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Sebastian Mallaby on hedge funds
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 Financial Times article 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.
Here is more, interesting throughout and in my view largely correct. See also related remarks by Megan McArdle.
Posted by Tyler Cowen on April 9, 2008 at 03:43 PM in Economics | Permalink
Comments
Q: What's the difference between banks and hedge funds?
A: Banks are more levered
The major investment banks are levered assets/equity ~30x. Major commercial banks are closer to 12x.
Most highly leveraged hedge funds top out around 10-12x, although LTCM was able for a few months to get 30-50 leverage, but that was rare and extreme, whereas the IBs are levered 30x every day.
When Amaranth blew up in 2006 and lost $6B in capital (actually $9B from peak to trough), the world was up in arms about hedge fund risk and systemic risk and counterparty riks emanating from the shadows of the lightly regulated pools of capital for wealthy and institutions.
Guess what? UBS has lost $37B in 6 months. Citigroup will soon report another mid teens billion writedown, bringing them close to $30B total. Who's the bigger systemic risk? Who's the more regulated?
'nuff said
Posted by: joe at Apr 9, 2008 5:01:57 PM
Is it useful to distinguish between investment and commercial banks here? Or between losses in the commercial (regulated) operations of companies like Citigroup and losses in their IB and trading activities?
Posted by: Bernard Yomtov at Apr 9, 2008 7:11:32 PM
First of all, hedge fund indicies are notorious for errors of composition and reporting (e.g. survivorship bias) that would send any self-respecting statistician (or economist) into a twitching ball of jello. Second, the "mean" result overshadows the Amaranths (down 100%) and the Paulsons (up ~1000%). That being said, hedge funds are getting a bad rap.
In my opinion, most (but not all) of the blame needs to be put on the investment banks, which injected most of the moral hazard into the system by figuring out ways of paying banks for even the most poorly underwritten loans and sending them on their way around the world. Once the incentive system shifted from "profit from risk-adjusted spread" to "profit from volume", it was off to the races.
Posted by: DougM at Apr 9, 2008 9:16:37 PM
Reading Mallaby's story, I'm not at all persuaded that he or anyone else knows what's really going on inside hedge funds. A lot of them barely reveal to their own investors what they actually hold. How "crowded" are a lot of trades? Lord knows.
The only reason we know about the banks' problems is that they're highly regulated public companies who can't easily stash a bunch of dubious assets on their balance sheets for long. Hedge funds, on the other hand, can buy time. They can put whatever value they want on exotic non-liquid assets, and nobody would know anything until investors tried to withdraw their funds, which is usually highly restricted. So the fact that rampant problems have yet to crop up throughout the hedge fund world isn't really proof of anything.
Posted by: Hugo at Apr 9, 2008 9:47:47 PM
Did he just compare hedge fund asset values to bank stock prices? That's not going to be a valuable comparison. Correct me if I'm wrong.
Posted by: scott clark at Apr 9, 2008 9:54:50 PM
exactly - stock prices to asset values cannot be compared. see felix salmon's critiques of this piece: http://www.portfolio.com/views/blogs/market-movers/2008/04/09/sebastian-mallaby-still-loves-hedge-funds
Posted by: ab at Apr 10, 2008 1:12:48 AM
The ability of hedge fund managers to do all these "exotic" things is a strength, isn't it? If they can prevent investors from withdrawing funds, can't they effectively "runs" and crises? Isn't the lack of transparency a benefit here? In order for a prisoner's dilemma of a bank run to exist, the investors must first perceive the dilemma. They may prefer not to even be able to do that (or not be able to act on those perceptions) at the onset, in order better secure their investments down the line.
I could see why this situation wouldn't be directly comparable to banks, but c'mon, I think the incentives are obvious. When people a) Don't think they will get bailed out by anyone, and b) have complete (or near-complete) freedom of contract, they tend to draft up agreements which leave them with an amount of risk they are comfortable with. Mistakes are made, but contracts evolve over time. The idea that regulators can do a better job at drafting up these contracts seems a bit weird to me.
Much of the world runs without transparency (and rightly so). I can't figure out why we think its always such a good thing in finance?
Posted by: Grant at Apr 10, 2008 9:13:18 AM
Isn't what triggered this whole mess the result of hedge funds held by IBs (e.g. Bear Stearns' High-Grade Structured Credit Strategies Master Fund Ltd and High-Grade Structured Credit Strategies Enhanced Leverage Master Fund Ltd.)
Is the author making a distinction between strategies or between entities?
Posted by: meter at Apr 10, 2008 9:31:12 AM
Scott wins my "most value added by an MR commmenter" award, that is exactly the kind of thing I come to a comments thread to see.
Posted by: Noumenon at Apr 10, 2008 9:42:47 AM
As much as the 2&20 system is often derided, Hedge managers also often have more of their personal money on the line than IB managers.
