Posts Tagged ‘hedge funds’
Hedge Funds Make A Political Mistake
The political flavor of the month is to push back against even the Obama adminstration’s mildly reformist inclinations on finance (e.g., Peter Weinberg in today’s FT is a nice example). And, of course, once you hire a lobbyist, he or she tells you that “winning” means stirring up Congress in favor of the status quo. Measured in these terms, the hedge fund industry has had a string of notable recent victories effectively preventing tighter regulation.
Advocates have a point, of course, when they argue that big banks rather than hedge funds were primarily responsible for crisis. But this misses where we are in the long-cycle of regulation/deregulation. Look at this picture (source: WSJ; more on Ariell Reshef’s webpage). Read the rest of this entry »
Was It The Hedge Funds? (Diane Rehm Show at 11am)
Hedge funds have been nominated as a prime culprit in the current financial disaster. European governments, in particular, seem keen to impose greater regulation on hedge funds, including more transparency and compliance requirements. In fact, this is will be one of the main deliverables they seek at the G20 summit on April 2nd.
I’m not opposed to stronger regulation, and hedge funds have obviously disappointed investors – especially with their illiquidity under pressure. But are hedge funds really responsible for the depth of the crisis? They were present at the scene of the crime, in terms of buying and trading what we now call “toxic assets,” but surely their role was minor relative to supposedly “regulated” US and European banks. Read the rest of this entry »
The Cost of Reputation
Or, more accurately, the cost of caring about your reputation.
My recent article on Risk Management for Beginners closed with some unrigorous speculation about the peculiar incentives of fund managers, who are consistently well compensated in decent and good years and, in bad years, lose their clients’ money and move on to start a new fund. Steven Malliaris and Hongjun Yan have a paper on this topic entitled “Nickels Versus Black Swans:” “nickels” being the typical hedge fund strategy of making a small but consistent return with a small risk of a huge loss, and “black swans” being Taleb’s preferred strategy that makes a small but consistent loss with a small risk of a huge gain.
Simplifying the model, the problem with a black swan strategy is that by the time the huge gain rolls around, you the manager have already been fired (your clients have withdrawn their money) because of your consistent losses. The result is overinvestment in nickel strategies and underinvestment in black swan strategies – even when the latter have a higher expected return. This result holds even when you assume that the investors are sophisticated, because the key factor is the reputational concerns of the fund managers themselves.
Malliaris and Yan also show that the system can reach multiple equilibrium points: the system can be in one equilibrium where most hedge funds are pursuing suboptimal strategies, and then suddenly shift to another quickly, meaning that the hedge fund industry does not allocate capital as efficiently as one might imagine. This might help explain why (a) everyone is saying that AAA-rated mortgage-backed securities are underpriced yet (b) no one is buying them.
This paper might be seen as simply translating common sense into mathematics. Seen another way, though, it helps explain why individually rational behavior (by fund managers) does not produce the efficient outcomes you learn in first-year economics.
Systemic Risk, Hedge Funds, and Financial Regulation
One of our readers recommended the Congressional testimony by Andrew Lo during last Thursday’s session on hedge funds. Lo is not only a professor at the MIT Sloan School of Management, but the Chief Scientific Officer of an asset management firm that manages, among other things, several hedge funds. He discusses a topic – systemic risk – that has been thrown around loosely by many people, including me, and tries to define it and suggest ways of measuring it. He recommends, among other things, that
- large hedge funds should provided data to regulators so that they can measure systemic risk
- the largest hedge funds (and other institutions engaged in similar activities) should be directly overseen by the Federal Reserve
- financial regulation should function on functions, such as providing liquidity, rather than institutions, which tend to change in ways that make regulatory structures obsolete
- a Capital Markets Safety Board should be established to investigate failures in the financial system and devise appropriate responses
- minimum requirements for disclosure, “truth-in-labeling,” and financial expertise be established for sales of financial instruments (such as exist, for example, for pharmaceuticals)
Lo also has a talent for explaining seemingly arcane topics in language that should be accessible to the readers of this site. The testimony is over 30 pages long, but it’s a good read. Here are a couple of examples to whet your appetite.
Hedge Funds, An Impression
I try to read four newspapers before the day really starts, and also look through a couple of on-line sites. I skim the lead economic stories and randomly dig all the way through the paper to the end of some business/financial stories.
Sometimes the news jumps off the page, and sometimes it seeps through. Now, about two hours after looking at today’s weekend papers, I realize that something is stuck in my mind, rather like a tune that you can’t get rid of. Read the rest of this entry »
