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
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