More Money Than God_Hedge Funds and the Making of a New Elite

by Sebastian Mallaby

Even if the average actively managed mutual fund is a rip-off, there is still a fair question as to whether hedge funds are better. This book has described the many ways hedge funds make money: by trading against central banks that aren’t in the markets for a profit; by buying from price-insensitive forced sellers; by taking the other side when big institutions need liquidity; by sensing all kinds of asymmetrical opportunities. It stands to reason that talented investors, free of the institutional impediments that constrain rivals, and powerfully motivated by performance fees, can rack up impressive profits—even when they pursue conceptually simple stock-picking strategies like those of the Tiger cubs, discussed in the appendix. But in its focus on the pioneers who shaped the industry, a history of hedge funds is necessarily biased toward winners. Perhaps the average hedge fund that attempts these strategies loses money? Or perhaps whatever alpha it makes is gobbled up by those performance fees?

  The answer to these reasonable questions will continue to be debated. Hedge funds generate returns partly by taking exotic types of risk; because these are difficult to measure, a precise verdict on the size of hedge funds’ risk-adjusted returns is bound to be elusive. As a group, funds-of-funds report returns that are lower than the returns reported by the hedge funds in which they invest; the gap is larger than can be explained by fees, suggesting that reported hedge-fund returns are frequently exaggerated. Nevertheless, the tentative bottom line on hedge-fund performance is surprisingly positive.

  The best evidence comes in the form of a paper by Roger Ibbotson of the Yale School of Management, Peng Chen of Ibbotson Associates, and Kevin Zhu of the Hong Kong Polytechnic University.8 The authors start with performance statistics for 8,400 hedge funds between January 1995 and December 2009. Then they correct for “survivorship bias”: If you just measure the funds that exist at the end of the period, you exclude ones that blew up in the meantime—and so overestimate average performance. Next, the authors tackle “backfill bias”: Hedge funds tend to begin reporting results after a year of excellent profits, so including those atypical bonanzas makes hedge funds appear unduly brilliant. Having made these adjustments, the authors report that the average hedge fund returned 11.4 percent per year on average, or 7. 7 percent after fees—and, crucially, that the 7. 7 percent net return included 3 percentage points of alpha. So hedge funds do seem to generate profits beyond what they get from exposure to the market benchmarks. And despite much griping about excessive hedge-fund fees, there is alpha left over for clients.

  One final comparison seems worthwhile: How do hedge funds stack up against their rivals in private equity? The two vehicles are both loosely described as “alternatives” by the investment industry, and they have some things in common: They are structured as private partnerships; they use leverage; they charge performance fees. Increasingly, private-equity companies have started hedge funds, and vice versa, further blurring the distinction. And yet the promise to investors is fundamentally different. Hedge funds aim to buy securities or currencies that the market has mispriced: They play a game of numbers and psychology. Private-equity funds promise to improve the performance of individual firms. They install new chief executives and get their hands on the controls, revamping everything from advertising budgets to middle-management incentives. Their claim is not that securities are mispriced but that management can be improved by an intelligent owner.

  So can it? Much as with hedge funds, you have to separate beta and alpha. By owning a portfolio of unlisted companies, private-equity funds deliver exposure to corporate profits that resembles the exposure from a stock-market index: This is the beta in their performance. The hope is that the funds can justify their fees by doing better than that—by beating the index and generating alpha. As it turns out, the academic verdict is positive for private-equity funds that specialize in venture capital, but ambiguous for buyout funds that take public companies private. Using various methodologies, three influential studies have found that venture capitalists generate alpha of around 4 to 5 percent per year, whereas buyout funds appear to generate returns that are little different from the S&P 500 benchmark.9 Moreover, private-equity funds have a clear disadvantage relative to hedge funds. They demand that investors commit capital for as much as a decade.

