The chaos in financial markets has embarrassed many on Wall Street, and hedge funds have come in for their share of criticism. Gleeful headlines trumpet bad results and outright blowups in various corners of hedge land. In March, the eminent commentator Martin Wolf that the hedge fund model was so flawed that the entire sector might end up on the scrap heap. Yet the truth is that the turmoil since last August has largely vindicated the funds' virtues. The central argument of my 2007 essay holds true today.

The most striking fact about the ongoing financial mayhem is that it is concentrated not in lightly regulated hedge funds but in more heavily regulated commercial and investment banks. It is banks that created subprime mortgage securities. It is banks that mispriced them. And it is banks that filled their own coffers with this toxic paper, losing hundreds of billions of dollars. A somewhat breathless March 31 proclaimed the closing of the worst month for hedge funds since the collapse of the infamous Long Term Capital Management in 1998. But the average fund tracked by the Chicago-based firm Hedge Fund Research declined by a mere 2.4 percent in March, bringing the cumulative fall for the first quarter of 2008 to 2.7 percent. By contrast, the bank-heavy financial services component of the S&P 500 fell 12.3 percent in the first quarter.

Hedge funds, for the most part, have weathered the storm remarkably well. Their occasional failures have stemmed mainly from errors that were not of their own making. Because banks have mismanaged themselves so thoroughly, they have had to mobilize capital by calling in loans to hedge funds, forcing the funds to sell off positions precipitously. Forced sales have driven down the value of the hedge funds' remaining holdings, undermining their creditworthiness and triggering a further calling in of loans, further forced sales, and further losses. This vicious circle has caused a few funds to go bust. But the trigger was not reckless behavior in unregulated hedge land. It was subprime losses in the regulated banking system.

Moreover, the smattering of bankruptcies has illustrated another hedge-fund virtue: unlike the bankruptcy of a bank, hedge-fund crashes generally do not destabilize the wider financial system. The prospect that even a medium-sized investment bank such as Bear Stearns would go bust panicked the Fed into risking $30 billion of taxpayers' money to secure a rescue. But the collapse of hedge funds such as Sowood Capital or Peloton Capital has not triggered official intervention. Granted, a blowup at a very big hedge fund would be different: when Long-Term Capital Management teetered on the brink ten years ago, the Fed got embroiled in the crisis. But the lesson is that the financial system becomes vulnerable when it is dominated by institutions that are too big or pivotal to fail. The proliferation of hedge funds is on balance a decentralizing and therefore healthy force (although a few prominent funds are big enough to rock the system).

The vicious circle of hedge funds selling assets and driving their value down triggered much told-you-so talk among the funds' critics. An old complaint is that hundreds of supposedly independent funds are engaged in copycat, or "crowded," trades; if one of them blows up and has to dump its positions, the adverse market move will trigger more explosions in the others. There is no doubt that some hedge-fund trades are crowded, and that contagion of this kind happens. But the question is whether hedge funds are more susceptible to contagion of this sort than other kinds of players.

Again, the turmoil of the past eight months vindicates the hedge funds. The most crowded trades have had to be unwound, and the upshot is that some hedge fund investors have lost money. But the financial system has not suffered as a result of these losses. Crowded hedge-fund trades turn out to be less of a problem than crowded bank purchases of subprime debt. Contagion has been a phenomenon not of hedge funds but of regulated lenders. Everybody knows that the banks hold copycat positions, so an announcement of losses at one lender has caused markets to hammer others.

Besides, hedge funds do not engage only in crowded trades. They have also acted as contrarians, betting against the crowd and so dampening the market's volatility. When the subprime bubble was inflating, several hedge funds, notably an outfit called Paulson and Co., bet that it would pop. These funds not only made astronomical profits, they also prevented the bubble from growing even bigger than it did. Now that the bubble has burst, hedge funds will likely serve as opportunistic buyers of distressed assets, putting a floor under their value. Already, a big hedge-fund called Citadel has bought the failed Sowood Capital and a fifth of the faltering broker, E*TRADE; and a fund called TPG-Axon Capital has injected capital into Merrill Lynch. SEC Commissioner Paul Atkins has recognized that "hedge funds are likely to be an important part of the solution to the subprime crisis."

