Capitalists We Don't Trust

By Sebastian Mallaby
Monday, December 18, 2006

Modern societies worship innovation. When tech wizards get rich by founding Facebook or YouTube, people tend to celebrate. But this healthy admiration for success is subject to exceptions. When a different species of tech wizard gets rich by founding a hedge fund, the reaction is ambivalent -- even though hedge funds contribute to the success of the economy as surely as tech firms.

Last week was fairly typical. The European Central Bank called for new regulation of hedge funds, including American ones. Germany's government declared that hedge fund oversight would be on the agenda when it hosts next year's Group of Eight meetings. Not to be outdone, the U.S. Securities and Exchange Commission proposed a rule that would bar all but the wealthiest 1.3 percent of households from investing in these demon vehicles.

How to explain all this suspicion? Hedge funds are simply pools of money whose managers are paid according to performance. This system of rewards is no more sinister than the patent system, which spurs inventors with the prospect of fabulous profits. Like intellectual property laws, hedge fund performance fees have created some impressive fortunes. Like intellectual property laws, they have inspired innovation, too.

The father of the modern hedge fund was arguably Helmut Weymar, a commodity trader who flourished in the 1970s. With the support of his PhD adviser, the Nobel Prize-winning economist Paul Samuelson, Weymar figured out a way to predict the African cocoa harvest by tracking weather patterns; he hired an agent who toured African fields in a Land Rover, recording the number, length and condition of the pods. Thanks to Weymar's ingenuity, the price of cocoa futures came closer to what the crop was really likely to be worth a few months later. Candy manufacturers got better information about the coming cost of their ingredients, which helped them run their businesses better.

Most of the best hedge funds of the past quarter-century have followed this pattern. Some were founded by outstanding traders, including three who got their start working for Weymar; others were spawned by mathematicians, computer scientists, physicists and economists who brought fresh approaches to financial markets from academia. In the 1980s, for example, psychologists showed how investors can be systematically irrational: They overreact to new information, extrapolate trends too far into the future and value a gain of, say, $100 less than they fear a loss of the same amount. By turning these insights into trading strategies, hedge funds sold irrationally expensive assets and bought irrationally cheap ones, moving prices closer to fundamental value.

In their ceaseless search for profits, hedge funds have sought out inefficiencies on the financial frontier. After Hurricane Katrina, some traditional insurers recoiled from covering offshore structures, a classic example of overreaction to a bad event. Hedge funds hired academic climatologists, crunched the numbers and made a tidy profit by underwriting storm risk. Equally, hedge funds loom large in the trading of new financial instruments. They have experimented in the markets for wine, art, special loans to rock stars -- and even in the contracts of Brazilian soccer stars.

What's not to like about all this invention? Hedge funds stand accused of being risky -- hence the SEC's proposal to raise the bar for investing in them from the current $1 million in assets (including primary residence) to $2.5 million in assets (excluding your home). But investing in hedge funds is not actually riskier than another practice that the SEC condones cheerfully: investing in individual stocks. In the 10 years ending in August 2006, according to one calculation, an investor who put his money into the stock of a randomly chosen company and kept it there for a month had about 12 chances in 10,000 of losing half or more of his stake. Over the same period, a randomly chosen hedge fund would have been six times as safe.

The most serious worry about hedge funds is that they may destabilize the financial system. But when you parse this argument carefully, as I do in the January-February issue of Foreign Affairs, it's not actually clear that hedge funds magnify "systemic risk," nor that regulation can improve matters. The latest German-European position, which calls for extra disclosure from hedge funds, is typically muddled. Forcing hedge funds to divulge the details of their trades would destroy the incentive for future innovation. On the other hand, incomplete disclosure would not give regulators the information needed to anticipate a crisis.

Of course, not all hedge funds are innovative, just as not all Silicon Valley start-ups create memorable products. Given the necessary secrecy of hedge funds, perhaps some suspicion is inevitable. But the critics of the funds should at least understand their contribution. By identifying irrational prices and correcting them, hedge funds promote the allocation of the world's capital to the countries, companies and individuals that will use it best.

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