Marginal Revolution: Should we be afraid of hedge funds?

リンク: Marginal Revolution: Should we be afraid of hedge funds?.

Sebastian Mallaby says no; this is the best piece I have seen on the topic.  Excerpt:

...hedge funds collectively do not so much create risk as absorb it.  The funds can be viewed as quasi insurers; by shouldering risks that others wish to avoid, they remove a potential obstacle to business.  For example, banks have to limit their lending for fear that borrowers might default.  But hedge funds are willing to buy credit derivatives that transfer the default risk from the banks to themselves -- freeing the banks to finance more economic activity.  Similarly, companies may reduce their cross-border activities if there is a limit to the foreign currency exposure they are willing to take on.  Hedge funds help to manage that exposure by trading in the currency derivatives that companies use to insure themselves.

Hedge funds can also reduce the danger that economies will overrespond to shocks.  If a currency or stock market starts to plummet, the best hope for stability lies in self-confident, deep-pocketed investors willing to bet that the fall has gone too far, and hedge funds are well designed to perform this function.  Whereas mutual-fund managers must be cautious about bucking conventional wisdom because the returns they generate are measured against market indices that reflect the consensus, hedge funds are rewarded for absolute returns, which allows their managers to engage in independent thinking.  Moreover, many hedge funds have "lock-up" rules that prevent investors from withdrawing money on short notice; when crises strike, the funds have the freedom to be buyers.

Hat tip to Free Exchange.  Here is my previous post on hedge funds.  I also would stress the more general point that a "hedge fund" is not a well-defined concept in every regard.  It is an institution which trades in financial assets, and should be evaluated in relatively general terms, rather than as some conceptually special kind of beast.

Posted by Tyler Cowen on December 15, 2006 at 11:25 AM in Economics | Permalink

Comments

My consulting co-workers and I were just arguing about this very point this morning. Thank you for the timely post.

Posted by: John at Dec 15, 2006 12:03:28 PM

I agree with the overall theme, but there is one danger posed by hedge funds. They can use a lot of leverage and may wind up to be on the wrong side at the same time together.

Posted by: JoshK at Dec 15, 2006 12:39:28 PM

Interesting thoughts. But if the merits are so great why not encourage every bank, mutal fund, or other institution to do the same things?

Let all investors everywhere be locked out whenever, and for as long as, managers think it a good idea. Send self-confident, independent-minded, deep-pocketed CFOs to the racetrack. Better yet, let college sophomores do the betting; they are even more self-confident and independent-minded and need only the deep-pockets.

Hedge funds simply avoid regulation and let managers take more risks. The brightest will make good decisions and a lot of money. Others won't.

Posted by: K at Dec 15, 2006 12:40:20 PM

As he in this article appears to be attempting to deal with the systemic risk issue raised by LCTM, talking about the positives of hedge funds is beside the point. The positives are an important considtion when trying to decide if the industry in general is good or bad. It is not relevant to the discussion about systemic risk. From his 3rd paragraph, it appears that he is trying to make the case that this fear of systemic risk is misguided BECAUSE hedge funds in general provide a useful risk transfer mechanism. It just isn't logical.

The issue with Hedge Funds isn't what the good guys do. They are extremely useful risk takers. The risk transfers that Hedge Funds initiate are, on balance, good for our economy.

This issue with Hedge Funds is what the bad guys might do AND have the capability to do. Systemic Risk is a possibility.

I am glad he wrote this article. It's just the excerpt you quoted seems misleading about what the issues are. This line is a misconstruing of what happends in a fund.

"hedge funds collectively do not so much create risk as absorb it" This, is true in one meaning of the word create, as they don't actually create a new risk catagory or create risk that didn't previously exist.

However, risk is not a well defined term. And, importantly, risk can sum. This summing can create risk on its own. Summing different risks to unregulated counterparties could have severe consequences. Transfering risk to a counterparty without sufficient capital can be system threatening.

