Should we be afraid of hedge funds?

Sebastian Mallaby says no; this is the best piece I have seen on the topic.  Excerpt:

…hedge funds collectively do not so much create risk as absorb it.  The funds can be viewed as quasi insurers; by shouldering risks that others wish to avoid, they remove a potential obstacle to business.  For example, banks have to limit their lending for fear that borrowers might default.  But hedge funds are willing to buy credit derivatives that transfer the default risk from the banks to themselves — freeing the banks to finance more economic activity.  Similarly, companies may reduce their cross-border activities if there is a limit to the foreign currency exposure they are willing to take on.  Hedge funds help to manage that exposure by trading in the currency derivatives that companies use to insure themselves.

Hedge funds can also reduce the danger that economies will overrespond to shocks.  If a currency or stock market starts to plummet, the best hope for stability lies in self-confident, deep-pocketed investors willing to bet that the fall has gone too far, and hedge funds are well designed to perform this function.  Whereas mutual-fund managers must be cautious about bucking conventional wisdom because the returns they generate are measured against market indices that reflect the consensus, hedge funds are rewarded for absolute returns, which allows their managers to engage in independent thinking.  Moreover, many hedge funds have "lock-up" rules that prevent investors from withdrawing money on short notice; when crises strike, the funds have the freedom to be buyers.

Hat tip to Free Exchange.  Here is my previous post on hedge funds.  I also would stress the more general point that a "hedge fund" is not a well-defined concept in every regard.  It is an institution which trades in financial assets, and should be evaluated in relatively general terms, rather than as some conceptually special kind of beast.


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