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October 1, 2010updated 29 Jan 2016 4:20pm

They’re Forever Bursting Bubbles

By Christopher Silvester

It’s not hedge funds’ fault that they’re so good at sensing (and shorting) trouble, says Sebastian Mallaby. Christopher Silvester meets a vocal defender of the hedgies
WHEN SEBASTIAN MALLABY, a former Economist reporter who now writes a column for The Washington Post alongside his job as director of the Maurice R Greenberg Center for Geoeconomic Studies, embarked on writing a book about hedge funds, he knew he faced a strategic problem. Already sympathetic to the positive role of hedge funds, he was confronted with the industry’s default posture of secrecy.

‘I think it’s changing gradually, but in 2006, when I began my research, hedge funds were very, very secretive,’ he recalls. ‘They’re starting to open up a bit now. Knowing that, I budgeted a lot of time to do the networking in order to get inside the tent.’

It took him roughly four years, from conception to publication, to produce More Money Than God: Hedge Funds and the Making of a New Elite, which was published in June. He needed ‘to get to know the people who knew the people who knew the real people’. Shrewdly, he started with the retired hedge-fund managers who had been big names in the 1970s, who tended to have more time on their hands, who were anxious to safeguard their reputational legacies, and whose trading secrets were no longer secret.

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‘Once I’d got to know them, they had mentored the next generation, and then the next generation passed me on to the next generation, and I deepened my circle of contacts until finally I remember I was working on one of my last chapters and I got an email from Bruce Kovner, one of the more secretive people in the business, saying, “Perhaps we should talk.”’

The book has been well received, by industry insiders as well as professional observers. It is a history of hedge funds since Alfred Winslow Jones created the first ‘hedged’ fund in 1948 — and, incidentally, introduced the industry’s notorious charging structure of a 20 per cent performance fee, inspired, he said, by the practice of ancient Phoenician merchants; this would then be taxed as a capital gain at 25 per cent rather than as income at 91 per cent.

At the same time, Jones wished to avoid regulation so that he could pursue leverage and sell short. By the 1990s, Mallaby writes in his introduction, ‘The hedge-fund titans were the new Rockefellers, the new Carnegies, the new Vanderbilts. They were the new American elite — the latest act on the carnival of creativity and greed that powers the nation forward.’
MALLABY BELIEVES THAT the important thing about hedge-fund managers is their creative, entrepreneurial spirit and is worried that greater regulation, as is being relentlessly championed by mainland Europe, will dampen if not stifle that spirit. At the same time, he believes that over-regulation will render hedge funds more rather than less dangerous to the financial system as a whole: ‘My worry is that if you turn hedge funds into more of a mutual fund, unit trust-like entity, you raise the cost of doing business for start-up hedge funds, and you basically encourage the industry to become a very large, concentrated set of players instead of a lot of scrappy start-ups.

‘In my view the scrappy start-ups are much more attractive, much less likely to fail. The arguments I make in my book in favour of hedge funds are really arguments in favour of entrepreneurial, small boutiques which have their own money assigned in the game, so they’re properly incentivised to manage risk.’

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The trouble is that the popular perception of hedge funds has been coloured by a false understanding of their role in the global crisis. Investment banks such as Bear Stearns and Lehman Brothers bleated that they were victims of short-selling. Hedge funds were being demonised for short-selling by various government leaders and even by woefully ignorant archbishops.

That is not how Mallaby sees short-selling. ‘It is healthy because it allows contrarians to take a view when something is over-valued. That’s more likely to reduce bubbles when they get big; and fewer bubbles will be healthier for the system,’ he says. ‘Shorting is also valuable because it allows people to be two different things — long and short — therefore hedging out the market risk and enabling them to take specific bets on risks that they really understand while hedging other ones that they don’t.’

Mallaby thinks you can just about make the case that in extremis, such as in the period immediately following the collapse of Lehman Brothers, short-selling should be banned so as to prevent negative rumours sinking what would otherwise be good companies.

‘But even that I find unconvincing because the truth is that Bear Stearns and Lehman Brothers went down not because people irrationally panicked, but because they rationally panicked. It was a very rational panic that these companies had crazy exposures to sub-prime mortgages and they hadn’t reported it properly to the markets, that they were concealing stuff. The reason people fled those firms and they went under was that they were mismanaged. Short-sellers are just the messenger and you shouldn’t shoot the messenger.’

In his chapter on the crisis, Mallaby examines the experience of Citadel, a hedge fund that wanted to be like Goldman Sachs. When the US government imposed a short-selling ban immediately after Lehman went down, Citadel found itself at a disadvantage because it had a large book of convertible arbitrage positions.

‘Once you banned the short-selling leg of that trade, the trade didn’t work any more and Citadel lost tons of money — all because the government thought it was helping the system by banning short-selling. But even though Citadel was effectively assaulted by government policies, it survived. Why? Because it was better managed than Goldman Sachs, better managed than Morgan Stanley.’
WHEN IT COMES to the Greek sovereign debt crisis, Mallaby is scornful of suggestions that hedge funds exacerbated the situation by shorting Greek government bonds and thus destabilising the euro. ‘Greece has got to be the poster child for when you can’t possibly blame markets for what went wrong,’ he insists.

‘The Greek government brought it on themselves. They said they had a 3 per cent of GDP fiscal deficit and then they said, “We were lying. It’s 13 per cent.” Don’t blame the markets for that. If hedge funds had cottoned on to this earlier and had shorted Greek bonds aggressively circa, let’s say, 2007 or 2008, they would have telegraphed to the world the Greek problem before it had got even bigger.’

There are two things in particular that Mallaby is anxious to discourage. One is the likelihood that an increasing number of large hedge funds will seek to become publicly quoted companies in an effort to emulate the investment banks. ‘When that happens,’ he writes in the conclusion to his book, ‘hedge funds will pose the threat to the financial system that they have wrongly been accused of posing in the past.’

The other is the practice of investment banks having hedge-fund subsidiaries. ‘I think they should be banned from owning hedge funds, because the incentives for those hedge-fund subsidiaries to manage risk are not as good as in other circumstances. During the crisis, the hedge-fund subsidiaries of banks were often where the trouble came from.

‘So Bear Stearns’ hedge fund went belly up in 2007 and they had to be bailed out by their Bear Stearns parent, which is a big reason why Bear Stearns then itself failed in 2008. JP Morgan’s hedge-fund subsidiary was quietly recapitalised. Goldman Sachs’s hedge-fund subsidiary was publicly recapitalised. UBS had a number of internal hedge funds which didn’t do too well either. There’s a bit of a pattern here and it’s not surprising, because if you have a hedge fund which is a subsidiary of a big bank, the managers running it know that if they take too much risk and blow up, the parent company has deep pockets and will bail them out. It’s moral hazard again.’

Notwithstanding these caveats, Mallaby believes that hedge funds ‘will thrive for years to come, despite a cacophony of naysayers’.

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Illustration by Russ Tudor

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