Michael Douglas in Wall Street: bankers, not hedge-fund managers, are the villains
Hedge funds are the bogeymen of international finance. In the past two years they have been denounced for destroying Bear Stearns and Lehman Brothers, taking the entire financial system to the edge of a precipice. They now stand charged by European politicians with threatening the very existence of the euro. Ministers talk openly of a destructive hedge-fund “wolfpack” and call for legislation to curb it. Regulators have long worried that a hedge-fund collapse might damage the financial system. Their ability to move markets has infuriated politicians: Malaysia’s former prime minister, Mahathir Mohamad, once called the hedge-fund manager George Soros a “criminal” for speculating against Asian currencies. When hedge funds shorted the French franc shortly after dumping Britain out of the exchange rate mechanism in 1992, French finance minister Michel Sapin called for speculating traders to be guillotined. It is easy to see why these private investment funds—which now number about 9,000, control a staggering $1.6 trillion of investors’ money, and dominate great chunks of the global financial markets—attract such attention. Their freedom to take big positions in securities round the globe endows them with a glamour that most conventional fund managers must envy. And then there is the money. The famous “two and 20” fee structure (they charge investors an annual fee of 2 per cent of the portfolio value, plus a fifth of any profits they make) has made some of their managers obscenely rich. When the Croesus-like US financier John Pierpont Morgan died in 1913, his fortune was $1.4bn in today’s money. In 2006, three hedge-fund bosses reputedly earned more than $1bn in one year alone. Top “hedgies” are the rock stars of the financial world, their art collections and marriages chronicled breathlessly in the glossy magazines. But are they the destructive force they are sometimes made out to be? The case for curbing hedge funds rests on the idea that they are reckless institutions whose risk-taking activities imperil the financial system. Yet a persuasive new history of hedge funds, Sebastian Mallaby’s More Money Than God, challenges the assumptions underlying the “wolfpack” charge. At the beginning of the hedge-fund movement, during the stock market boom following the second world war, funds were obsessed with controlling risk—far more so than the modern investment banks that dominate the City and Wall Street. When Alfred Winslow Jones, the founder of the sector, designed the first fund in 1948, he developed statistical methods to manage the risk of picking the wrong stocks, such as charting the volatility of shares and tracking his performance against the market. He wasn’t always right, but the controls prevented blow-ups. Not all subsequent funds have had Jones’s acute risk awareness. Indeed, some have been reckless. The first big blow-up—the collapse of Askin Capital Management in 1994—came when interest rate rises caused the mortgage-backed securities it had borrowed heavily to buy to fall drastically in value. Others have been more thoughtful but failed to see other pitfalls, such as Long Term Capital Management, a super-highly leveraged fund that collapsed spectacularly during 1998’s Russian debt crisis. But modern hedge funds have learned from such mistakes. Perhaps because they are not shielded from losses by taxpayers as banks are (and because hedgies stake their own money alongside that of outsiders), they are more careful about risk. There is less leverage in their system, and their risk management is smarter. That’s not to say that hedge funds don’t take losses. One of the world’s biggest funds, Citadel, lost $9bn of investors’ money during the credit crunch. Yet here was a case where investors who had made returns in the good times took the pain when things went wrong. This is surely much healthier than what happened with the Wall Street investment banks, where taxpayers stepped in, protecting investors from their folly and socialising the losses. Of course, the charge that they threaten financial stability is not the only one laid at the hedge funds’ door. They have been accused of other crimes—such as shorting stocks speculatively and of lacking transparency. But most of these are bunk. Shorting is not a crime, but a way of keeping markets liquid and steering securities that are trading irrationally (remember the dotcom boom?) back towards their true value. As for transparency, while investors in a hedge fund are entitled to know what strategies it is pursuing (remember Madoff?), a leveraged hedge fund that told everyone what it was doing would not last long. European politicians who call for more regulation are barking up the wrong tree. Unlike the banks, hedge funds do not have a “too big to fail” problem. Tougher regulation might actually create one, by forcing umpteen nimble little funds to merge into cumbersome behemoths. Rather than go down that route, Sebastian Mallaby argues that the better course might be to let largely unregulated hedge funds manage more of the risk in the financial system—not less. Indeed they are already moving in this direction: funds like Citadel increasingly handle big financial transactions of the sort that were the exclusive property of Wall Street banks a few years ago. Such a development might actually reduce moral hazard—and result in fewer blow-ups. It’s an enticing and believable vision. The hedge-fund titans, with their mansions and private jets, may not seem very appealing. But at least they pay their way without taxpayers’ help. Better the bogey men than Wall Street’s vampire squids.
