Kennan’s Warning on Ukraine
Ambition, Insecurity, and the Perils of Independence
LOCUSTS OR FIRE FIGHTERS?
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. As any newspaper reader knows, technology firms are the leading edge of the U.S. knowledge economy; they made possible the productivity revolution of the past decade. But the same could just as well be said of hedge funds, which allocate the world's capital to the companies, industries, and countries that can use it most productively.
Of course, that is not how hedge funds are viewed most of the time. The recent implosion of Amaranth Advisors -- a hedge fund that lost $6 billion in a matter of days thanks to one Ferrari-driving 32-year-old trader (and his greedy bosses' abandonment of proper risk management) -- has rekindled the fears that attended the collapse of Long-Term Capital Management in 1998, an event that even then Federal Reserve Chair Alan Greenspan believed "could have potentially impaired the economies of many nations, including our own."
In the United States, the Securities and Exchange Commission (SEC) has tried to regulate the sector further -- a 2004 SEC rule requiring the registration of hedge-fund advisers was vacated by a federal court in 2006 -- and continues to be interested in increasing oversight. The attorney general of Connecticut, a state in which many hedge funds are headquartered, has set up a special unit to prosecute hedge-fund abuses and decries what he regards as the "regulatory black hole" in which these funds exist. In East Asia, governments still blame hedge funds for their supposed role in the 1997-98 financial crisis. And in Europe, Franz MÃ¼ntefering, Germany's deputy chancellor, has complained that hedge funds "remain anonymous, have no face, fall like a plague of locusts over our companies, devour everything, then fly on to the next one."
Such antipathy seems likely only to intensify as hedge funds continue their extraordinary growth. In the eight years since Long-Term Capital collapsed, the volume of money managed by U.S. hedge funds has risen from about $300 billion to well over $1 trillion, according to HedgeFund Intelligence. In Europe and Asia, meanwhile, assets under hedge-fund management have grown to $325 billion and $115 billion, respectively, and London has emerged as a hedge-fund center second only to the New York area. The total assets in the hedge-fund sector remain much smaller than those in banks and pension funds. But whereas hedge-fund assets have quintupled in eight years, the world's stock of equities, tradable debt, and bank deposits has only doubled, according to data from the McKinsey Global Institute. Moreover, because the sector as a whole is leveraged and some funds trade intensively, hedge funds are thought to account for a third of the turnover in U.S. equities and an even higher share in more exotic financial instruments.
The fear of the growing influence of hedge funds is compounded by the aura of mystery that surrounds them. Whereas financial markets thrive on transparency, hedge funds are limited in what they can disclose to the public at large. They are sold through privately distributed prospectuses that describe the funds' investment parameters, terms of investment, redemption rules, and the like. But even some of the fund-of-funds managers who have emerged as expert intermediaries between hedge funds and investors have only a general idea of the trading strategies that some of their component funds pursue.
The suspicion is pervasive enough to make a new regulatory push seem probable. This past October, Senator Chuck Grassley (R-Iowa), the outgoing chair of the Senate Finance Committee, complained in a letter to Treasury Secretary Henry Paulson that ordinary Americans are increasingly exposed to hedge funds via their pension plans and demanded to know why the funds are allowed to get away with secrecy. Press coverage is suffused with the supposition that more regulation would be welcome, and even an October survey of private economists conducted by The Wall Street Journal found that a majority favored tougher oversight. Industry leaders who once might have urged regulators to leave them alone now plead instead only that restrictions should avoid being too onerous. And European regulators are as keen to subject hedge funds to controls as their American counterparts.
But the fear of hedge funds is overblown, based more on ignorance or simplistic caricatures than on actual knowledge. Many of the proposals for new regulation are so vague as to be impossible to evaluate or are poorly suited to address the supposed problems at issue. And even the most serious cause for concern -- that hedge-fund operations might generate a "systemic risk" for the financial system as a whole -- is neither limited to the hedge-fund sector nor best addressed through regulation of it. 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 -- and to let them have the tools they need to do their jobs well.
MYTHS AND FACTS
Along with the growth of the hedge-fund sector has come variation that makes generalizations difficult. Hedge funds are private investment pools allowed to operate with a great deal of freedom and flexibility, including having the ability to leverage their assets through borrowing and to bet that stocks will fall as well as rise. Some use intensely mathematical methods; others pursue stock-picking strategies that depend on human judgment about the quality of corporate managers. Some borrow and trade aggressively; others do not. Arbitrage funds take no view on markets' fundamental value but exploit price misalignments between equivalent assets; other funds trade on convictions about value, using various methods of assessing it.
