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.

Along with the growth of the hedge-fund sector has come variation that makes generalizations difficult. Hedge funds are private investment pools allowed to operate with a great deal of freedom and flexibility, including having the ability to leverage their assets through borrowing and to bet that stocks will fall as well as rise. Some use intensely mathematical methods; others pursue stock-picking strategies that depend on human judgment about the quality of corporate managers. Some borrow and trade aggressively; others do not. Arbitrage funds take no view on markets' fundamental value but exploit price misalignments between equivalent assets; other funds trade on convictions about value, using various methods of assessing it.

If hedge funds are not actually an army of undifferentiated attack clones, neither are they entirely unregulated, despite the popular image. Like any other investors, hedge-fund managers are subject to prosecution for insider dealing or fraud; they are overseen by the SEC if they have broker or dealer affiliates; they may be regulated by the Commodity Futures Trading Commission if they trade futures or by the Federal Energy Regulatory Commission if they trade energy contracts; their borrowing is indirectly monitored by the Federal Reserve; and so on. Further regulation may or may not be appropriate, but any benefits it might bring would have to be measured against the risks of impeding innovation in the capital markets -- an outcome that would be about as desirable as stifling innovation in Silicon Valley.

Popular resentment of hedge funds begins with the suspicion that they earn too much. The founder-owners of the most successful firms do take home several hundred million dollars annually, much more than top Wall Street executives. Reporting from the epicenter of this gold rush, the Stamford Advocate observed recently that six local hedge-fund managers pocketed a combined $2.15 billion in 2005. Such payouts are the result of hedge funds' unique fee structures, which combine large annual management fees with a share of annual investment profits.

But the sophisticated investors who pay such fees do so voluntarily, because they believe that the returns they will receive will more than compensate for those fees. Hedge-fund managers who do poorly or do not outperform relevant indices will soon have no money left to manage: in 2005, 848 hedge funds went out of business. And high performance fees can be less corrupting than the alternative. Since they rely only on management fees, for example, mutual-fund companies have an incentive to focus on boosting the volume of the money under their management rather than on their investment performance.

The extraordinary earnings of the top hedge-fund managers reflect the workings of a daunting star system. Every year, hundreds of smart analysts sign up to join the industry, just as thousands of aspiring movie stars arrive in Hollywood. Only a few do enough to justify the high fees charged: come up with an insight into how a certain company or currency has been mispriced, see illogical discrepancies between the prices of sets of financial assets, and so forth. And those who do come up with such breakthroughs not only make fortunes for themselves and their clients. By buying irrationally cheap assets and selling irrationally expensive ones, they shift market prices until the irrationalities disappear, thus ultimately facilitating the efficient allocation of the world's capital.

If some are concerned about hedge-fund managers' compensation, others are concerned about their integrity. Arguing for its rule requiring hedge-fund advisers to register themselves and be subject to inspections, the SEC cited 51 fraud cases involving hedge funds between 2000 and 2004 and claimed that at the time of the rule's adoption, in 2004, 400 hedge funds and at least 87 hedge-fund advisers were under investigation.

An industry of around 9,000 hedge funds is indeed bound to harbor some criminals. But insider trading is already illegal, and prosecutors have the tools to go after offenders in hedge funds without new regulations. The number of fraud cases suggests that regulators are not shy about using these powers, and hedge funds regularly experience inquiries from the SEC when they happen to trade heavily in a stock ahead of a price-moving announcement. Moreover, some of what politicians and journalists label "hedge-fund abuses" involve leaks of inside information from investment banks rather than from hedge funds, making the hedge-fund managers who receive the leaks accomplices rather than the chief offenders.

Still other critics attack hedge funds for the consequences of their buying and selling decisions. Thus, Germany's deputy chancellor compared hedge funds to locusts because of their role in hostile takeovers of German companies, and some Britons vilified George Soros because his hedge fund upended the British government's economic policy in 1992. And after the East Asian crisis in the late 1990s, Malaysia's prime minister, Mahathir bin Mohamad, lamented that "all these countries have spent 40 years trying to build up their economies and a moron like Soros comes along with a lot of money to speculate and ruins things."

The common assumption underlying such criticisms is that politicians know and seek the public good, whereas market forces, represented here by hedge funds, seek only profits, without regard to any costs or consequences that might follow. But German politicians' objections to hostile takeovers have little to do with any rational conception of the public good, and a lot to do with their cozy relationship with incumbent captains of industry. And although the European Exchange Rate Mechanism (ERM) may have appealed to British Prime Minister John Major, anxious to differentiate himself from his Europe-bashing predecessor, Margaret Thatcher, his country's membership in the ERM made no economic sense after Germany refused to raise taxes to pay for unification, thus generating interest rates high enough to threaten recession in the United Kingdom. By betting against the pound and helping to destroy the ERM, Soros ended up making money not by economic vandalism but by liberating Britons from their leaders' unsustainable choices. As the economist Melvyn Krauss and the former hedge-fund manager Michael Simoff have written, hedge funds may be a disruptive force -- but they disrupt what needs disrupting.

RISK MANAGEMENT