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.

Hedge funds are sometimes accused of destabilizing capital markets. This is the fear that goes back to the collapse of Long-Term Capital Management: that the implosion of a major hedge fund could be devastating not merely for its investors but for the broader financial system as well. Regulators in both the United States and Europe have expressed some variant of this worry, and not without reason. But the dangers created by hedge funds need to be balanced against the many ways in which the funds actually reduce risk.

Contrary to popular mythology, hedge funds are not precipice dwellers. In the United States and Europe, regulations restrict access to hedge funds to rich individuals and institutions on the theory that the funds are too risky for the average investor. But because most hedge funds hold a portfolio of positions and can go short as well as long -- borrowing stocks and selling them, in the hopes of buying them back after their prices have fallen -- they can be less volatile than individual stocks or standard mutual funds. After the technology bubble burst, investors discovered that holding supposedly sedate stock-index funds could make for a bumpy ride; meanwhile, hedge funds as a group delivered strong positive returns over the period. The best way for large investors to avoid the precipice is to hold a diversified portfolio of investments, in which hedge funds can certainly play a part.

Moreover, hedge funds collectively do not so much create risk as absorb it. The funds can be viewed as quasi insurers; by shouldering risks that others wish to avoid, they remove a potential obstacle to business. For example, banks have to limit their lending for fear that borrowers might default. But hedge funds are willing to buy credit derivatives that transfer the default risk from the banks to themselves -- freeing the banks to finance more economic activity. Similarly, companies may reduce their cross-border activities if there is a limit to the foreign currency exposure they are willing to take on. Hedge funds help to manage that exposure by trading in the currency derivatives that companies use to insure themselves.

Hedge funds can also reduce the danger that economies will overrespond to shocks. If a currency or stock market starts to plummet, the best hope for stability lies in self-confident, deep-pocketed investors willing to bet that the fall has gone too far, and hedge funds are well designed to perform this function. Whereas mutual-fund managers must be cautious about bucking conventional wisdom because the returns they generate are measured against market indices that reflect the consensus, hedge funds are rewarded for absolute returns, which allows their managers to engage in independent thinking. Moreover, many hedge funds have "lock-up" rules that prevent investors from withdrawing money on short notice; when crises strike, the funds have the freedom to be buyers.

This does not mean that they will extend a safety net every time a market falls. But in 1988, the Brady Commission report on the stock-market collapse of the previous year found that hedge funds had been net buyers during the crash. And contrary to Mahathir's fulminations, it was banks that caused the flight of "hot money" from East Asia during the 1997-98 crisis -- with hedge funds being among the first to go back in.

Finally, hedge funds can reduce the chances that markets will rise to unsustainable levels in the first place. Unlike most other investors, they can profit from falls in the market as well as from rises. Their ability to short stocks has given rise to a cottage industry of specialist funds that scour the financial press for glowing corporate profiles and bet against the hype. Hedge-fund managers can make mistakes or fall prey to groupthink, just as anybody else can, but they have greater flexibility and more incentives than other investors to buck trends rather than follow them.

NIGHTMARE ON WALL STREET?

If hedge funds reduce and manage risk in all these ways, what of the systemic risk that concerns regulators? That risk is real -- but restrictions on hedge funds are the wrong way to deal with it.

From a policy perspective, it does not matter if one hedge fund goes down. The fund's investors take a hit, but they were presumably aware of the risks all along. Ordinary citizens may be increasingly exposed to hedge funds via their retirement plans, as Senator Grassley says, but large corporate pension funds allocate on average only about one percent of their assets to hedge funds, so that exposure is trivial. What matters is whether a collapse has knock-on effects, particularly for the banking system more generally.

Banks are exposed to hedge funds in part because they lend to them. When Long-Term Capital Management collapsed in 1998, it emerged that banks had lent it enough to be left with significant losses. But the answer to this problem is not to regulate hedge funds but to do better at supervising the already regulated banks. This is what the Federal Reserve Bank of New York and its European counterparts have done. Since Long-Term Capital Management's collapse, banks have lent hedge funds only money that the banks could afford to lose. In the late 1990s, hedge-fund borrowing peaked at about 2.5 times capital (meaning that every dollar in the sector was supplemented by an additional 2.5 dollars of borrowed money); today, according to JP Morgan, the borrowing amounts to only a little more than the capital in the sector.