If hedge funds are not actually an army of undifferentiated attack clones, neither are they entirely unregulated, despite the popular image. Like any other investors, hedge-fund managers are subject to prosecution for insider dealing or fraud; they are overseen by the SEC if they have broker or dealer affiliates; they may be regulated by the Commodity Futures Trading Commission if they trade futures or by the Federal Energy Regulatory Commission if they trade energy contracts; their borrowing is indirectly monitored by the Federal Reserve; and so on. Further regulation may or may not be appropriate, but any benefits it might bring would have to be measured against the risks of impeding innovation in the capital markets -- an outcome that would be about as desirable as stifling innovation in Silicon Valley.
Popular resentment of hedge funds begins with the suspicion that they earn too much. The founder-owners of the most successful firms do take home several hundred million dollars annually, much more than top Wall Street executives. Reporting from the epicenter of this gold rush, the Stamford Advocate observed recently that six local hedge-fund managers pocketed a combined $2.15 billion in 2005. Such payouts are the result of hedge funds' unique fee structures, which combine large annual management fees with a share of annual investment profits.
But the sophisticated investors who pay such fees do so voluntarily, because they believe that the returns they will receive will more than compensate for those fees. Hedge-fund managers who do poorly or do not outperform relevant indices will soon have no money left to manage: in 2005, 848 hedge funds went out of business. And high performance fees can be less corrupting than the alternative. Since they rely only on management fees, for example, mutual-fund companies have an incentive to focus on boosting the volume of the money under their management rather than on their investment performance.
The extraordinary earnings of the top hedge-fund managers reflect the workings of a daunting star system. Every year, hundreds of smart analysts sign up to join the industry, just as thousands of aspiring movie stars arrive in Hollywood. Only a few do enough to justify the high fees charged: 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. By buying irrationally cheap assets and selling irrationally expensive ones, they shift market prices until the irrationalities disappear, thus ultimately facilitating the efficient allocation of the world's capital.
If some are concerned about hedge-fund managers' compensation, others are concerned about their integrity. Arguing for its rule requiring hedge-fund advisers to register themselves and be subject to inspections, the SEC cited 51 fraud cases involving hedge funds between 2000 and 2004 and claimed that at the time of the rule's adoption, in 2004, 400 hedge funds and at least 87 hedge-fund advisers were under investigation.
An industry of around 9,000 hedge funds is indeed bound to harbor some criminals. But insider trading is already illegal, and prosecutors have the tools to go after offenders in hedge funds without new regulations. The number of fraud cases suggests that regulators are not shy about using these powers, and hedge funds regularly experience inquiries from the SEC when they happen to trade heavily in a stock ahead of a price-moving announcement. Moreover, some of what politicians and journalists label "hedge-fund abuses" involve leaks of inside information from investment banks rather than from hedge funds, making the hedge-fund managers who receive the leaks accomplices rather than the chief offenders.
Still other critics attack hedge funds for the consequences of their buying and selling decisions. Thus, Germany's deputy chancellor compared hedge funds to locusts because of their role in hostile takeovers of German companies, and some Britons vilified George Soros because his hedge fund upended the British government's economic policy in 1992. And after the East Asian crisis in the late 1990s, Malaysia's prime minister, Mahathir bin Mohamad, lamented that "all these countries have spent 40 years trying to build up their economies and a moron like Soros comes along with a lot of money to speculate and ruins things."
The common assumption underlying such criticisms is that politicians know and seek the public good, whereas market forces, represented here by hedge funds, seek only profits, without regard to any costs or consequences that might follow. But German politicians' objections to hostile takeovers have little to do with any rational conception of the public good, and a lot to do with their cozy relationship with incumbent captains of industry. And although the European Exchange Rate Mechanism (ERM) may have appealed to British Prime Minister John Major, anxious to differentiate himself from his Europe-bashing predecessor, Margaret Thatcher, his country's membership in the ERM made no economic sense after Germany refused to raise taxes to pay for unification, thus generating interest rates high enough to threaten recession in the United Kingdom. By betting against the pound and helping to destroy the ERM, Soros ended up making money not by economic vandalism but by liberating Britons from their leaders' unsustainable choices. As the economist Melvyn Krauss and the former hedge-fund manager Michael Simoff have written, hedge funds may be a disruptive force -- but they disrupt what needs disrupting.
