21 December 2006
By: Sebastian Mallaby, Foreign Affairs
Published: January/February 2007
 In this comprehensive defense of the hedge fund industry, Washington Post columnist Sebastian Mallaby echoes a theme that has weaved its way through stories several times on this blog: the parallels between technological innovation and financial innovation, between e-business start-ups and hedge fund start-ups, and between economic efficiencies resulting from process disintermediation and financial efficiencies resulting from the disintermediation of securities (such as mutual funds).
Writes Mallaby:
“Imagine two successful companies. Both are staffed by very smart people; both are innovative; both have an impact far beyond their industry, improving the productivity of the capitalist system as a whole. But the first, based near San Francisco, is the subject of adoring newspaper profiles, whereas the second, based in the New York area, is usually vilified.
“Actually, you do not have to imagine any of this, because it describes a double standard that already exists. The first company in the story is a technology firm; the second is a hedge fund. As any newspaper reader knows, technology firms are the leading edge of the U.S. knowledge economy; they made possible the productivity revolution of the past decade. But the same could just as well be said of hedge funds, which allocate the world’s capital to the companies, industries, and countries that can use it most productively.”
Focusing mainly on the policy implications of the hedge fund industry, Mallaby takes a page from the Bank of Canada’s view on hedge funds. He positions hedge funds as firefighters, not firestarters:
“But the fear of hedge funds is overblown, based more on ignorance or simplistic caricatures than on actual knowledge. Many of the proposals for new regulation are so vague as to be impossible to evaluate or are poorly suited to address the supposed problems at issue. And even the most serious cause for concern — that hedge-fund operations might generate a “systemic risk” for the financial system as a whole — is neither limited to the hedge-fund sector nor best addressed through regulation of it. Rather than seeing hedge funds as sources of dangerous financial fires, in fact, it is more accurate to see them as the financial system’s benevolent fire fighters — and to let them have the tools they need to do their jobs well.”
Mallaby goes on to do a superb job of addressing many of the common misconceptions and the popular myths surrounding hedge funds.
On the source of hedge fund antipathy:
“Popular resentment of hedge funds begins with the suspicion that they earn too much.”
On hedge fund (un)regulation:
“…hedge funds are not actually an army of undifferentiated attack clones, neither are they entirely unregulated, despite the popular image.”
“An industry of around 9,000 hedge funds is indeed bound to harbor some criminals. But insider trading is already illegal, and prosecutors have the tools to go after offenders in hedge funds without new regulations.”
On fees:
“…high performance fees can be less corrupting than the alternative. Since they rely only on management fees, for example, mutual-fund companies have an incentive to focus on boosting the volume of the money under their management rather than on their investment performance.”
On hedge fund volatility:
“…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.”
On systemic risks:
“Viewed globally, this system of wagers is a giant zero-sum game. In order to be worried, you have to believe that one side of some risky bet is concentrated in a particular corner of the financial system, and that it could collapse without the other parts of the system coming to the rescue. Such a possibility is real, but it does not justify a clampdown on hedge funds. To the contrary, the proliferation of hedge funds actually diminishes the risk of the nightmare scenario, and so regulation that discouraged the creation of new funds would be counterproductive. The more hedge funds there are, the less likely it is that they will all be concentrated on one side of a given trade…”
The second half of this article addresses the pros and cons of several policy frameworks that are currently being floated in the US and abroad (governing such things as transparency, borrowing caps, registration etc.)
Finally, Mallaby sums up the essence of his argument - that hedge funds absorb economic shocks, rather than promote them - by referring to the words of an economist and a former hedgie:
“As the economist Melvyn Krauss and the former hedge-fund manager Michael Simoff have written, hedge funds may be a disruptive force — but they disrupt what needs disrupting.”
Amen.
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February 26th, 2008 at 1:52 pm
Great article and points made above. I couldn’t agree more. I think part of the disconnect is the lack of education the general public has about hedge funds. They have been defined in very constrained and slanted ways and it is hard to find sources of clear information about how they operate and why they use the strategies they employ.
I wrote a similar article to the one above on why hedge fund taxes should not be changed here: http://richard-wilson.blogspot.com/2008/01/hedge-fund-taxation.html