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Tuesday, May 16, 2006

Hedge Funds

Have you heard about hedge funds, but aren't quite sure how they work? This article by James Surowiecki of The New Yorker will help:

Hedgemony, The Financial Page, by James Surowiecki, The New Yorker: In the past five years, hedge funds have become a new power on Wall Street; the number of funds has doubled, to more than eight thousand, and the assets they control have tripled, to more than a trillion dollars. In the process, they’ve also become a favorite scapegoat..., blamed for everything from inflating the housing bubble and demolishing stock prices to jacking up the price of oil. ... William Donaldson, the former head of the S.E.C., has warned that “disaster” looms if hedge funds aren’t regulated...

That’s not quite what Alfred Winslow Jones had in mind when he started the first hedge fund, in 1949. Looking to make money in both up and down markets, Jones adopted a strategy of buying some stocks and selling others short. ... In the half century since, hedge funds have moved a long way beyond Jones’s simple “long-short” approach, and they now pursue a dizzying array of investment tactics in nearly every market in the world. But they have retained a few of the original characteristics: they’re free to invest in whatever assets they want; they can buy those assets with borrowed money, using leverage to improve their returns; they generally have long “lock-up” periods for their investors’ money; and, if they are successful, the people responsible earn vast fortunes.

Aside from the part about vast fortunes, that doesn’t sound especially demonic. But hedge funds are easy to hate. They’re secretive, rarely making public disclosures..., and so are fertile terrain for fraud and incompetence. ... Hedge funds often trade in markets—and with investment strategies—that few investors understand. Many critics suspect hedge funds of hunting in packs: conspiring to bring down ailing companies or currencies, or artificially inflating the price of commodities. Worst of all, the funds’ reliance on leverage increases the scale of disaster when things go wrong. ...

Yet hedge funds have been far more of a boon to financial markets than a bane. Markets work best when investors are drawing on diverse sources of information ... The sheer variety of investing strategies that hedge funds use—in contrast to mutual funds, whose managers mostly just buy stocks and bonds—enhances the diversity of markets. In the U.S. stock market, hedge funds’ willingness to sell stocks short also makes the market smarter and more efficient. ... And, because investors in hedge funds typically have to give notice of a month or more before withdrawing their money, managers are freer to pursue contrarian trading strategies that may work only over the long term.

That doesn’t mean that hedge funds are immune to trends: a year ago, a number of big hedge funds suffered major losses from a bad bet on G.M.’s stocks and bonds. But a series of academic studies has found scant evidence of the pack mentality that hedge funds are often accused of...

Hedge funds are speculators, and we think of speculators as contributing to volatile markets and wild price spikes. But a ... study published by the Federal Reserve Bank of Cleveland says that hedge funds tend “to reduce, not increase, the volatility of price,” something that the authors attribute to the funds’ willingness to go against the prevailing wisdom. ...

So what’s the catch? Only this: while the proliferation of hedge funds may be good for markets, it may not be good for their clients. The more funds there are trying to make money, the harder it is to get an edge. Even if hedge funds have done well in the past (and that’s an ongoing debate), no one disputes that hedge-fund performance has declined as the hedge-fund boom has got under way...

Update: The right-leaning American Enterprise Institute has:

Update: More from the Fed:

Anything else should people know about these markets?

    Posted by on Tuesday, May 16, 2006 at 12:33 AM in Economics | Permalink  TrackBack (0)  Comments (26)

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