A new guide by Philip Coggan should make us pause before demanding greater regulation of hedge funds, an investment class that even some who use them do not fully understand.
Since the crisis at Long-Term Capital Management, a hedge fund whose losses threatened the stability of the whole financial sector in 1998, regulators and bankers have obsessed about the risks of trading with hedge funds. These funds are still widely regarded with fear and awe (and often incomprehension). But they have emerged remarkably unscathed from the recent market dislocation, and examples of banks losing money from hedge fund failures are extremely rare.
There are lots of different hedge funds doing different things in different ways. Philip Coggan’s excellent short guide is wise to eschew definitional precision; instead, he shows the affinities between hedge funds that employ different strategies and structures. Potter Stewart, an American Supreme Court judge, said that he could not define pornography but knew it when he saw it. Coggan approaches hedge funds the same way. A chapter is devoted to describing the operations and strategies of each of the major hedge funds, with a paragraph or two on each. This gets across a lot of information in a short book.
He notes that everything hedge funds do is also done on the proprietary trading desks at major banks. So what is different about hedge funds? He quotes International Asset Managers as saying that “it is better to think of a hedge fund as a fund that hedges away any risk not related to its speculative strategy” (p 82). This suggests that demand from hedge funds drives the market, but the opposite may be closer to the truth. It is rather that banks – which are exposed to bundles of risks arising from their banking and hedging activities – want to sell off certain specific risks, which hedge funds buy. This is partly a result of IT developments, which mean that risks can be disaggregated and traded with lower transaction costs. But it is especially driven by regulatory constraints on banks, which make it relatively expensive to hold some risks.
In effect, this is regulatory arbitrage: identifying cases where the cost to a bank of holding a particular risk is higher than the price available in the market from someone else willing to take the risk. Sometimes that could be because the regulator demands too high a charge through misunderstanding the risk. Sometimes it is the banks that misunderstand the risk, not realising that they may face residual exposure that they thought was hedged. And sometimes it is because it makes sense for a bank to pay a high price to hedge even remote risks when they threaten its survival. Understanding regulatory arbitrage is crucial to understanding hedge funds, because it is their lower regulatory costs that make it attractive for them to hold risks that banks and fund managers want to sell off.
Coggan tends to see the regulatory context primarily in terms of bureaucracy, enticing successful traders to work in a more entrepreneurial environment with few controls: “They want to escape from the paperwork that dogs their long-only counterparts” (p. 64). But it is about much more than working styles; it is about the relative costs of bearing certain risks.
If this works correctly, it means that banks will have lower risks, which will protect depositors and better ensure financial stability. Hedge funds will take high risks for correspondingly rich rewards, but the theory is that investors will be wealthy and sophisticated and able to bear substantial losses. It is a win-win situation. However, in practice the risks can be severe. Large and widespread hedge fund losses will seriously damage pension funds as well as individual rich investors. And banks are dependent on hedge funds. If they are no longer able to offload risks through structured credit securities, credit default swaps and total return swaps, they will either need more capital, or will be less able to offer credit to their customers. That will have an impact on the real economy.
The slickness with which the financial world has responded to regulation also makes it harder to regulate the economy effectively; in effect, the financial world is building better mice as quickly as the regulators can build better traps. For example, the ability to hedge interest rate exposure is good for real companies, who are more insulated from risks unrelated to their trading activities. But it makes it harder to fine-tune the economy through interest rate changes because they will feed through more slowly when companies re-hedge or take out new borrowing. Similarly it is harder to understand the banks’ business models, and the risks that they entail, when they are caught up in such a complex web of intermediation.
Hedge fund managers are amply rewarded, typically charging a 2% management fee plus 20% of profits. They promise “alpha”, which is defined as return greater than the market. For example, if a fund is focusing on the FTSE 100 then the difference between the FTSE 100 return and the fund return is alpha. Coggan tends to identify alpha with skill, which may be generous. Simply taking bigger risks (for example, by leveraging exposure through options rather than share purchases) can boost return, increasing the manager’s fee. If it all goes horribly wrong, they can close the fund and leave the investors nursing their losses. The imbalance between managers, who enjoy a huge chunk of returns, and investors who bear all of the losses, is often highlighted as encouraging hedge funds into highly risky speculation to maximise their own fees without due regard to investors’ capital.
Coggan is wise to the old trick of closing down underperforming funds and then marketing the “survivors” with tall tales of their amazing outperformance, which is less amazing if you factor in all of the other funds that were closed down. If you set up 20 funds and close the worst 15 after the first year, then even if your performance is merely average the surviving funds will all be in the top quartile. A lot of the so-called “alpha” that hedge funds generate can be explained this way.
Overall the book scores highly on accuracy, even on the most complex issues. The highlight is the chapter discussing criticisms of hedge funds. Coggan has the measure of the debate better than anyone else I have read. He acknowledges their risks and costs but recognises the positive roles they play. His book should force us to pause and reflect carefully on vague demands for more regulation of hedge funds and concentrate rather on better regulation of the financial system as a whole.