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The Role of Hedge Funds in Financial Crisis

On October 2, the U.S. House Oversight and Government Reform Committee announced a Hearing on Regulation of Hedge Funds scheduled for Thursday, November 13, 2008.

The focus is on the causes and impacts of the financial crisis on Wall Street, and the Committee will hear from hedge fund managers who have earned over $1 Billion.

The underlying premise of these hearings was expressed by Dr. Mahathir Bin Mohamad, the former Prime Minister of Malaysia, who wrote on September 26 “Because of the extraordinary greed of American financiers and businessmen, they invent all kinds of ways to make huge sums of money. We cannot forget how in 1997-98 American hedge funds destroyed the economies of poor countries by manipulating their national currencies”. The Prime Minister is recognized as an authority on the role of hedge funds in financial crises, given his experience managing the Asian currency crisis as it engulfed his nation in September eleven years ago. He is particularly critical of the role of George Soros who will in fact be invited to testify before the House Committee at their November hearing.

It is perhaps too early to write about the causes and consequences of the current financial crisis while the storm still rages. However, it is not too early to examine the history of the earlier financial crisis. During the 1990s, according to the International Monetary Fund, financial intermediaries had been investing steadily into South East Asia. There was a net inflow of about US$20 billion into the region over and above portfolio and direct investment, up until 1995 and 1996 when the amount increased dramatically to US$45 billion per annum. Then with the collapse in both the Baht and the Ringgit in 1997, there was a sudden outflow of US$58 billion. It was self-evident to the central bankers in the region that the collapse in the currency had everything to do with an attack on the currencies of the region by well-financed international speculators. As Dr. Mahathir observed in a Wall Street Journal opinion piece that was published on September 23, 1997: “We are now witnessing how damaging the trading of money can be to the economies of some countries and their currencies. It can be abused as no other trade can. Whole regions can be bankrupted by just a few people whose only objective is to enrich themselves and their rich clients…. We welcome foreign investments. We even welcome speculators. But we don’t have to welcome share- and financial-market manipulators. We need these manipulators as much as travelers in the good old days needed highwaymen”. What was most remarkable about this statement was that its premises and its conclusion were immediately accepted by the international community, despite the fact that Dr. Mahathir did not provide any evidence to support his analysis of the role of hedge funds in the Asian financial crisis.

The first premise of Dr. Mahathir’s argument is that hedge funds act in concert to destabilize global economies. This is at best a misapprehension of the definition of a “hedge fund”. There is no such thing as a well defined hedge fund strategy or approach to investing. Rather, a hedge fund is a limited investment partnership otherwise exempt from registering with the Securities and Exchange Commission under Sections 3C1 and 3C7 of the Investment Company Act of 1940. As I note in my testimony last year before the House Financial Services Committee the available data show a remarkable diversity of styles of management under the “hedge fund” banner. The long-short strategy often associated with hedge funds captures about 30 to 40 percent of the business. The style mix has been fairly stable (in terms of percentage of funds) although there has been a dramatic rise in assets managed by funds of funds. These diversified portfolios of hedge funds are attractive to an institutional clientele. Event-driven funds focussing on private equity have risen in market share from 19% to 25% over the past decade, while the global macro style popularized by Soros has actually fallen from 19% to 3%. In my paper Hedge Funds with Style, with William Goetzmann, Journal of Portfolio Management 29, Winter 2003 101-112 we show that accounting for style differences alone explains about 20 percent of the cross sectional dispersion of hedge fund returns. The facts do not support a presumption that hedge funds adopt similar investment strategies coordinated with the objective of causing global instability. If their objective was to profit from the current instability, they were remarkably unsuccessful. According to Hedge Fund Research, the average fund this year is down 17 percent.

