Hot on the heels of last week’s spirited defense of hedge funds by the Alternative Investment Management Association (see related posting), a leading commentator has also weighed in on popular misconceptions about hedge funds. His analysis is generating a lot of buzz not because it contains some new and controversial research, but because his is one of the few pro-hedge fund voices in the non-hedge fund media.
You may remember the name Sebastian Mallaby of the Council on Foreign Relations. In December 2006 he wrote an excellent article for the journal Foreign Affairs (see related posting) in which he made the following observation:
“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.”
Since then, Mallaby hasn’t lost any of his sense of irony with regard to the way society and the media view hedge funds. In a January 28, 2008 op-ed for the Washington Post, Mallaby contrasts hedge funds with investment banks, writing:
“Hedge funds are having a rough month right now, but they have generally weathered the market chaos with relatively few losses. A smart player named John Paulson personally earned at least $3 billion by betting that the subprime bubble would pop; he did the whole world a favor, since his trading prevented the bubble from inflating even more than it might have otherwise. Now that the bubble is history, other hedge funds are swooping in to recapitalize flailing corners of the market. A big fund called Citadel has propped up the online brokerage E-Trade.
“Contrast that with the investment banks. Giant after lumbering giant has reported mega-losses on subprime mortgages or, in the case of Societe Generale last week, on an extraordinary failure to control a rogue trader. The share prices of Bear Stearns and Citigroup have fallen by half over the past year; Merrill Lynch is down 40 percent. Stress at the banks makes it harder for companies to borrow; the entire economy is saddled with a credit crunch. The nightmare that a wounded bank might actually go under terrifies regulators, which goes some way toward explaining last week’s panicky decision by the Fed to slash short-term interest rates.”
And on April 9, Mallaby updated his views for the readers of Foreign Affairs. Like AIMA, he takes direct aim at those who blame hedge funds for the credit crunch. He argues that while hedge funds may have been accomplices, the real instigators of the recent financial mayhem are the banks. Says Mallaby:
“The most striking fact about the ongoing financial mayhem is that it is concentrated not in lightly regulated hedge funds but in more heavily regulated commercial and investment banks. It is banks that created subprime mortgage securities. It is banks that mispriced them. And it is banks that filled their own coffers with this toxic paper, losing hundreds of billions of dollars.”
Mallaby makes a few arguments that may be a little over the top (e.g. “[Hedge funds] occasional failures have stemmed mainly from errors that were not of their own making”). But his broader point is a good one – that hedge funds are just one player in the much larger game of financial markets:
“The vicious circle of hedge funds selling assets and driving their value down triggered much told-you-so talk among the funds’ critics. An old complaint is that hundreds of supposedly independent funds are engaged in copycat, or “crowded,” trades; if one of them blows up and has to dump its positions, the adverse market move will trigger more explosions in the others. There is no doubt that some hedge-fund trades are crowded, and that contagion of this kind happens. But the question is whether hedge funds are more susceptible to contagion of this sort than other kinds of players.”
He also takes aim at Martin Wolf, Chief Economics Commentator for the Financial Times for his indictment of the industry last month (see related posting). As you may recall, Wolf said hedge funds were destined for the scrap heap of financial history since they simply peddled exotic risks. Counters Mallaby:
“This is an elegant thesis, but there are two problems with it. First, there is no sign that it is coming true: flows of money into hedge funds continue to be robust, for the good reason that their performance has remained superior to most other types of assets. Second, it is not at all clear that the peddling of exotic risk is the rule rather than the exception.”
As a footnote, we were recently asked by the media what we thought about AIMA’s assertive stance with regard to media coverage of hedge funds. “Why does this bias exist?” we were asked. The reason, we surmised, was that few if any hedge funds have anything to gain by setting the public record straight. After all, unlike Mallaby’s technology firms and banks, the public’s opinion of hedge funds is of little consequence to hedge fund managers. As a result, the only ones left to advocate a more balanced view of the industry are the trade associations, think tanks and hedge fund blogs.
Addendum: Like Mallaby, the brains at Wharton are sanguine about the role of hedge funds in recent market turmoil. Responding to a recent NYT op-ed by Ben Stein accusing hedge funds of market manipulation, prof. Jeremy Siegel says: “He just believes that because one set of securities is under-priced, it’s got to be manipulation and it’s got to be the hedge funds.”