Hedgemony

The New Yorker

THE FINANCIAL PAGE

by James Surowiecki

Issue of 2006-05-22
Posted 2006-05-15

In the past five years, hedge funds have become a new power on Wall Street; the number of funds has doubled, to more than eight thousand, and the assets they control have tripled, to more than a trillion dollars. In the process, they’ve also become a favorite scapegoat for bad financial news, blamed for everything from inflating the housing bubble and demolishing stock prices to jacking up the price of oil. A German politician has called hedge funds “locusts” of the global economy, while William Donaldson, the former head of the S.E.C., has warned that “disaster” looms if hedge funds aren’t regulated. The title of a recent column made the point nicely: “Instruments of Satan.”

That’s not quite what Alfred Winslow Jones had in mind when he started the first hedge fund, in 1949. Looking to make money in both up and down markets, Jones adopted a strategy of buying some stocks and selling others short. Because, at the time, mutual funds were legally barred from selling stocks short, Jones avoided government regulations by restricting participation in the fund to a small number of wealthy investors. In the half century since, hedge funds have moved a long way beyond Jones’s simple “long-short” approach, and they now pursue a dizzying array of investment tactics in nearly every market in the world. But they have retained a few of the original characteristics: they’re free to invest in whatever assets they want; they can buy those assets with borrowed money, using leverage to improve their returns; they generally have long “lock-up” periods for their investors’ money; and, if they are successful, the people responsible earn vast fortunes.

Aside from the part about vast fortunes, that doesn’t sound especially demonic. But hedge funds are easy to hate. They’re secretive, rarely making public disclosures about their investments or their performance, and so are fertile terrain for fraud and incompetence. Last year, investors in a fund called the Bayou Group found out that its managers had been lying about its performance for years, having blown all the money on bad investments. Hedge funds often trade in markets—and with investment strategies—that few investors understand. Many critics suspect hedge funds of hunting in packs: conspiring to bring down ailing companies or currencies, or artificially inflating the price of commodities. Worst of all, the funds’ reliance on leverage increases the scale of disaster when things go wrong. In 1998, the collapse of Long-Term Capital Management, a giant hedge fund that had made huge leveraged bets on currencies and government bonds, exacerbated a global financial crisis.

Yet hedge funds have been far more of a boon to financial markets than a bane. Markets work best when investors are drawing on diverse sources of information and relying on many different kinds of tools to figure out what’s going to happen next. The sheer variety of investing strategies that hedge funds use—in contrast to mutual funds, whose managers mostly just buy stocks and bonds—enhances the diversity of markets. In the U.S. stock market, hedge funds’ willingness to sell stocks short also makes the market smarter and more efficient.

Paradoxically, some of the characteristics of hedge funds that make them seem frightening also make them valuable. Secrecy, for instance, makes it harder for hedge-fund managers to imitate what their peers are doing, a common flaw among mutual-fund managers. And, because investors in hedge funds typically have to give notice of a month or more before withdrawing their money, managers are freer to pursue contrarian trading strategies that may work only over the long term. That doesn’t mean that hedge funds are immune to trends: a year ago, a number of big hedge funds suffered major losses from a bad bet on G.M.’s stocks and bonds. But a series of academic studies has found scant evidence of the pack mentality that hedge funds are often accused of. A recent paper by the economists Burton Malkiel and Atanu Saha, for instance, showed that the range of performance among hedge-fund managers was much wider than among mutual-fund managers, which suggests that they’re operating more independently.

Hedge funds are speculators, and we think of speculators as contributing to volatile markets and wild price spikes. But a recent study of eleven commodities markets found that when speculators made up forty per cent or more of the market, prices were roughly half as volatile as they were in markets where speculative trading was less prevalent. Similarly, a study published by the Federal Reserve Bank of Cleveland says that hedge funds tend “to reduce, not increase, the volatility of price,” something that the authors attribute to the funds’ willingness to go against the prevailing wisdom. It’s probably no accident that in the past three years, as hedge funds have made an increasingly large percentage of stock-market trades, market indexes have become far less volatile.

So what’s the catch? Only this: while the proliferation of hedge funds may be good for markets, it may not be good for their clients. The more funds there are trying to make money, the harder it is to get an edge. Even if hedge funds have done well in the past (and that’s an ongoing debate), no one disputes that hedge-fund performance has declined as the hedge-fund boom has got under way. The investors who have given hedge funds billions of dollars in capital in the past few years may end up without much to show for it. It’s their loss, but it’s our gain.