Atkins, however, is in the minority. The Bush administration's proposed regulatory overhaul of financial markets would increase oversight of hedge funds, even though it is not clear that officials know how to improve hedge-fund safety. Thoughtful people--including one prominent hedge-fund manager I know--believe that regulators should cap permissible leverage in hedge funds, because the temptation to borrow excessively in order to boost returns will otherwise be irresistible. After all, hedge-fund managers pocket 20 percent of the upside and only lose on the downside to the extent that they have their own wealth in the fund. Quite simply, they face asymmetric incentives. As my Council on Foreign Relations colleague Brad Setser argues, Wall Street has long been populated with undercapitalized, overleveraged players. Some are called banks and some are called hedge funds, but their risk is determined not by their names but by how much they have borrowed.

It is true that crazy leverage is the common thread in most blowups. The late lamented Carlyle Capital borrowed some $30 for every $1 in capital; Long-Term Capital Management had a leverage ratio of between 30 and 100. Given that many hedge funds operate with a ratio nearer to two, it may seem reasonable for the government to ban the reckless high-wire acts, especially if the government is going to foot the medical bill when the trapeze artists topple. But there is the rub. To date, the government has not footed the bill for a hedge-fund failure. Even the Long-Term Capital rescue involved no government money.

Admittedly, the recent market turmoil has muddied this argument. The Fed has now offered to lend investment banks emergency money via its discount window, so it is backstopping these banks' lending to hedge funds--and hence indirectly underwriting the high-wire acts in hedge land. If it turns out that this policy shift is costing taxpayers' money, there may be a case for limiting hedge-fund leverage (just as the Basel capital-adequacy ratios are supposed to limit banks' leverage). But for the moment the argument for regulation looks weaker than the argument for a hands-off approach. A regulatory cap on leverage could do damage, since the proper cap varies depending on a fund's investment strategy. It would also be hard to enforce: after all, the Basel ratios are notoriously malleable. And starving well-managed hedge funds of credit is likely to reduce the efficiency of markets; most funds earn their keep by moving prices quickly to the level that reflects the underlying value of assets, ensuring that the world's stock of savings is allocated productively.

Of course, the financial turmoil is not yet over, and the verdict on hedge funds could look different in a year or so. An explosion at a really big hedge fund would force the Fed to intervene, though it would be less scary than the equivalent at a bank and is less likely to happen. But the extraordinary events since the publication of my essay have not changed the bottom line. In the stress-testing of the past eight months, hedge funds have done admirably.

One final point is worth making. To say that hedge funds are on balance a stabilizing force in markets is not to say that they are good places to put your money. Martin Wolf's prediction--that hedge funds will end on the scrap heap--is based on the reality that they can generate apparently good earnings in unattractive ways. They can take exotic risks that pay off solidly in nine out of ten years while generating a catastrophic loss in the other one. It is true that some funds invest this way, and that clients may have difficulty distinguishing returns based on skill from returns that are merely a payment for shouldering exotic risk. If clients respond by pulling back, the industry could be in trouble.

This is an elegant thesis, but there are two problems with it. First, there is no sign that it is coming true: flows of money into hedge funds continue to be robust, for the good reason that their performance has remained superior to most other types of assets. Second, it is not at all clear that the peddling of exotic risk is the rule rather than the exception. Were hedge fund legends such as George Soros or Julian Robertson merely lucky risk takers rather than the beneficiaries of their own skill? What of contemporary success stories such as Jim Simons? The only way to answer this question is to learn as much as possible about the stories of these funds, and to understand how they managed to establish long and impressive track records. The stories might make for a good book. I hope so; I am writing it.

You are reading a free article.

Subscribe to Foreign Affairs to get unlimited access.

  • Paywall-free reading of new articles and a century of archives
  • Unlock access to iOS/Android apps to save editions for offline reading
  • Six issues a year in print, online, and audio editions
Subscribe Now
  • Sebastian Mallaby directs the Maurice R. Greenberg Center for Geoeconomic Studies at the Council on Foreign Relations. He is writing a history of hedge funds.
  • More By Sebastian Mallaby