Hedging Bets

Don’t believe everything you hear about the clout of hedge funds.

Hedge fund managers are the swashbuckling buccaneers of high finance. Their annals are enlivened by headstrong characters, starting with the founding father of the industry, Alfred Winslow Jones, who, after attending the Marxist Workers School in Berlin, established the first “hedged” investment fund in 1949. (Jones’ fund was hedged in the sense that, by taking both long and short positions in stocks, it was insulated from movements in the level of the market. Nowadays the name is applied to private funds open to high-wealth individuals, regardless of investment style.) There is George Soros, the Hungarian émigré whose multibillion-dollar bet broke the Bank of England in 1992. There is Julian Robertson, the muscular Southerner who, when not competing in extreme Outward-Bound-like challenges, made and lost billions betting on global markets.

Some would portray hedge fund managers less romantically—less Errol Flynn or even Johnny Depp than Somali pirates. Hedge funds gang up on weak countries. If toppling their currencies means toppling their governments, then so be it. If you listen to Angela Merkel and Nicolas Sarkozy, the hedge fund “wolf pack” has driven spreads on Spanish and Portuguese bonds to unjustified heights in a calculated effort to dismember the euro zone.

Either way, the story makes for colorful reading. In More Money Than God, Sebastian Mallaby tells it well, if not exactly for the first time. What he brings to the table is unmatched access. One suspects that the masters of the hedge fund universe, seeking to secure their places in the history books, saw the Paul Volcker Senior Fellow in International Economics at the Council on Foreign Relations as the kind of responsible chronicler in whose presence it was safe to let down their hair.

Not that this cocksure breed is reticent about describing how they made money at someone else’s expense. I have a bit of firsthand experience with this. In 1998, Malaysian Prime Minister Mahathir bin Mohamad famously accused hedge funds of colluding to destabilize Asian currencies and asked the International Monetary Fund to investigate. * The fund put me on the job. Armed with a corporate credit card and an IMF rolodex, my little team traveled to London, New York, and Greenwich, Conn., to interview the usual suspects.

I assumed our interlocutors would be less than forthcoming, confronted by a posse whose opening was essentially “Hi, we’re from the IMF, and we’d like to know whether you caused the Asian crisis.” In fact, they were refreshingly straightforward, used as they were to being judged on their results, not their methods. When we asked, “do you and your colleagues at other funds talk to one another about what countries and currencies are vulnerable,” we got answers like “Sure, guys are always calling me and asking what other countries we can blow up.”

Mallaby’s account benefits from this kind of candor. But it also inclines him to give the claims of hedge fund influence too much credence. Other institutional investors take all the same bets—for and against currencies, for and against securities, for and against commodities. And other institutional investors, notably banks, have even more financial firepower at their disposal. They also trade on the same kind of information. Mallaby describes how the event that led Soros to take a position against the Thai baht in 1997 was a meeting in which the Bank of Thailand’s No. 2 described his reluctance to use interest rates to defend the currency. In investigating the same episode for the IMF, we found that the real villain of the piece was the investment bank that was advising the Bank of Thailand about how to defend the baht and at the same time using that information to bet against it. Hedge fund managers may be amoral, but at least they’re up-front about it.

All of which suggests that the importance of hedge funds in moving markets is exaggerated. Anticipating the point, Mallaby suggests several ways in which they may have disproportionate impact. First, hedge funds are the smart money. The best traders go out on their own where they can make “2 and 20,” a 2 percent maintenance fee on the money they manage plus 20 percent of the profits. Given their reputation as the smart money, where hedge funds lead, the herd follows. Thus, even when the bets taken by hedge funds are not large enough to sway markets by themselves, they can send the herd stampeding off in one direction or the other.