Hedge funds are sometimes accused of destabilizing capital markets. This is the fear that goes back to the collapse of Long-Term Capital Management: that the implosion of a major hedge fund could be devastating not merely for its investors but for the broader financial system as well. Regulators in both the United States and Europe have expressed some variant of this worry, and not without reason. But the dangers created by hedge funds need to be balanced against the many ways in which the funds actually reduce risk.
Contrary to popular mythology, hedge funds are not precipice dwellers. In the United States and Europe, regulations restrict access to hedge funds to rich individuals and institutions on the theory that the funds are too risky for the average investor. But because most hedge funds hold a portfolio of positions and can go short as well as long -- borrowing stocks and selling them, in the hopes of buying them back after their prices have fallen -- they can be less volatile than individual stocks or standard mutual funds. After the technology bubble burst, investors discovered that holding supposedly sedate stock-index funds could make for a bumpy ride; meanwhile, hedge funds as a group delivered strong positive returns over the period. The best way for large investors to avoid the precipice is to hold a diversified portfolio of investments, in which hedge funds can certainly play a part.
Moreover, 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.
This does not mean that they will extend a safety net every time a market falls. But in 1988, the Brady Commission report on the stock-market collapse of the previous year found that hedge funds had been net buyers during the crash. And contrary to Mahathir's fulminations, it was banks that caused the flight of "hot money" from East Asia during the 1997-98 crisis -- with hedge funds being among the first to go back in.
Finally, hedge funds can reduce the chances that markets will rise to unsustainable levels in the first place. Unlike most other investors, they can profit from falls in the market as well as from rises. Their ability to short stocks has given rise to a cottage industry of specialist funds that scour the financial press for glowing corporate profiles and bet against the hype. Hedge-fund managers can make mistakes or fall prey to groupthink, just as anybody else can, but they have greater flexibility and more incentives than other investors to buck trends rather than follow them.
NIGHTMARE ON WALL STREET?
If hedge funds reduce and manage risk in all these ways, what of the systemic risk that concerns regulators? That risk is real -- but restrictions on hedge funds are the wrong way to deal with it.
From a policy perspective, it does not matter if one hedge fund goes down. The fund's investors take a hit, but they were presumably aware of the risks all along. Ordinary citizens may be increasingly exposed to hedge funds via their retirement plans, as Senator Grassley says, but large corporate pension funds allocate on average only about one percent of their assets to hedge funds, so that exposure is trivial. What matters is whether a collapse has knock-on effects, particularly for the banking system more generally.
Banks are exposed to hedge funds in part because they lend to them. When Long-Term Capital Management collapsed in 1998, it emerged that banks had lent it enough to be left with significant losses. But the answer to this problem is not to regulate hedge funds but to do better at supervising the already regulated banks. This is what the Federal Reserve Bank of New York and its European counterparts have done. Since Long-Term Capital Management's collapse, banks have lent hedge funds only money that the banks could afford to lose. In the late 1990s, hedge-fund borrowing peaked at about 2.5 times capital (meaning that every dollar in the sector was supplemented by an additional 2.5 dollars of borrowed money); today, according to JP Morgan, the borrowing amounts to only a little more than the capital in the sector.
Banks are also exposed to the possibility that trouble at one hedge fund will create trouble at others. Hedge funds tend to invest on margin: they borrow money so that they can buy stocks, bonds, or various derivative contracts, and the lending banks then retain those financial instruments as collateral. If an investment loses value, the bank issues a margin call, demanding that the hedge fund pony up fresh capital to replenish the collateral; this can force a fund to sell its holdings just as they are losing value. If a hedge fund is a big player, the pressure of its selling could potentially drive prices down further -- triggering another round of margin calls and another round of forced selling. If such a vicious cycle drove down the value of a particular part of the market, others who invested in it could also see their assets wiped out.
The nightmare scenario involves a host of hedge funds making similar bets. If the bets 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. The banks themselves, moreover, may have made similar bets through their own proprietary trading desks, meaning that their own capital would be taking a hit just when it was needed to cushion losses on hedge-fund lending. When Timothy Geithner, the president of the New York Federal Reserve Bank, sounded a warning about hedge funds this past September, this is what was worrying him.
