In Defense of Hedge Funds

By Jonathan Hoenig –
IT’S BOTH AMAZING AND a little bit bizarre that the same mainstream media that told folks to stick it out for the long haul while the market melted in 2000 and 2001 are now writing smear pieces about hedge funds simply because they’re not minting money this year. Indeed, we’re now in the golden age of hedge fund hysteria, with each passing day delivering new negative charges against an industry that by almost every yardstick should be celebrated, not demonized.

At the heart of this hysteria is a complete ignorance of what hedge funds really are, both among the regulators who oversee them and the financial media that have, in recent weeks, whipped up a panic about how hedge funds threaten to disrupt financial markets world-wide. So let’s start by simply defining the term: A hedge fund is a pool of money pledged by “accredited” (read: rich) investors and managed by a general partner. While most people assume that hedge funds trade frequently and make big bets on financial esoterica, the truth is a hedge fund is a legal structure, not an investment technique.
So while the media routinely characterize hedge funds as “risky” or “highly leveraged,” the reality is hedge fund strategies, just like mutual fund strategies, run the gamut from the ultra-conservative to the highly volatile. Some funds use high levels of leverage, others sit in cash for months at a time. Some employ complex spread trades, while others simply buy and sell stocks. Just knowing someone runs a hedge fund tells you absolutely nothing about how it’s run. What matters are the strategies, positions and discipline that the manager uses to maximize the money.
Yet that reality hasn’t stopped one of the more ignorant perspectives regarding hedge funds from spreading like wildfire. Thanks to the negative media coverage, there now exists the notion that hedge funds are ticking time bombs, recklessly leveraged and dangerously allocated portfolios just teetering on the verge of throwing international markets into a near meltdown.
It’s a perspective that’s fueled by a new breed of sloppy journalism that makes Newsweek magazine’s Koran desecration story look like the Oxford English Dictionary. Business reporters now attribute just about any financial occurrence to those pesky and uncontrolled hedge funds. Oil prices high? Must be the hedge funds cornering crude. Tech stocks falling? Must be the hedge funds selling them short. They’ve become a convenient media scapegoat for every market move.
Most recently, it was the carnage in General Motors (GM) that was falsely attributed to hedge funds’ influence. And while many funds certainly lost money trading GM’s equity and debt, so did thousands of other investors, ranging from institutional pension accounts hedged with derivatives to Midwestern Ma and Pa Kettle’s 100 shares of common stock. And despite the fact that the size of assets controlled by hedge funds is still dwarfed by those controlled by mutual funds and other investors, the press has become quite comfortable with attributing every market maelstrom to this woefully misrepresented group. Because hedge funds are required under Securities and Exchange Commission regulation to keep a low profile (more on that in a moment), they are never able to clearly respond and silence the rumor, innuendo and gossip that now passes for legitimate reporting.
Another major point the fear mongers have focused on in recent weeks is the notion that hedge funds are somehow unregulated. While this is untrue, the inaccurate perception nevertheless fuels conspiracy theorists who claim that a secret cabal of investors is always behind the scenes pulling the markets’ strings. The fact is that hedge funds are exceedingly regulated. SEC rules limit those who may invest to wealthy investors. And while mutual funds and brokers spend billions of dollars a year on advertising, hedge funds aren’t allowed to promote or publicly solicit business in any fashion. Can you think of any other industry that is subject to such Orwellian constraints?
Naturally, because hedge funds aren’t permitted to promote themselves, the only time one ends up hearing about them is on the infrequent occasion when something goes wrong. While the vast majority of the thousands of hedge funds out there are run by hard-working, honest and ethical people, the press only reports on the few bad apples.
The truth is that the real loss of capital over the past few years hasn’t come from hedge funds, which have outperformed the market, but from SEC-regulated investments. On the corporate side, you’ll remember that Enron, WorldCom and Adelphia were all highly regulated firms. And among investors, just consider how many trillions of dollars were squandered thanks to the recommendations, trading and money-management skills of SEC-regulated mutual funds and investment advisers.
Try to keep in mind that hedge funds aren’t run by lawless bandits who, if not for federal regulators, would screw every investor out of their last dime. They are governed, as every one of us is, by the rule of law that prohibits violating individual rights. When cheating, fraud or financial impropriety exists, the law protects investors and offers legal recourse.
What the market needs isn’t more hedge fund regulation, but more openness. By lifting the public solicitation restrictions that keep hedge funds in the shadows, the investing public would be better informed of how the industry’s risks and opportunities compare with other investment options.
No doubt the cynical media will continue to suggest that hedge funds’ activities hurt investors large and small. Participants in hedge funds, so the argument goes, are being taken by the industry’s supposedly unreasonably high fees. Non-participants are hurt by their reckless and market-moving trading. Both suggestions are patently incorrect.
Despite all the hissing about hedge funds’ high costs, the truth is that they’ve been worth it, outperforming almost every other asset class. Since December 1993, for example, the CSFB/Tremont Hedge Fund Index has bested the S&P 500, the Russell 2000 and the MSCI World Dollar index.
More recently, hedge funds actually made money in May, according to both Standard & Poor’s and Hennessee Group, a research and consulting firm that tracks hedge fund performance. So despite all the negative smear pieces in the press, all the concerned lawmakers who’ve whipped up fear regarding the danger of hedge funds and all the calls for increased regulation, the truth of the matter is that hedge funds are, once again, outperforming the rest of the pack. As of June 1, Hennessee pegs year-to-date hedge fund performance at -0.27%, while S&P estimates a loss of -0.42%. That’s better than the 1.98% loss for the Dow Jones Industrials, the 0.98% decline for the S&P 500 and the 4.66% drop in the Nasdaq Composite.
It turns out hedge funds aren’t conniving fraudsters or market manipulators, but hardworking, opportunistic investors simply trying to make a buck. Look beyond the hysteria and you’ll see that while not every fund has made money they’ve generally provided investors with superior risk-adjusted results. And even beyond benefiting their investors, hedge fund activities have behooved the general public by adding liquidity to the marketplace, helping to ensure that investors of every size can assume or lay off risk at will. Far from disruptive, their influence is steadying, taking risks and entering markets that less adventurous investors would likely avoid. That’s the real story the mainstream press has yet to tell.
Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC.

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