For most hedge funds the majority of bonuses are required to be held as fund assets for sever years. So traders and managers who get big bonuses become big owners of the fund. They therefore care a lot about risk. In investment banks this is much less the case.
Also, although the comments on asset values vs stock price is valid, I think there is one mitigating factor most hedge funds trade things that are marked to market so their net asset position is cleared through their prime broker. So asset values should be pretty close to market value. If a hedge fund held asset that were not marked to market they would need a very large cash position to support hedges or would have blown up. Either way we have not seen huge numbers of hedge fund blow ups from sub-prime.
Posted by: eccdogg at Apr 10, 2008 11:17:08 AM
“Market value” is a nice story for those hedge funds out in the illiquid parts of the market.
So, MTM might not be a good story to tell others.
Posted by: hubrix at Apr 10, 2008 1:29:24 PM
One of the major problems was the hedge funds were borrowing short-term to fund long-term asssets. When asset prices went south, the value of the funds' assets was questionable and hence creditors were lending virtually unsecured. That caused many lenders to pull their loans, and funds could not find other lenders. Hence a credit crisis. Today we have lots of liquidity but no credit.
Posted by: jorod at Apr 10, 2008 1:51:23 PM
Hugo says that banks are transparent compared to hedge funds because the former are more highly regulated. Banks are required to open their books in various ways, but regulation is not the sole or even major reason for transparency.
Banks are more transparent because of the business they are in -- counterparties would not bank with them otherwise. (Of course, banks offer less transparency than in a free market. For example, FDIC guarentees limit the demand for transparency.)
No one would accept checks, hold savings accounts, buy CD's, or take a line of credit from a bank that did not meet basic business standards for a bank.
Hedge funds provide various levels of transparency, but the larger ones cannot afford to let knowledge of their more concentrated positions get out. Amaranth was smashed when the nature of its natural gas exposure got out.
But hedge fund assets are marked to market every night to the extent possible by their prime broker. (Funds are given no credit on assets that cannot be valued.) If funds take large losses or are not appropriately capitalized, their prime broker takes away their leverage. Hedge funds give full transparency to prime brokers or whoever else finances any "exotic non-liquid assets" or they get no leverage on them.
And hedge fund administrators certify their asstes and returns to investors monthly or quarterly and auditors do the same annually.
Hedge funds cannot arbitrarily "buy time". Long Term Capital and Amaranth were brought down in a matter of weeks after taking large losses.
If hedge funds manipulate the prices of illiquid stock or mislead investors, they are prosecuted for fraud. The Fed doesn't step in and guarentee their holdings as was done for Bear.
The subprime bubble didn't happen due to a lack of transparency in any normal sense. Rather market participants overlooked the risk of giving great leverage (no money down) to subprime borrowers.
Regulators won't let you leverage your IRA at all, or go more than 2 to 1 in your brokerage account, or let most hedge funds go more than 4 to 1. But people who couldn't prove their income, or put 10 percent down were given ARM's and interest-only loans. Everyone knew this was happening, but most misjudged the scale of it and most failed to see 4 when faced with 2 plus 2. People saw the dots but didn't connect them. The question is why?
Posted by: John Kunze at Apr 10, 2008 2:11:02 PM
Another problem is the tax code which encourages borrowing to invest in real estate. This ensures a steady fuel of debt into the real estate market. Mr. Kunze is exactly right. People were knowingly making bad loans but looked the other way to book the fees and commissions, knowing they could stick the loans to investors. Quick profits overtook good judgement in normally eithically and rational business people.
Posted by: jorod at Apr 10, 2008 4:25:21 PM
Another question. Is there some survivorship bias here? Haven't some hedge funds been forced to close entirely in recent months? Does this analysis include them, or are we only comparing the survivors to the banks?
Posted by: Bernard Yomtov at Apr 11, 2008 12:23:47 PM
There is no complete source of hedge fund performance data, so all hedge fund indicies are necessarily incomplete. Indicies tend to include only funds that have been around for a year or more and are alive today, so they undercount failed funds. This survivorship bias makes it difficult to make meaningful comparisons between returns on hedge funds and other types of investment.
But there is no evidence that hedge funds are going out of business substantially more often now than in previous years. Several large hedge funds collapsed when the subprime bubble burst (including some run by Bear). These were mainly concentrated in mortgage backs. But hedge funds follow many different strategies and most have survived. Returns have generally been negative in recent months, but that is true of the market as well.
Posted by: John Kunze at Apr 11, 2008 12:49:15 PM
John,
Thanks. My only point was the one you made explicitly: survivorship bias makes it meaningless to compare hedge fund performance with stock market performance. After all, how many -100% returns does one need to average in to bring the mean down to below that of the S&P?
I also wonder how hedge fund returns are calculated and more importantly, by whom? Are the reported returns verified by an auditor or some other objective party?
Posted by: Bernard Yomtov at Apr 11, 2008 6:10:44 PM
