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Physicist, Startup Founder, Blogger, Dad

Friday, December 22, 2006

In defense of hedge funds

The article below gives a well-reasoned defense of hedge funds. The money line is, for me, the following:

As any newspaper reader knows, technology firms are the leading edge of the U.S. knowledge economy; they made possible the productivity revolution of the past decade. But the same could just as well be said of hedge funds, which allocate the world's capital to the companies, industries, and countries that can use it most productively.

The argument is similar to the (correct) observation that you need venture capitalists and entrepreneurs to have a startup ecosystem. My only problem with the current situation is that I suspect a lot of managers are getting paid without generating much alpha. As the industry matures, and replication of vanilla strategies better developed, I imagine we'll see the fees come down.

I guess the other thing to add is that not all financial games that make money for a hedge fund necessarily lead to more efficient resource allocation in the overall economy. It's much more obvious to the average person or journalist that a technology company (even if it fails) is trying to do something which advances society.

Foreign Affairs: Imagine two successful companies. Both are staffed by very smart people; both are innovative; both have an impact far beyond their industry, improving the productivity of the capitalist system as a whole. But the first, based near San Francisco, is the subject of adoring newspaper profiles, whereas the second, based in the New York area, is usually vilified.

Actually, you do not have to imagine any of this, because it describes a double standard that already exists. The first company in the story is a technology firm; the second is a hedge fund. As any newspaper reader knows, technology firms are the leading edge of the U.S. knowledge economy; they made possible the productivity revolution of the past decade. But the same could just as well be said of hedge funds, which allocate the world's capital to the companies, industries, and countries that can use it most productively.

Of course, that is not how hedge funds are viewed most of the time. The recent implosion of Amaranth Advisors -- a hedge fund that lost $6 billion in a matter of days thanks to one Ferrari-driving 32-year-old trader (and his greedy bosses' abandonment of proper risk management) -- has rekindled the fears that attended the collapse of Long-Term Capital Management in 1998, an event that even then Federal Reserve Chair Alan Greenspan believed "could have potentially impaired the economies of many nations, including our own."

...In the end, the critics of hedge funds would do well to remember why this sector has emerged as such a force. Until the late 1960s, the financial world was quaintly stable: exchange rates were inflexible, interest rates were regulated, and the whole system was anchored by a fixed gold price. But that world collapsed when inflation drove the dollar off the gold standard and currencies and interest rates began to float; from then on, it became impossible to amass savings without facing financial uncertainty. Tools for coping with that uncertainty -- deep markets in futures, options, and other derivative instruments -- sprang up in response to the newly volatile environment. And hedge funds emerged as the masters of these tools, providing quasi insurance to investors and firms and introducing a healthy dose of contrariness into financial markets. For this, they are accused of generating risk. But their real systemic function is to manage it -- and it is their very success in doing so that has generated both their profits and their phenomenal growth.

1 comment:

Anonymous said...

"I guess the other thing to add is that not all financial games that make money for a hedge fund necessarily lead to more efficient resource allocation in the overall economy."

Well, "all" is a high benchmark. But at least as high a percentage of the "financial games" that hedge funds use drives efficiency gains as whatever it is that start-ups do. In fact, because the winnowing process is more efficient (better measurement), I'd bet that the net increase in efficiency from hedge fund activities is greater than that generated by tech start-ups.

But, as always, specifics help. I can't think of a single major hedge fund strategy which does not improve efficiency for the economy as a whole.

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