Power to the Hedge Funds!

Long demonized, they may be the model firms of the future.

Michael Hirsh

Newsweek Web Exclusive

Apr 23, 2009 | Updated: 9:18 a.m. ET Apr 23, 2009

Hedge funds are evil. We all know that without being told. They're secretive clubs of filthy-rich guys whose only goal is to make each other richer so they can buy overpriced art and palatial estates in the Hamptons. We also know that as the bubble began to overheat in the last few years, our government authorities were most worried about the damage that those unregulated, mysterious hedge funds might do to the financial system. In 2007 the President's Working Group under then–Treasury Secretary Hank Paulson issued new guidelines for "private pools of capital," especially hedge funds. And after the crash last year, hedge funds came under attack for short-selling and "gating" investors (refusing redemptions). A lot of people were waiting for the hedge-fund industry—which would get no bailouts à la AIG and Citigroup—to collapse into the dustbin of history.

It never happened. Sure, plenty of hedge funds went under: a record 1,471 were liquidated in 2008, out of a total of 6,845, according to Hedge Fund Research, a Chicago-based tracking firm. The industry's total capital plunged by $600 billion to $1.33 trillion as of the end of the first quarter of 2009, during which investors yanked another $104 billion out of them, according to data released Tuesday.

But here's the key point: the fallout happened very quietly—with no systemic risk discernible. Compared to the overlong horror movie we've been watching—Night of the Living Dead Banks—what happened in the hedge-fund world sounds almost healthy and clean. After all, that's the way capitalism is supposed to work: incompetents go out of business, smart guys clean up. And overall, the hedge-fund industry has shown remarkable resiliency in the face of the catastrophe, turning in a gain of 0.53 percent in the first quarter. (In addition, a lot of the worst performance occurred in September and October, when failing banks turned off credit to the hedge funds, forcing liquidations.) Most hedge funds are way down since last fall's market crash, but as more and more pension funds and institutional investors like universities decide where to put their money in the future, they might look at the average returns.

Ken Heinz, the head of Hedge Fund Research, says that while the industry has had an astonishingly wide range of returns—from a 59 percent drop for the worst performers over 12 months to a 33 percent gain for the best—the average decline was 19 percent. That sounds bad, except that equity funds plunged about 40 percent during the same period. If you're an institutional investor, which are you going to choose? Over the longer term, some of the numbers—depending on how you slice and dice them—look even better. Compared to the 10-year Standard & Poor's average—which is at a miserable minus 26 percent—the record of the biggest hundred hedge funds averages a 100-percent-plus gain during that same 10-year period. "The hedge fund industry has frankly acquitted itself fairly well," says Dan Gertner of Grant's Interest Rate Observer. "Much better than the investment banking."

In fact, the ones who caused most of the trouble on Wall Street were not hedge-fund managers but the bumbling CEOs of big investment banks and other companies that were trying to act like hedge funds: Stanley O'Neal of Merrill. Dick Fuld of Lehman. Charles Prince of Citigroup. And most notoriously, AIG, which Federal Reserve Chairman Ben Bernanke described contemptuously as a hedge fund attached to "a large and stable insurance company." A really, really bad hedge fund.

Many of the actual hedge funds got it wrong too, but unlike AIG or Citigroup, the ones that bungled their investments have simply disappeared forever, with little disturbance to the economy. No single firm has posed a systemic risk, even with hundreds of billions of dollars at play. The days when a ridiculously overleveraged Long Term Capital Management could bet billions without putting up any margins—which almost took down the financial system in 1999—are over. The hedge-fund world's survivors, meanwhile, include some of those who were most ahead of the curve on Wall Street—like Paul Singer of Elliott Associates, who in an extraordinarily prescient analysis in September 2006 declared that the subprime mortgage securitization market was a historic scam. He correctly identified the ratings agencies as chief culprits. Singer—known for his acerbic wit—declared facetiously: "Through the ages humans have tried to spin gold from lead. To make silk purses out of sows' ears. To take dung and call it roses. But the time has finally arrived when this has been accomplished." A number of his fellow hedge-fund managers promptly bet on a downturn.

Hedge-fund managers—the good ones, that is—have often served as invaluable early-warning systems. Before Enron collapsed it was Jim Chanos, president of Kynikos Associates, that gave the story to Bethany McLean of Fortune magazine. Her story, "Is Enron Overpriced?" was the first major sign that the company was an out-and-out fraud.

Hedge funds may even point the way to the future, in a one-eyed-man-is-king-of-the-blind kind of way. The subprime-mortgage disaster holds three major lessons for what must happen to Wall Street:

• One, the pretense that risk can be sold away and "dispersed" in bundles of securities needs to be abandoned; instead risk needs to be brought back within a firm's walls and watched closely. Retail banks need to reassume the risk of their borrowers, investment banks need to keep stuff on their balance sheets, and so on.
  
• Second, and a related point: compensation needs to be structured so that every big player has his own skin in the game.
  
• Three, the structure of Wall Street needs to change dramatically. The Citigroup financial supermarket model is an abomination. (In fact, the latest signs out of Citigroup are that the promised reorganization of the giant company—in which underperforming assets were going to be placed into a "bad bank"—may end up being more cosmetic than not, a mere accounting trick.) Congress should begin considering ways to resurrect a version of Glass-Steagall, which sensibly separated retail and commercial banks from investment banks after combined versions of the two wreaked similar damage in the late 1920s. "Anything that is 'too big to fail' is now 'too big to exist'," MIT's Simon Johnson, the former chief economist at the IMF, said in congressional testimony on Tuesday.

The hedge-fund model may offer a way forward on all of these fronts. Grant's Gertner suggests that the best path toward the future may be through the past, and not just in revisiting the virtues of Glass-Steagall. Wall Street's most successful long-term model has been the partnership on the Brown Brothers Harriman (or Goldman Sachs) model, wherein the firm is always betting the owners' own capital. Such a structure ensures careful risk assessment. Similarly, a lot of hedge-fund managers have a lot of net worth invested in their funds. If there's one thing we've learned in the last couple of years, it's that very few players on Wall Street ever understood risk. The ones that did ought be entrusted with risk in the future, while those who didn't should be kept away from it with a stick. The latter group includes the big banks, which ought to act more like utilities (they already are, in fact), and investment banks, which perhaps need to go back to issuing securities and brokering and forget about proprietary trading. Maybe only the hedge funds have earned the right to be the big risk takers of the future.