Will Hedge Funds Survive?

Investors are angry at those hedge funds that refused to meet legitimate redemption requests. As a result, demands for greater liquidity and transparency will confront the industry as a whole from now on, as investors fear getting trapped or duped -- fears that are not unreasonable given recent events. The valuation of illiquid or less liquid assets -- especially debt -- will be another complex and controversial issue. The fees of hedge-fund managers are based in part on the valuation of funds' assets, creating incentives for managers to value assets highly. But what if the assets cannot be readily sold at the prices in question? Are the fees truly justified?

Hedge funds will also face questions about the clawback of performance fees (stipulations that fees paid by investors when funds generate profits be returned in the event of subsequent losses), as well as issues regarding the inadequacy of so-called key-man clauses that require liquidation of a fund if certain individuals are no longer employed there. And increased national or international regulation of the industry as a whole is also a possibility, although how likely such regulation is and what it might involve remains unclear.

Some of the calls for greater regulation are grounded in a sense that hedge funds were part of a broader financial industry run amok, an industry whose culture and practices in recent years were prime causes of the recent crisis. Hedge funds themselves, this argument runs, were material contributors to the broader economic meltdown and need to be reined in to be sure that future catastrophes are prevented.

But this is just not true. The crisis had many causes, the most important of which was the combination of the subprime mortgage meltdown with the securitization of these mortgages into pools that were improperly rated and sold into a highly leveraged global financial market. Although a minority of hedge funds were indeed highly leveraged and had to sell in the deleveraging panic of the last quarter of 2008, they were not central players in how the crisis unfolded. Most hedge funds were unlevered. The speculative excesses of one unit of one financial firm -- AIG -- caused more problems than the entire hedge-fund industry.

Given the concentration of talent at hedge funds, the industry will no doubt survive the crisis, albeit emerging a bit smaller and humbled. However poorly hedge funds performed in 2008, after all, they did much better than regular mutual funds and most buy-and-hold stock portfolios, which were crippled by their long-only bias. It remains a fact that most of the world's greatest investors continue to run hedge funds (which, it is worth noting, is quite different from saying that most hedge funds are run by great investors). And the destruction of many of Wall Street's most venerable institutions, along with a huge collapse in asset prices and a flight of capital from the financial markets, has created a huge opportunity for talented investors to reap outsize returns in the years to come.

When the dust settles, therefore, hedge funds will end up being seen not as some fad of the prior bubble or as illegitimate havens for "malefactors of great wealth," but rather as an integral part of the enduring global financial landscape.