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The Problem with Hedge Funds

By Dr. Mark W. Hendrickson

Hedge funds are in the news again. (I wrote about the Melvin Capital hedge fund blow-up a couple of months ago.) A firm named Archegos Capital Management “blew up” (to use the common vivid metaphor), vaporizing tens of billions of dollars of paper wealth. What happened was that the prices of several highly leveraged investments made by Archegos turned against them, triggering margin calls from banks that had lent money to Archegos. The only way to raise the cash to meet the margin calls was to sell Archegos’ stocks, thereby flooding the market with sell orders and causing a rapid decline in stock prices.

The carnage from the forced stock liquidations was severe: the stock of ViacomCBS plummeted from $100 on Monday, March 22, to $48 on Friday, March 29; Discovery Communications fell from $74 on Monday to $42 on Friday, and Baidu from $266 to $208.

The stock prices of the banks linked to Archegos also took hits. The two that fell the most were Japan’s Nomura (16%) and Credit Suisse (14%).

[A technical note here: Archegos is legally classified as a “family office.” While similar to hedge funds in that they make highly leveraged investments and often earn millions for those who run the funds, family offices cannot accept investments from the public and are more opaque than hedge funds. (For example, the major banks that lent money to Archegos did not know of similar arrangements with other banks; thus, the total risk exposure of Archegos was hidden from them. Even now, it remains difficult to tabulate the exact dollar amount of risk exposure that Archegos had. Early guestimates were that Archegos’ approximate $10 billion of capital had been leveraged to $50 billion, but Bloomberg suggests the actual sum might have been as high as $100 billion.) Because of the greater privacy allowed, George Soros and other famous investors have switched from the hedge fund to the family office model. Because the two legal structures are lumped together in the public mind, and because of the similarity of investment goals and techniques, this article will lump these capital investment firms as “hedge funds.”]

Hedge funds have an enormous image problem. We only seem to hear about them when one blows up or when a headline trumpets that a hedge fund manager paid a record-breaking price for some property. (Examples: “Billionaire Ken Griffin Buys America’s Most Expensive Home for $238 Million”; or, from a year earlier, “New York hedge fund billionaire [Steven Schonfeld] to buy American’s most expensive house ever...”)

Are hedge funds rogue institutions that should be banned? One can easily draw that conclusion from the media coverage that hedge funds receive. To many, it seems that hedge funds are devices that financially ambitious individuals use to enrich themselves while endangering and occasionally wreaking havoc on either the national or global economy. (Subtitle of March 29 Wall Street Journal article about the consequences of the Archegos debacle: “Global banks tumbled...”)

This view of hedge funds, while based on indisputable facts, is nevertheless skewed. Most hedge funds quietly go about their business and never cause a ripple in financial markets. To categorically despise hedge funds is as bigoted as hating an entire race of people because of bad experiences with a few members of that race.

Interestingly, data provided by Investopedia show that hedge funds on the whole are not particularly good investments. They collectively underperformed the S&P 500 Index by about 2.25% in annualized return from January 1994 to October 2018 with the infamous short-sale strategy faring even worse. One would think that rational investors would deliberately avoid hitching their hopes to a strategy that, on average, yields inferior results and that hedge funds would diminish in size as a result of market forces. However, the lure of potential large gains is too powerful for many wealthy individuals to resist, as is the attraction of mega-paydays for aggressive fund managers.

In a sense, then, human nature is the intractable problem. So, what, practically speaking, should be done to rein in hedge fund excesses?

There is a laissez faire case that government should stay out of it and let market forces punish excesses. Certainly, by engineering bailouts for blown up hedge funds and their partners, as the financial titans of Wall Street and the Federal Reserve did after the LCTM blow up of 1998 and the Melville Capital blow up last January, the financial establishment has increased moral hazard. That is, by making it known that they will step in and rescue those who are entangled with imprudent funds, the establishment has increased the likelihood of future over-aggressiveness by signaling that a bailout will be made available.

There is a case to be made, too, for government intervention. Government properly acts to protect the innocent. Nobody would object to a law that forbade individuals from starting fires close enough to a neighbor’s property that the neighbor’s house might catch fire. Similarly, a case can be made that it is legitimate for government to intervene to remove enough opacity from hedge funds and limit their use of leverage enough so that they are less likely to precipitate a large chain reaction of losses that hurt small innocent retail investors.

However, efforts to reform hedge funds bear risks of their own. Stricter limits on leverage might be a great idea in theory, but if rules are passed hastily that require other highly leveraged hedge funds to deleverage in a short time frame, then government intervention may precipitate the very event that it is trying to protect against—a market crash. Any reform should proceed cautiously.

Dr. Mark W. Hendrickson is a retired adjunct faculty member, economist, and fellow for economic and social policy with the Institute for Faith and Freedom at Grove City College.

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