Hands Off Hedge Funds

Sebastian Mallaby

From Foreign Affairs, January/February 2007

Summary:  The massive growth of hedge funds has sparked warnings of instability and demands that the industry be regulated. But the fear of hedge funds is overblown, based on a misunderstanding of their role in the international financial system. In reality, hedge funds do not increase risk; they manage it -- and policymakers, rather than clamping down, should make sure hedge funds have the tools to perform this function well.

Sebastian Mallaby is a Washington Post columnist and the author of The World's Banker: A Story of Failed States, Financial Crises, and the Wealth and Poverty of Nations.

LOCUSTS OR FIRE FIGHTERS?

Imagine two successful companies. Both are staffed by very smart people; both are innovative; both have an impact far beyond their industry, improving the productivity of the capitalist system as a whole. But the first, based near San Francisco, is the subject of adoring newspaper profiles, whereas the second, based in the New York area, is usually vilified.

Actually, you do not have to imagine any of this, because it describes a double standard that already exists. The first company in the story is a technology firm; the second is a hedge fund. As any newspaper reader knows, technology firms are the leading edge of the U.S. knowledge economy; they made possible the productivity revolution of the past decade. But the same could just as well be said of hedge funds, which allocate the world's capital to the companies, industries, and countries that can use it most productively.

Of course, that is not how hedge funds are viewed most of the time. The recent implosion of Amaranth Advisors -- a hedge fund that lost $6 billion in a matter of days thanks to one Ferrari-driving 32-year-old trader (and his greedy bosses' abandonment of proper risk management) -- has rekindled the fears that attended the collapse of Long-Term Capital Management in 1998, an event that even then Federal Reserve Chair Alan Greenspan believed "could have potentially impaired the economies of many nations, including our own."

In the United States, the Securities and Exchange Commission (SEC) has tried to regulate the sector further -- a 2004 SEC rule requiring the registration of hedge-fund advisers was vacated by a federal court in 2006 -- and continues to be interested in increasing oversight. The attorney general of Connecticut, a state in which many hedge funds are headquartered, has set up a special unit to prosecute hedge-fund abuses and decries what he regards as the "regulatory black hole" in which these funds exist. In East Asia, governments still blame hedge funds for their supposed role in the 1997-98 financial crisis. And in Europe, Franz Müntefering, Germany's deputy chancellor, has complained that hedge funds "remain anonymous, have no face, fall like a plague of locusts over our companies, devour everything, then fly on to the next one."

Such antipathy seems likely only to intensify as hedge funds continue their extraordinary growth. In the eight years since Long-Term Capital collapsed, the volume of money managed by U.S. hedge funds has risen from about $300 billion to well over $1 trillion, according to HedgeFund Intelligence. In Europe and Asia, meanwhile, assets under hedge-fund management have grown to $325 billion and $115 billion, respectively, and London has emerged as a hedge-fund center second only to the New York area. The total assets in the hedge-fund sector remain much smaller than those in banks and pension funds. But whereas hedge-fund assets have quintupled in eight years, the world's stock of equities, tradable debt, and bank deposits has only doubled, according to data from the McKinsey Global Institute. Moreover, because the sector as a whole is leveraged and some funds trade intensively, hedge funds are thought to account for a third of the turnover in U.S. equities and an even higher share in more exotic financial instruments.

The fear of the growing influence of hedge funds is compounded by the aura of mystery that surrounds them. Whereas financial markets thrive on transparency, hedge funds are limited in what they can disclose to the public at large. They are sold through privately distributed prospectuses that describe the funds' investment parameters, terms of investment, redemption rules, and the like. But even some of the fund-of-funds managers who have emerged as expert intermediaries between hedge funds and investors have only a general idea of the trading strategies that some of their component funds pursue.

The suspicion is pervasive enough to make a new regulatory push seem probable. This past October, Senator Chuck Grassley (R-Iowa), the outgoing chair of the Senate Finance Committee, complained in a letter to Treasury Secretary Henry Paulson that ordinary Americans are increasingly exposed to hedge funds via their pension plans and demanded to know why the funds are allowed to get away with secrecy. Press coverage is suffused with the supposition that more regulation would be welcome, and even an October survey of private economists conducted by The Wall Street Journal found that a majority favored tougher oversight. Industry leaders who once might have urged regulators to leave them alone now plead instead only that restrictions should avoid being too onerous. And European regulators are as keen to subject hedge funds to controls as their American counterparts.

But the fear of hedge funds is overblown, based more on ignorance or simplistic caricatures than on actual knowledge. Many of the proposals for new regulation are so vague as to be impossible to evaluate or are poorly suited to address the supposed problems at issue. And even the most serious cause for concern -- that hedge-fund operations might generate a "systemic risk" for the financial system as a whole -- is neither limited to the hedge-fund sector nor best addressed through regulation of it. Rather than seeing hedge funds as sources of dangerous financial fires, in fact, it is more accurate to see them as the financial system's benevolent fire fighters -- and to let them have the tools they need to do their jobs well.

MYTHS AND FACTS