  Of course, hedge funds are not a substitute for other investment vehicles. For ordinary savers, mutual funds that cheaply mimic an index remain the best option. But from the point of view of large investors, hedge funds compare well with most of their rivals. They are not more prone to insider trading or fraud, and they deliver real value for their clients. “Where are the customers’ yachts?” the author Fred Schwed demanded in his classic account of Wall Street. To which the response is: Ask Harvard! Ask Yale! Their endowments returned, respectively, 8.9 percent and 11.8 percent annually between 1999 and 2009—and this despite the losses in the credit crisis. Hedge funds are a major reason why universities can afford more science facilities and merit scholarships, and why philanthropies from the Open Society Institute to Robin Hood have more money to give out. And if hedge funds also serve rich clients well, thereby contributing to the troubling gap in modern society between the superwealthy and the rest, the answer is not to smother their trading. It is progressive taxation.

  IF HEDGE FUNDS ARE GOOD FOR THEIR CLIENTS, WHAT other arguments point in favor of regulating them? A long-standing line of criticism focuses on trend-following hedge funds, which allegedly drive prices to illogical extremes, destabilizing economies. What merit might there be in this objection?

  The first thing to be said is that most hedge funds make money by driving prices away from extremes and toward their rational level. This is what arbitrage funds do, including the fast-trading statistical arbitrage funds that are frequently excoriated. Equally, when a Julian Robertson–style stock picker buys underpriced companies and shorts overpriced ones, he is moving stocks closer to the level that reflects the best estimate of their value, helping to allocate capital to the firms that will use it most productively. Likewise, commodity traders who respond quickly to news of gluts and shortages tend to stabilize markets, not deepen the panic, because their responses generate price signals that force healthy adjustment. When a commodity trader bids up the oil price on the news of a coup in Africa, he is telling the world’s motorists to economize before unsustainable consumption pushes prices up even more sharply.

  Still, it clearly is true that markets sometimes overshoot, and that trend-following hedge funds can contribute to this problem. Warning motorists to ease up on the gas pedal is a good thing when there is a real oil shortage, but if hundreds of traders jump on the bandwagon and push oil prices needlessly far, they are merely hurting consumers and companies and setting up the market for a destabilizing correction. In 2007, for example, investors pushed the price of a barrel of crude up from $61 to $96, which was probably a fair response to booming demand in emerging markets. But in the first half of 2008, oil rose to $145—a level that probably exceeded anything that was justified by the fundamentals. In the same way, currency traders are sometimes sending rational signals and sometimes driving currencies to irrational extremes. The Soros-Druckenmiller sterling trade fits into the rational category: Germany’s postunification commitment to high interest rates made the sterling peg untenable. So does Thailand’s 1997 devaluation: The country’s growing trade deficit was incompatible with its pegged exchange rate. But clearly there are also times when the currency market overshoots. In 1997, Indonesia was running a small trade deficit and a flexible exchange rate, yet it suffered a far bigger devaluation than Thailand because political instability sent the markets into a panic.

  If trend-following can be destructive, could hedge-fund regulation dampen it? Of course, restrictions on hedge funds would limit contrarian trend-bucking as well as trend-following trading, and there are no data to prove what the effect would be on balance. But despite the proud tradition of trend-following hedge funds from Commodities Corporation to Paul Tudor Jones, hedge-fund regulation would pro
bably exacerbate the markets’ tendency to overshoot. Because of the way they are structured, hedge funds are more likely to be trend bucking than other types of investors.

  Hedge funds combine three features that equip them to be contrarian. First, they are free to go short as well as long, unlike some other institutional investors. Second, they are judged in terms of absolute returns; by contrast, mutual-fund managers must be cautious about bucking the conventional wisdom, because their performance is measured against market indices that reflect the consensus. Third, hedge funds have performance fees. To muster the self-confidence to be a trend bucker, you have to invest heavily in research, and performance fees generate the resources and incentives to do that. John Paulson did not develop the conviction to face off against the mortgage-industrial complex without spending serious money on homework. He purchased the best database on house-price statistics, commissioned a technology company to help him warehouse it, and hired extra analysts to interpret the numbers.

