A lot of commentators - particularly in the mass media - have blamed hedge funds for the financial crisis. But unfortunately, their rhetoric is often very knee-jerk and lacks the necessary detail to actually make their arguments convincing. So in our yearning for a cogent argument against hedge funds, we were very excited to read this column yesterday by Kiplinger.com contributing columnist Steven Goldberg called “Ban Hedge Funds?”
But alas, Goldberg’s arguments don’t wash. In fact, they’re so stained with apparent indignation toward hedge funds that we felt a need to document the fallacies and half-truths raised in the piece. As players in financial markets, hedge funds - like mutual funds, banks, pension funds, and individual investors - are all accomplices to the calamities. But the cause? I guess that you can find research to prove anything. But here’s our take on the arguments raised by Goldberg…
Claim: “Much of the demand for what Warren Buffett years ago termed ‘financial weapons of mass destruction’ came from hedge funds.”
Reality Check: Depends on what you mean by “much”. According to this 2006 table from the British Bankers Association (cited by academic Houman Shadab in this paper), hedge funds were responsible for less than a third of the CDS market. (see related post)
Claim: “The funds typically charge annual fees of 2%, plus 20% of all fund gains.”
Reality Check: Just this week, the Economist cited HFR data showing the average hedge fund management fee was really only 1.55% (about the same as a mutual fund). Data firm, Barclayhedge recently produced this chart that shows less than a third of hedge funds charge 2% or more in management fees (see related post). [click to enlarge chart]
Claim: “To make those huge profits, many hedge funds use leverage, sometimes to the tune of 20 to 1 or even 30 to 1…”
Reality Check: Goldberg is careful with his wording here, writing that “some” hedge funds use high leverage and that it has recently dropped. But there is no hiding from his thesis that (all) “hedge funds should be banned.” So let’s revisit overall hedge fund leverage. In this post, we included several charts showing hedge fund industry leverage, including this one from Morgan Stanley showing that leverage was closer to 2:1 even in the halcyon days for the hedge fund industry (some estimates have it as high as 3:1 overall).
Claim: “When the market began to drop in earnest last fall, hedge funds often sold blue chips — because the managers could sell them without disrupting their prices as much as they would affect the prices of less-liquid investments had they sold them.”
Reality Check: This is also true for countless other investors. Harvard, for example, reduced its equity allocation by 80% in Q4. Blaming hedge funds sold liquid securities before illiquid ones is like blaming individual investors for not selling their real estate holdings before their large cap equities. In addition, long/short equity funds - the largest single category of funds - tend to be long small caps and short large caps. So when they closed out their positions, they would have also had to buy-back significant amounts of blue chip stocks.
Claim: “It was Lehman’s bankruptcy that brought on the worst financial crisis since the Great Depression. Hedge funds are enormous participants in short sales.”
Reality Check: Again, Goldberg has done his homework and points out that short selling “keeps markets honest.” But once again, he uses a specific transgression - naked shorting that he associates with Lehman’s demise - as an argument that (all) “hedge funds should be banned.” Like his leverage argument above, this amounts to cherry picking. Using Goldberg’s own logic “hedge funds are enormous participants in…(a process that)…keeps markets honest.”
Claim: “Those who are well-connected enough to invest in the few good ones can, indeed, profit from hedge funds — and diversify their investments. But most of the hedge funds available to common folk aren’t worth nearly what they charge.”
Reality Check: While is does appear that Goldberg thinks hedge funds deliver both profit and diversification, he seems to suggest that those in a more accessible regulatory wrapper (a long/short mutual fund for example) are too expensive. But as mutual funds, these vehicles charge no performance fee and have management fees that are generally in line with the mutual fund industry. If he is suggesting that “common folk” can only invest in lower quality hedge funds than the well-connected, then he must surely be an advocate of opening up the industry to retail investors, allowing broader marketing and making “good” hedge funds part of his clients’ portfolios.
Claim: “…people in the mutual fund business have done pretty well for themselves without helping to bring the global economy to its knees.”
Reality Check: Not so fast. While it’s true that hedge funds punch above their weight in capital markets due to higher portfolio turnover, to suggest that mutual funds have not had any role in the financial calamity is disingenuous. Of course they have. According to a report by the Investment Company Institute, net outflows from equity and balanced funds in Q3 and Q4 of last year was around US $350 billion.
According to Morgan Stanley and HFR data cited by Pensions & Investments (see related post), net hedge fund outflow over this period was a comparable US $390 billion. Sure, hedge funds were levered up more than mutual funds. But clearly - as financial markets players - mutual funds and hedge funds both played a role in the market mayhem of the past year.
None of these “reality checks” is bullet proof. Far from it. But after reading Goldberg’s column, we were left a lingering desire for someone to take on hedge funds using real data and facts, not opinion and conjecture often reinforced by the echo chamber of the mainstream media.