The problem with LCTM wasn't that it lost lots of money - the problem was there was a risk they couldn't pay. Amaranth lost $6B, but, they could pay. If they had been leveraged like LCTM, the entire planet would be feeling the fallout right now.

Posted by: mickslam at Dec 15, 2006 1:32:08 PM

I agree with JoshK and Mickslam. Further, one problem with hedge funds isn't just that they are unregulated (that could be good or bad), but that nobody (even the industry, such as it is) has a good idea about what the industry as a whole is doing. The top hedge funds of the past made tons of cash using innovative, but easily imitated, algorythmic trading strategies. As alpha has decreased and beta returned, it seems quite possible that everyone is placing the same bets at pretty much the same time. That could be great under normal conditions, but if one of the mathematical assumptions proves wrong under changed conditions, you've suddenly found yourself with a whole lot of systemic hurt. With banks, the banking regulators are charged with looking for just these kinds of systemic risks. But with hedge funds, there is no one out there doing this. Each hedge fund is, of course, worried about its own exposure, but there is no one charged with looking at the big picture.

Posted by: M.D. Fatwa at Dec 15, 2006 2:10:25 PM

I agree with the overall theme, but there is one danger posed by hedge funds. They can use a lot of leverage and may wind up to be on the wrong side at the same time together.

Why do the financial institutions allow them such leverage in the first place? I can't even use the proceeds from shorting stocks in my brokerage accounts.

Posted by: Half Sigma at Dec 15, 2006 3:34:11 PM

"I agree with the overall theme, but there is one danger posed by hedge funds. They can use a lot of leverage and may wind up to be on the wrong side at the same time together."

When is the last time the commenter looked at the balance sheet of a life insurance company or a commercial bank? These ostensibly safe financial institutions sport Assets/Equity ratios north of 15x. If "leverage" is such a scary beast, why aren't we calling for the end of all organized financial intermediation. Most hedge funds with which I am familiar rarely carry leverage more than 5x their capital base.

Posted by: Will at Dec 15, 2006 5:07:26 PM

Banking and insurance companies are both regulated and their leverage ostensibly monitored at either the state or federal level. Further, leverage itself isn't so much a problem, but risk (hence all the concern about Basel II for banks, etc.) Having a lot of leverage and assets all in T-bills is different than a lot of leverage and assets all in low-rated credit derivatives. But fundamentally the problem is nobody knows. Even Will's post above indicates the problem -- i.e., comparing the balance sheets of a life insurance company or commercial bank versus "hedge funds with which I am familiar". One is data, the other anecdote. And with hedge funds, all we've got is anecdotes.

Posted by: M.D. Fatwa at Dec 16, 2006 2:52:03 PM

Yes, we can always trust those regulators to protect the financial system from excessive risk. Look at the bang up job they did with S&Ls in the 1980s. I believe the inflation adjusted losses put to the taxpayers in the S&L crisis exceeds the combined losses from LTCM and Amaranth by a factor of 100x. Continental Illinois, Salomon Brothers, even Enron...all regulated by those crackerjack detectives from the federal government. I am afraid regulation is no defense at all from risk in the financial system. If the private sector has learned to live with the risk embedded in traditional financial institutions over the centuries, I am certain it can learn to live with the risks embedded in hedge funds, whether they are regulated or not. I would argue the risk in hedge funds is actually less, because absent a regulatory umbrella and the implicit or explicit promise of a government bailout for depositors/policyholders, these insitutions cannot benefit from the moral hazard encouraged by government guarantees. Customers and counterparties actually have to think about the creditworthiness and risk charaterisitics of hedge funds...usually they don't bother with banks because they think Uncle Sam will pick up the tab. Self interest, and the risk of real losses to the unwary, are likely to prove a more effective regulator of hedge funds than any government agency...a view that would likely be endorsed by economists from Adam Smith to Milton Friedman.

Posted by: Will at Dec 16, 2006 6:44:21 PM