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.
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
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.
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.
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?
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.
“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.
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?
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?
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?
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