Semi-Daily Journal Archive

The Blogspot archive of the weblog of J. Bradford DeLong, Professor of Economics and Chair of the PEIS major at U.C. Berkeley, a Research Associate of the National Bureau of Economic Research, and former Deputy Assistant Secretary of the U.S. Treasury.

Saturday, December 23, 2006

Not Many Managers Are Worth Paying 2%-and-20%...

Jeff Matthews clearly goes to more interesting Starbuckses.... Starbucksii... Starbuckiani than I do:

Jeff Matthews Is Not Making This Up: Since When Did "Hedge Funds" Stop Hedging?:

"Shorts? Listen, my previous fund got hammered on the short side." That is a quote from a fellow sitting at a table squeezed next to me in a major metropolitan Starbucks. The individual in question, who has a few grey hairs like yours truly, is marketing his fund to two younger men who--based on the sophisticated nature of their espresso drinks as well as the unsophisticated nature of their questions--appear to be fund-of-fund investors.

While I don't know the man with the grey hairs, I vaguely recognize him from company meetings in years past as a fellow hedge fund veteran. And what I find interesting about the whole thing is that, based on the quote above as well as snatches of conversation I can't avoid hearing from three feet away, he is quite vociferously playing down his reputation as a hedge fund guy who actually used to hedge his portfolio with shorts.

He is doing so for the purpose of talking up his current, non-hedged hedge fund to his audience, by which I mean the two fund-of-funds managers who, based on their questions thus far, I frankly would not let invest my dog Lucy's biscuit money, let alone the millions or billions of fund-of-fund money they appear to be investing on behalf of institutions seeking a slice of the hedge fund pie. I say this not to disparage fund-of-fund managers as an asset class, but when I hear one of these financial middlemen earnestly explain that "the problem with shorting is that your potential gain is limited to 100% while your potential losses are infinite"--as if that insight just occurred to him, and he had to pass it along before his flash of brilliance got lost in the ether--it does not reflect glory on his peers.

Now, what's the point of all this? you might well ask.

The point is that hedge fund managers appear to be shedding their short-selling identities in order to attract money, precisely at a time when markets are hitting new highs. I find this a fascinating, particularly now that Iraq has turned into a full-fledged civil war, whatever the euphemism of the day, while cost pressures are rising around the world and we've had a currency panic in Thailand, not to mention the forcible appropriation of multi-billion-dollar natural resources from public companies by a thug masquerading as an elected President in Russia, who not for nothing is probably the single most powerful person on earth. And since we know that what goes around, as they say, comes around, it seems to me that maybe now that grown men are eagerly disposing of their past life on the short-selling side of the hedge fund equation, we might be closer to a time when it could actually be worth looking for shorts rather than longs.

After all, if "hedge funds" don't hedge, they're not "hedge funds," are they?

Almost as hard to believe as the conversation overheard by Jeff Matthews is Sebastian Mallaby on hedge funds.

I am reasonably confident that the rise of hedge funds has improved the price-discovery process and helped channel somewhat more capital to fund real investments in things that are truly valuable, I suspect that hedge funds today do not materially add to systemic market risk (although I make no forecasts about the future), I doubt that hedge fund investors are demanding sufficient transparency, and I find it overwhelmingly unlikely that the average hedge fund investor is getting value for the 2%-anfd-20% he or she is paying to hedge fund managers. Sebastian Mallaby, by contrast, says that he knows that hedge funds do not materially add to systemic market risk, that he knows that it would be a mistake to mandate more disclosure than hedge fund investors demand for themselves, and that he knows that hedge fund investors are getting a good deal from the managers who charge 2%-and-20%. How he knows all these things that I do not is unclear: he must have much, much better sources of information than I do, and have spent much more time thinking hard about the issues than I have (NOT!):

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....

[H]edge funds' unique fee structure... sophisticated investors who pay such fees do so voluntarily... believe that the returns they will receive will more than compensate.... The extraordinary earnings of the top hedge-fund managers reflect the workings of a daunting star system.... Only a few... come up with an insight into how a certain company or currency has been mispriced, see illogical discrepancies between the prices of sets of financial assets, and so forth. And those who do come up with such breakthroughs not only make fortunes for themselves and their clients... they shift market prices until the irrationalities disappear, thus ultimately facilitating the efficient allocation of the world's capital....

[H]edge funds are not precipice dwellers.... [H]edge funds hold a portfolio of positions and can go short as well as long... they can be less volatile.... [H]edge funds collectively do not so much create risk as absorb it....

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.... [H]edge funds are rewarded for absolute returns, which allows their managers to engage in independent thinking....

[W]hat of the systemic risk that concerns regulators?... The nightmare scenario involves a host of hedge funds making similar bets... [that] turn out to be wrong, a fund could unravel, causing the others to unravel in turn -- and banks that could comfortably swallow the default of one or two funds might find themselves overwhelmed by the default of dozens.... Timothy Geithner... was not, however, saying that the nightmare scenario is likely.... [T]here has to be someone on both sides of each trade... you have to believe that one side of some risky bet is concentrated in a particular corner of the financial system.... The more hedge funds there are, the less likely it is that they will all be concentrated on one side....

Others call for more disclosure, which would allow lenders and regulators to gauge whether funds are crowding dangerously onto one side.... But periodic snapshots of a fund's positions might reveal little... even extensive disclosures can fail to reveal a fund's real risks.... Rather than forcing more disclosure, it would be better to allow the market to promote it...


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