admittedly, the turmoil following the collapse of Lehman Brothers hurt hedge funds' returns. But even then, they did better than their peers. They were down 18 % by the end of the year, a decline half as severe as that of the stock market.

The real humiliation of 2008 did not befall hedge funds. It befell banks, insurers, government-chartered housing lenders, and money market funds—and especially the mightiest of all Wall Street titans: investment banks. Until the financial crisis, the brain-power of these behemoths was presumed to be the force that made global markets work. If you were impertinent enough to ask how trillions of dollars of exotic trades could slosh across borders without risking a breakdown, the answer was that Lehman Brothers and its ilk had designed the instruments, modeled the risks, and had all bases covered.

Now that this answer has been exposed as a lie, the puzzle is how to erect a new scaffolding for global finance. The leading answer in Washington, expressed in the reform package emerging from Congress, is to regulate the investment banks and other traditional risk takers. This is a worthy project that must be attempted, but it would be naïve to expect too much from it. The crisis proved the fallibility of regulators from the Securities and Exchange Commission to the respected Financial Services Authority in London to the highly professional Federal Reserve. When multiple overseers fail in multiple places, one must accept that even smart reforms may not change the pattern decisively.

The crisis also demonstrated flaws in large financial firms. These start with the too-big-to-fail problem. Large banks cannot be allowed to go down; knowing that, their creditors lend without monitoring their risks; as a result, their risk-taking is undisciplined. At the same time, each trading desk within a large banking supermarket has strong reason to load up on risk. If its bets come good, huge bonuses will ensue. If they go bad, the losses will be spread across the whole institution.

Given the difficulties with financial reform, legislators should embrace a complementary approach: As well as struggling to tame financial behemoths, they should promote boutique risk takers. With only a few exceptions, hedge funds have the powerful virtue of being small enough to fail; indeed, some 5,000 went out of business in the course of the past decade, and none imposed losses on taxpayers. Mythology notwithstanding, the average hedge fund's leverage is more sober than that of banks and investment banks.

The question for policy-makers is what kind of financial institution will absorb risk most efficiently—and do so without a backstop from taxpayers. The answer awaits discovery in the story of A.W. Jones and his descendants. The future of finance lies in the history of hedge funds.

This article appears in full on CFR.org by permission of its original publisher. It was originally available here.

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