But Mallaby’s own account casts doubt on the smart-money presumption. For every tale of exceptional profits, there is another of exceptional losses. Soros made a fortune betting against the Thai baht but lost his shirt betting on the Indonesian rupiah. * LTCM had a glorious four-year run but avoided bankruptcy in 1998 only with the help of a rescue orchestrated by the Federal Reserve Bank of New York. If hedge fund managers command a special aura, this is in part because they are more prone to talk about their successes than their failures. Indices of hedge fund performance lend themselves to the same exaggeration. As unregulated private partnerships of wealthy investors, hedge funds can choose when to start publicly reporting their returns. New funds generally start reporting when their returns are favorable. Old ones falling on hard times close up shop, dropping out of the population of funds being tracked. Both biases inflate the rate of return of the industry as a whole.

Even if hedge fund managers are not smarter, Mallaby notes, they may still be able to move markets by their adaptability and speed. Unlike pension funds and mutual funds, they don’t have restrictive covenants and mandates limiting them to particular investments. They can go short as well as long. When circumstances change, they can turn their portfolios upside down, upending markets with them.

But proprietary traders at big banks have more or less the same freedom of action. A prop trader’s only mandate is to make money. The positions of the proprietary trading desk may be only a small part of the typical bank portfolio, but the bank of which they are part may be many times larger than even the largest hedge fund. It is this, and the worry that prop trading creates volatility, that has led the Obama administration to propose prohibiting commercial banks from engaging in the practice.

So how serious a threat do hedge funds pose to financial stability? Mallaby’s answer is: much less than other financial institutions. Because even the largest hedge funds are significantly smaller than the bank holding companies, they pose less of a risk to systemic stability. This in turn means that they can’t count on being bailed out. The scores of hedge funds laid low by the subprime crisis were left to their fate. Their managers were forced to fold up their tents and return whatever capital they had left to their shareholders.

For this and other reasons, hedge funds actually have better incentives than banks to prudently manage risk. The typical hedge fund manager has 100 percent of his personal wealth invested in his fund. Unlike a prop trader at a bank, who earns a big bonus when a gamble pays off but can subsist on his six-figure salary when it doesn’t, a hedge fund manager making a bad bet stands to lose everything. This explains how it was that, compared with investment banks like Bear Stearns, hedge funds relied significantly less on borrowed money in the run-up to the financial crisis.

The cases in which hedge funds jeopardize financial stability, like the collapse of Long-Term Capital Management in 1998, are exceptions. LTCM was unusually large and leveraged. Its early success and luminary cast of Nobel Laureates attracted investors in droves and encouraged other financial institutions to lend to it. But when other funds began emulating its strategy, eliminating the arbitrage opportunities that were LTCM’s bread and butter, its principals further increased the fund’s leverage in an effort to boost the return on capital. They built big positions in specialized markets, becoming such large players that when prices moved against them, their forced sales precipitated a crash.

This is an argument for why hedge funds should disclose their positions to the regulators, who will then be able to detect crowded trades before they become a problem. It is why there should be a registry to which all lending to a hedge fund by different counterparties is reported, so that no one, not least the regulators, is ignorant of its overall level of indebtedness. But it is not obviously grounds for going further. It is not an argument for capital requirements and limits on borrowing, since hedge funds already hold generous amounts of their investors’ capital and, having learned the lesson of LTCM, limit their borrowing. It is not an argument for preventing them from going short. It is not an argument for banning them outright.

So why are European politicians in such a huff? The reason, not for the first time, is atmospherics. Hedge funds, having come out of New York and London, are emblematic of the Anglo-American financial capitalism that European politicians despise. But if Merkel and Sarkozy are truly concerned about inadequate disclosure and transparency, they should go after Switzerland. If they really care about the risks that leverage poses to the financial system, they would do better to look to their own banks, which are the most highly leveraged in the world. It would not hurt to subject hedge funds to a bit of additional regulatory scrutiny. But there are bigger fish to fry.

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Corrections, June 30, 2010: This article originally misidentified Malaysia’s prime minister as Mohamad bin Mahathir. (Return to the corrected sentence.) It also misidentified Indonesia’s currency as the rupee. (Return to the corrected sentence.)