  Even a self-described trend follower such as Paul Jones underlines the contrarian potential of hedge funds. Jones is a trend follower because he knows that contrary to the efficient-market view, investors frequently react to information gradually. Pension funds, insurance funds, mutual funds, and individuals all absorb developments on their own timescales, so prices respond incrementally rather than in one jump. But precisely because he understands the markets’ momentum, Jones has a knack for sensing when it has gone too far. He is the last person to exacerbate a trend, because once a move becomes overextended, he is looking to profit from its reversal. That is why he bet against the trend on Wall Street by shorting the market on the eve of the 1987 crash. That is why he did the same in Tokyo in 1990. And in the summer of 2008, as it happens, Jones saw that the oil market was overheated too. “Oil is a huge mania,” he declared in a magazine interview a few weeks before the bubble burst. “It is going to end badly.”10 When a trend begins to distort the economy because it has lost touch with fundamentals, the most famous hedge-fund trend follower of them all is likely to become a trend breaker.

  The same can be said for hedge funds in general. In Europe’s exchange-rate crisis, Soros and Druckenmiller did not simply lead an attack pack of trend followers against every currency indiscriminately. On the contrary, they actually made money betting that the French franc would resist pressure for devaluation. Equally, during the crisis in East Asia, hedge funds helped to precipitate devaluation in Thailand, because the trade deficit made the peg illogical. The crazy crash of the rupiah was driven not by hedge funds but by Indonesians who were rushing to expatriate their money. Far from jumping on that bandwagon, the Soros team pushed back against it unsuccessfully. Ultimately, another hedge fund, Tom Steyer’s Farallon, helped to begin Indonesia’s turnaround with its contrarian purchase of Bank Central Asia.

  The point is not that hedge funds are never guilty of herding—clearly there are times when they are. In 1993 Michael Steinhardt rode a red-hot bond market into bubble territory; the next year he paid heavily. But the point is that, because of their structure and incentives, hedge funds are more likely to be contrarian than other types of investors. The regulatory lesson is contrarian too. The best way to dampen trend following is not to constrain hedge funds. It is to let them go about their business.

  IN SUM, HEDGE FUNDS DO NOT APPEAR TO BE ESPECIALLY prone to insider trading or fraud. They offer a partial answer to the too-big-to-fail problem. They deliver value to investors. And they are more likely to blunt trends than other types of investment vehicle. For all these reasons, regulators should want to encourage hedge funds, not rein them in. And yet there is one persuasive argument for regulating hedge funds—or rather, regulating some of them.

  The persuasive argument is that hedge funds are growing. The case in favor of hedge funds is a case for entrepreneurial boutiques; when hedge funds cease to be small enough to fail, regulation is warranted. Equally, when hedge funds become public companies, they give up the private-partnership structure that has proved so effective in controlling risk: Again, the case for regulation becomes stronger. Even though some five thousand hedge funds failed between 2000 and 2009, and even though none of them triggered a taxpayer bailout, the Long-Term Capital experience serves as a warning. No public money subsidized Long-Term’s burial. But the Fed was sufficiently concerned to convene the undertakers.

  How large does a hedge fund have to be to warrant regulation? Unfortunately, there is no simple answer. The systemic consequences of a hedge fund’s failure depend on when it occurs. Part of the reason why LTCM triggered the intervention of the Fed was that it happened at a time when markets were already running scared in the wake of Russia’s default. By contrast, part of the reason why Amaranth’s failure had no systemic consequences was that it came at a time when Wall Street was comfortably awash in easy money. Still, even though it’s impossible to know in advance whether the failure of a given hedge fund would trigger government intervention, there are three major clues to the answer: the size of its capital, the extent of its leverage, and the types of markets that it trades in.

  Consider the case of LTCM. On the first test—size of capital—it looked unthreatening: At a bit under $5 billion, its capital was half the size of Amaranth’s. The second test, however, raised a forest of red flags: LTCM was leveraged twenty-five times, meaning that its sudden collapse would cause $120 billion worth of positions to be unloaded on the markets; and the fund’s derivative positions created another $1.2 trillion of exposure. Finally, some of the markets in which LTCM traded were esoteric and illiquid, so that a fire sale by LTCM could cause them to freeze up completely. The combination of these considerations caused the Fed’s Peter Fisher to get involved in LTCM’s burial. The lesson is that, as of 1998, a $120 billion portfolio attached to an enormous derivatives book was large enough to trigger regulatory concern, given the additional conditions of post-Russia panic and the fund’s participation in illiquid markets.

