San Francisco Business Times
Long Term Capital Management was back in the news this month announcing a $700 million comeback from its recent near-death experience. This attracted attention from sources as diverse as the SEC, which launched an investigation about its fund-raising practices, and Saudi Prince Alwaleed Bin Talal, who had helped bail out Citibank during the 1980s, as a potential investment partner. Calls for regulations have resounded since a potential systemic risk crisis threatened to emerge in the fall.
Should all hedge funds be painted with the LTCM brush? What empirical basis do we have to evaluate regulatory proposals? In demystifying the hedge fund world, both the boasts of hedge fund promoters and the paranoia of regulators appear largely overblown.
In the rush to regulate, we should recall that hedge funds became a significant force because of a restrictive wave of regulations in the early 1990s that limited life insurance companies, pension funds, banks and other financial institutions from investing in "riskier" asset classes. Just as regulations drove risk management out of financial institutions and into unregulated funds, a drive to regulate hedge funds directly would simply drive them offshore beyond the reach of both market and regulatory oversight.
As in other recent financial crises, the problem appears to concentrate in excessive bank lending, rather than capital market operations. Excessive bank lending in East Asia resulted in $300 billion in bank losses, compared to $30 billion in hedge fund losses over the same period. The convergence of low transparency by governments and banks negatively affected both emerging markets and their investors, including hedge funds.
This problem could be resolved by disclosing the source of funds, rather than restricting hedge funds directly. The systemic risk posed by LTCM resulted from the fact that virtually no investor knew the extent of leverage (which inflated LTCM returns) or bank exposure.
Leverage needs to be understood in its capacity to create valuable capital structures or destroy them as unsustainable risks are absorbed. LTCM managed assets in excess of 30 to 50 times its capital because of its reputation as an elite hedge fund and the resulting overgenerous lending terms from commercial and investment banks. The overleveraging of LTCM, one of the reasons for its near collapse, was the exception for these funds, not the rule. Most hedge funds do not engage in extreme leverage. The vast majority of hedge funds rarely employ leverage that exceeds 2-3:1.
Research on hedge funds puts all this into some perspective. The total size of the hedge fund market is estimated at between $100 billion to $300 billion with anywhere from 1,115 to 5,500 involved. Compared to the $3.2 trillion in mutual funds, it appears unlikely that hedge funds could create the massive destabilization predicted. Overall, hedge fund performance is only modestly above equity indexes on a risk-adjusted basis. The claims of extraordinary performance in the industry appear overstated.
Hedge funds do not appear to have precipitated the Asian financial crisis: Long and short positions of these funds are not correlated with changes in currency exchange rates in those Asian countries; hedge funds did not initiate speculative currency attacks. Instead of contributing to excess volatility, there is evidence that hedge funds may mitigate it.
Positively, hedge funds provided capital and liquidity to emerging markets that had been previously excluded from capital access. Now that this drawbridge of capital has been raised from these emerging markets, it's uncertain that financial institutions, which will now be allowed under regulatory scrutiny to remediate risk management activities of hedge funds internally, will return liquidity to emerging markets.
The regulatory sea change under way is in the shift from risk-based capital requirements to portfolio risk management for financial institutions. Increasing such flexibility could remove the restrictions on riskier lending that shut those financial institutions out of profitable high yielding investment strategies in the first place. It would also enable financial institutions to reinvent themselves through principles of modern portfolio theory rather than regulatory restriction in risk management and assessment. Capital adequacy standards have not been successful in limiting financial crises, while portfolio risk management, when disclosed and evaluated, can.
With the demise of aggressively leveraged hedge funds by money managers that knew more about math than markets, a very serious question remains for the developing world: How will growth be funded in emerging markets? The lessons and legacy of hedge funds and their future will be defined in the answer.
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Dr. Glenn Yago is director of capital studies at the Milken Institute in Santa Monica. Noah Hochman, a research analyst at the institute, co-wrote this opinion. The views expressed here are their own.