The second premise of Dr. Mahathir’s argument is that hedge funds are risktakers – gunslingers on a global scale. While it is true that the aggressive incentive fee structures (often 20 percent of any profits on top of a management fee of about 2 percent of assets under management) appear to encourage risk taking, career concerns are an offsetting factor. Given that the typical hedge fund has a half life of five years or less and the fact that it is hard to restart a hedge fund career after a failure, managers can be quite risk averse as we document in Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry, with William Goetzmann and James Park, Journal of Finance 61 2001 1869-1886. According to a recent Wall Street Journal article (10/14/2008)some of the few remaining successful hedge fund managers such as Steven Cohen of SAC Capital Advisors, Israel Englander of Millenium Partners and John Paulson of Paulson & Co (who is scheduled to appear in the November 13 hearings) have taken their funds out of the market and are in cash investments.

This last result seems at variance with popular wisdom that has arisen around some recent and spectacular hedge fund failures. The failure of Amaranth, a multi-strategy fund with more than $8 Billion assets under management, with more than 80 percent invested in a natural gas trading strategy, is often cited as an example of undiversified financial risk exposure. However, a close reading of the U.S. Senate Permanent Subcommittee on Investigation’s report on the Amaranth blow-up, Excessive Speculation in the Natural Gas Market shows clearly that excessive risk taking took place in a context of poor operational controls, where trading limits were exceeded multiple times and ordinary risk management procedures were dysfunctional. In recent research forthcoming in the Financial Analysts Journal Estimating Operational Risk for Hedge Funds: The ω-Score, with William Goetzmann, Bing Liang and Christopher Schwarz we argue that operational risk is a more significant explanation of fund failure than is financial risk, and that financial risk events typically occur within the context of severe operational risk.

Given that the initial premises are false, it is not surprising that the strong conclusions Dr. Mahathir draws from them do not follow. In Hedge Funds and the Asian Currency Crisis of 1997, with William Goetzmann and James Park, Journal of Portfolio Management 26 Summer 2000 95-101 we show that while it is possible that hedge funds involved in currency trade could have put into effect the destabilizing carry trade Dr. Mahathir describes, there is no evidence that these funds maintained significant positions in the Asia currency basket over the time of the crisis. As to the question of illicit enrichment that Dr. Mahathir charges George Soros with, his funds did not increase in value, but actually lost five to ten percent return per month over the period of the crisis.

From a point of pure logic, there cannot be any factual basis for any of these claims. Malaysia is fortunate in having a very fine and able Securities Commission. If there were any factual evidence at all to support a claim that Soros had intervened in the markets to bring down the Ringgit, it would have been produced by now. I should note that the silence is deafening. I suspect that what is really going on is that Soros was an expedient target of opportunity. The only remaining question is why, given the lack of evidence, Dr. Mahathir felt compelled to bring such serious charges against the hedge fund industry in general, and George Soros in particular. There is an interesting story here which I document in Hedge funds: Omniscient or just plain wrong, Pacific-Basin Finance Journal 9 2001 301-311.

It is interesting to note that Dr. Mahathir’s feelings about currency speculation have changed over the years. In the shark-infested waters of international Finance the name of Malaysia’s central bank, Bank Negara stands out. In late 1989, Bank Negara was using its inside information as a member of the club of central bankers to speculate in currencies, sometimes to an amount in excess of US$1 billion a day. The US Federal Reserve Board had advised Bank Negara to curtail its foreign exchange bets, which were out of proportion to its reserves which at that time were about US$7 billion. At the time, Dr. Mahathir defended this currency speculation, referring to it as active reserve management and was quoted by the official Bernama News Agency in December 1989 as saying “We are a very small player, and for a huge country like the United States, which has a deficit of US$250 million, to comment on a country like Malaysia buying and selling currency is quite difficult to understand”. According to a report in the Times of London (4/3/1994) . Bank Negara came something of a cropper in 1992 when it thought to bet against George Soros on whether Britain would stay in the European Rate Mechanism (ERM), and promptly lost US$3.6 billion in the process and would end up making a US$9 billion loss for 1992. Malaysia’s loss was Soros’ gain.

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