Geithner was not, however, saying that the nightmare scenario is likely. In financial markets, there has to be someone on both sides of each trade; if a group of hedge funds is betting heavily on a fall in energy prices or the convergence of Latin American interest rates, somebody else must be betting just as heavily on the opposite outcome. Viewed globally, this system of wagers is a giant zero-sum game. In order to be worried, you have to believe that one side of some risky bet is concentrated in a particular corner of the financial system, and that it could collapse without the other parts of the system coming to the rescue.
Such a possibility is real, but it does not justify a clampdown on hedge funds. To the contrary, the proliferation of hedge funds actually diminishes the risk of the nightmare scenario, and so regulation that discouraged the creation of new funds would be counterproductive. The more hedge funds there are, the less likely it is that they will all be concentrated on one side of a given trade, and the more likely it is that if trouble at one hedge fund initiates a downward spiral in a particular corner of the market, falling prices will draw in other funds smelling a bargain.
This is precisely what happened after Amaranth's collapse this past September: the fund had to sell its positions fast, and others (including other hedge funds) were only too happy to accept the resulting discount. Because they are global, opportunistic, and nimble, hedge funds are likely to pile into any market where the distress of other institutions creates anomalous pricing.
It is true that if hedge funds become very large, they pose a more serious risk. If Amaranth had lost $26 billion rather than $6 billion, it might have been harder for other market players to take over its trading positions. Troubling concentrations of risk can occur within banks as much as within hedge funds: part of the nightmare scenario lies in the direct risk to the banks from their own proprietary trading desks, and banks such as Morgan Stanley have been building up their asset-management business by buying stakes in hedge funds. But imposing some arbitrary regulatory cap on the size of hedge funds would unjustly penalize successful firms. The best safeguard against the risk posed by large funds is the presence of other large funds.
THE AGE OF UNCERTAINTY
If it is wrong to discourage the formation of new hedge funds and wrong to impose a limit on funds' size, what of other possible regulatory options? Some call for limits on funds' borrowing. But that might curtail their ability to act as opportunistic buyers in a crisis: it would ration the fire fighters' access to the fire hydrants.
Others call for more disclosure, which would allow lenders and regulators to gauge whether funds are crowding dangerously onto one side of a particular trade. But periodic snapshots of a fund's positions might reveal little if it trades intensively, and even extensive disclosures can fail to reveal a fund's real risks. In a 2005 paper for the National Bureau of Economic Research, Nicholas Chan, Mila Getmansky, Shane Haas, and Andrew Lo demonstrated how a hedge fund could report strong and consistent returns over 96 months and still present a risk of sudden implosion. A further reason to be cautious in demanding disclosure is that hedge-fund privacy can serve a useful purpose. Without a right to privacy, funds could not be sure of capturing the value of their intellectual property, as there is no patent protection for trading strategies. Forcing disclosure indiscriminately on all funds could thus damage their incentive to discover and correct market inefficiencies.
Rather than forcing more disclosure, it would be better to allow the market to promote it. As the hedge-fund industry has grown, it has gradually become more transparent. Brokers that supply leverage to hedge funds have grown more insistent on understanding their clients' risks. Proliferating funds of funds demand at least a general description of their exposure from the hedge-fund managers to whom they entrust capital. These pressures give hedge funds an incentive to disclose more than they have in the past, since the more they reveal, the more readily they can raise capital. And in some cases, funds may choose to reveal a lot. In November, Fortress Investment Group, which manages private equity funds and hedge funds, took the radical step of seeking a public listing, with all the disclosure requirements that come with it. Other funds may decide that secrecy is so important to their business model that it is worth accepting higher costs of capital, and they should be free to make that judgment.
In the end, the critics of hedge funds would do well to remember why this sector has emerged as such a force. Until the late 1960s, the financial world was quaintly stable: exchange rates were inflexible, interest rates were regulated, and the whole system was anchored by a fixed gold price. But that world collapsed when inflation drove the dollar off the gold standard and currencies and interest rates began to float; from then on, it became impossible to amass savings without facing financial uncertainty. Tools for coping with that uncertainty -- deep markets in futures, options, and other derivative instruments -- sprang up in response to the newly volatile environment. And hedge funds emerged as the masters of these tools, providing quasi insurance to investors and firms and introducing a healthy dose of contrariness into financial markets. For this, they are accused of generating risk. But their real systemic function is to manage it -- and it is their very success in doing so that has generated both their profits and their phenomenal growth.