Hedge funds are the bogeymen of international finance. In the past two years they have been denounced for destroying Bear Stearns and Lehman Brothers, taking the entire financial system to the edge of a precipice. They now stand charged by European politicians with threatening the very existence of the euro. Ministers talk openly of a destructive hedge-fund “wolfpack” and call for legislation to curb it. Regulators have long worried that a hedge-fund collapse might damage the financial system. Their ability to move markets has infuriated politicians: Malaysia’s former prime minister, Mahathir Mohamad, once called the hedge-fund manager George Soros a “criminal” for speculating against Asian currencies. When hedge funds shorted the French franc shortly after dumping Britain out of the exchange rate mechanism in 1992, French finance minister Michel Sapin called for speculating traders to be guillotined. It is easy to see why these private investment funds—which now number about 9,000, control a staggering $1.6 trillion of investors’ money, and dominate great chunks of the global financial markets—attract such attention. Their freedom to take big positions in securities round the globe endows them with a glamour that most conventional fund managers must envy. And then there is the money. The famous “two and 20” fee structure (they charge investors an annual fee of 2 per cent of the portfolio value, plus a fifth of any profits they make) has made some of their managers obscenely rich. When the Croesus-like US financier John Pierpont Morgan died in 1913, his fortune was $1.4bn in today’s money. In 2006, three hedge-fund bosses reputedly earned more than $1bn in one year alone. Top “hedgies” are the rock stars of the financial world, their art collections and marriages chronicled breathlessly in the glossy magazines. But are they the destructive force they are sometimes made out to be? The case for curbing hedge funds rests on the idea that they are reckless institutions whose risk-taking activities imperil the financial system. Yet a persuasive new history of hedge funds, Sebastian Mallaby’s More Money Than God, challenges the assumptions underlying the “wolfpack” charge. At the beginning of the hedge-fund movement, during the stock market boom following the second world war, funds were obsessed with controlling risk—far more so than the modern investment banks that dominate the City and Wall Street. When Alfred Winslow Jones, the founder of the sector, designed the first fund in 1948, he developed statistical methods to manage the risk of picking the wrong stocks, such as charting the volatility of shares and tracking his performance against the market. He wasn’t always right, but the controls prevented blow-ups. Not all subsequent funds have had Jones’s acute risk awareness. Indeed, some have been reckless. The first big blow-up—the collapse of Askin Capital Management in 1994—came when interest rate rises caused the mortgage-backed securities it had borrowed heavily to buy to fall drastically in value. Others have been more thoughtful but failed to see other pitfalls, such as Long Term Capital Management, a super-highly leveraged fund that collapsed spectacularly during 1998’s Russian debt crisis. But modern hedge funds have learned from such mistakes. Perhaps because they are not shielded from losses by taxpayers as banks are (and because hedgies stake their own money alongside that of outsiders), they are more careful about risk. There is less leverage in their system, and their risk management is smarter. That’s not to say that hedge funds don’t take losses. One of the world’s biggest funds, Citadel, lost $9bn of investors’ money during the credit crunch. Yet here was a case where investors who had made returns in the good times took the pain when things went wrong. This is surely much healthier than what happened with the Wall Street investment banks, where taxpayers stepped in, protecting investors from their folly and socialising the losses. Of course, the charge that they threaten financial stability is not the only one laid at the hedge funds’ door. They have been accused of other crimes—such as shorting stocks speculatively and of lacking transparency. But most of these are bunk. Shorting is not a crime, but a way of keeping markets liquid and steering securities that are trading irrationally (remember the dotcom boom?) back towards their true value. As for transparency, while investors in a hedge fund are entitled to know what strategies it is pursuing (remember Madoff?), a leveraged hedge fund that told everyone what it was doing would not last long. European politicians who call for more regulation are barking up the wrong tree. Unlike the banks, hedge funds do not have a “too big to fail” problem. Tougher regulation might actually create one, by forcing umpteen nimble little funds to merge into cumbersome behemoths. Rather than go down that route, Sebastian Mallaby argues that the better course might be to let largely unregulated hedge funds manage more of the risk in the financial system—not less. Indeed they are already moving in this direction: funds like Citadel increasingly handle big financial transactions of the sort that were the exclusive property of Wall Street banks a few years ago. Such a development might actually reduce moral hazard—and result in fewer blow-ups. It’s an enticing and believable vision. The hedge-fund titans, with their mansions and private jets, may not seem very appealing. But at least they pay their way without taxpayers’ help. Better the bogey men than Wall Street’s vampire squids.
