Risk-Return Profile

It is true that hedge funds go bust, Amaranth being one prominent example. But thrifts, banks, and mortgage finance companies have been known to go bust as well. What matters is not the fact of bankruptcies but the knock-on effects for financial stability. And it is hard to see why the system as a whole is more fragile because of hedge funds.

A financial system is most vulnerable when it is dominated by a small number of large institutions. If one megabank blows up, there will be mountains of unpaid debt to other banks; this could cause the other banks to fail, setting off a chain reaction. In the U.S. financial system, two institutions stand out for the risk associated with their size: Fannie Mae and Freddie Mac, the two semiofficial mortgage financiers. The combined bond portfolio of these players is larger than the outstanding stock of Treasury bills and much larger than any hedge fund.

As new players in the financial arena, hedge funds spread risks rather than concentrate them. Insurers used to pay for hurricanes; now they share that burden with hedge funds. Banks used to shoulder the risk that borrowers might default; now hedge funds can help them. And if a financial institution anywhere should hit distress, hedge funds will be among the first to spot a buying opportunity. When Amaranth went bust, the market for energy derivatives was spared disruption because Amaranth's trading book was quickly taken over by two rivals. One was a hedge fund.