  Now consider the precedents from 2006–2008. In the case of Amaranth, the three tests would have correctly predicted that the fund’s collapse would not cause a problem. With capital of $9 billion, Amaranth was a large but not enormous hedge fund. Its leverage was normal, so its total portfolio was smaller than LTCM’s. And its disastrous natural-gas trades were nearly all conducted on exchanges, meaning that they could be liquidated easily. In sum, there were no red flags in any of the three categories, so it is not surprising that Amaranth’s failure generated more newspaper headlines than shocks to the financial system. Similarly, the three tests would have predicted the systemic insignificance of Sowood’s collapse the following year: A $3 billion fund with leverage in the normal range is plenty small enough to fail, particularly when its troubles are concentrated in the relatively liquid corporate bond market.

  The two most revealing lessons of this period come from the quant quake of 2007 and Citadel’s near failure a year later. In both cases, the first two tests would have raised a red flag. As a group, the quant funds deployed at least $100 billion of capital in the strategies that went wrong, and were leveraged about eight times, producing a combined superportfolio of at least $800 billion. Likewise, Citadel had $13 billion in capital and was leveraged eleven times, producing a portfolio of $145 billion, not counting derivatives positions. Yet although their total exposure was worrisomely large, neither the quant funds nor Citadel proved systemically important, because they passed the third test with flying colors. The quant funds traded exclusively in superliquid equity markets, so when the crisis came they could cut leverage rapidly. Citadel, for its part, had a big book of over-the-counter transactions with other firms that could potentially be difficult to exit. But to the extent that Citadel held these illiquid positions, it took pains to lock up medium-and long-term borrowing to back that portion of its portfolio—it managed its liquidity as LTCM had tried to do, but more successfully. By backing investments that could not be sold instantly with loans that could not be yanked instantly either,
Citadel avoided tumbling into a death spiral of forced selling in illiquid markets. The lesson is that portfolios above a certain threshold may prompt regulatory concern; but if regulators are satisfied that the firm’s liquidity is well managed, they should leave it to go about its business.

  These experiences suggest a tiered series of regulatory responses. When a hedge-fund company builds up total leveraged assets of more than, say, $120 billion, it should undergo regulatory cross-examination about the size of its derivatives positions and its liquidity management. Obviously the choice of threshold will be somewhat arbitrary, but given that markets have grown considerably since LTCM caused trouble with its $120 billion portfolio, setting the bar at that level seems appropriately cautious. Next, when a hedge fund acquires total assets of more than, say, $200 billion, it should face the second level of oversight, which would include scrutiny of its leverage—and, if those tricky calculations of risk-weighted assets suggest that its capital buffer is too thin, the fund would be required to add some extra padding. Again, this seems a cautious bar: At $200 billion, a hedge fund would still be considerably smaller than a small investment bank such as Bear Stearns, which held assets of $350 billion as of 2006. Finally, if a hedge fund goes public, the presumption of competent risk management should be softened, and the firm should attract more frequent and insistent attention from regulatory examiners.

  This three-tiered oversight regime would deliberately leave nearly all hedge funds outside the net. As of January 2009, Institutional Investor magazine listed only thirty-nine hedge funds worldwide with capital over $10 billion. The other nine thousand or so funds, accounting for a bit over half the capital in the sector, would be left alone unless unusually high leverage got them over the $120 billion threshold. There would be no need to make the nine thousand register with government agencies and no need to saddle them with time-consuming oversight—unless they were suspected of insider trading or other violations. Unburdened by compliance costs, the vast majority of hedge funds would be free to grow and thrive, hopefully taking over some of the risk that is currently managed by too-big-to-fail behemoths. Meanwhile, the small number of hedge funds that pose genuine risks to the financial system would be handled in a different way. They would be treated as though they were investment banks, since that is roughly what they would be.