Pruning Season

(2 of 2)

The turmoil has some questioning not just hedge-fund performance of late, but also the industry's essential business model. Hedge funds employ a dizzying array of investment strategies, from reliance upon superstar managers who preside like Delphic oracles to the use of byzantine computer algorithms that pick out minute pricing discrepancies and take advantage of them. The profits on these transactions may be small, but funds multiply them many times over by leveraging their investors' capital. This strategy can go awry — as it did spectacularly in 1998 when Long Term Capital Management, a giant U.S. fund whose founders included two Nobel laureates, lost $4.6 billion after Russia defaulted on its government bonds. Long Term Capital Management was heavily leveraged. It had equity equaling only 3% of its assets. That's the equivalent of a $3.3 million home-equity loan on a $100,000 house. When the market turned skittish after the Russian default, the fund had to rapidly unwind illiquid positions, sustaining huge losses in the process. Only a bailout brokered by the Federal Reserve Bank of New York staved off a wider collapse of the U.S. financial system.

Today, amid the credit crunch, leverage is again proving to be a troublesome strategy. Borrowing has become prohibitively expensive. Plus, in markets where deep losses are inflicted on virtually all asset classes, there are fewer pricing discrepancies for hedge funds to take advantage of. Then there's the short-selling — betting on falling stock prices — that funds use to hedge against losses and theoretically make money whether equity markets rise or fall. Funds that employ long/short strategies have been hampered by government bans on short-selling intended to calm unsettled markets. Indeed, shorting strategies have been widely blamed for exacerbating volatility. On Oct. 28, German automaker Volkswagen briefly became the world's most valuable company when hedge funds that had shorted the company's stock on the premise that it was overvalued were forced to buy it back in a panic after smaller rival Porsche announced that it had secretly bought up a sizable share of VW. The stock's rollercoaster ride may have cost short-sellers up to $40 billion.

The current crisis may only be highlighting deeper flaws in the hedge-fund model. In 2006, the European Central Bank warned that too many hedge funds were investing in the same way. Because those sophisticated computer models were crunching the same data, there was a higher probability that hedgies would make the same bad bets, potentially causing a devastating cascade of failures. With so many fund managers following the herd, in other words, there was a greater chance that they would go over a cliff together. "A bank run doesn't affect just one bank," says Andrew Lo, a finance professor at MIT who applies ideas from psychology and evolutionary biology to investment. "It can easily spread to the entire banking industry. What we're seeing now [in hedge funds] is a bank run, but a bank run gone wild. It's a bank run on steroids because the losses are so great."

And the crisis may be exposing another, more insidious, flaw. As the industry has grown, it has become harder to tell good investment managers from lucky ones — and lucky ones from outright frauds. In a recent paper, Dean Foster, a professor at the University of Pennsylvania's Wharton School, and H. Peyton Young, a senior fellow in economics at the Brookings Institution, argued that the lack of industry regulation makes bad managers nearly impossible to detect. By making bets that have a relatively low probability of failing — say, 10% — an unskilled manager has a 90% chance of making good. But if the bet does go south, the industry's fee structure, which often includes 2% of investors' money plus another 20% of profits, ensures that the manager will walk away from the wreckage rich, even if his investors do not.

Young suggests that greater transparency, including disclosing risk to investors, could rebuild shaken confidence in the industry. Indeed, given the populist backlash against complicated financial mechanisms, tighter regulation now seems inevitable. In the U.S., Congress has scheduled hearings to examine the role of hedge funds in the ongoing financial crisis. "It's going to be quite a slog to get really serious reforms," Young says. "But I'd argue it is in the industry's interest to promote greater transparency."

A sea change in hedge funds may not be entirely bad news for investors, either. According to NYU economist Brown, an industry shakeout could get rid of many undercapitalized or poorly managed funds, leaving remaining funds to consolidate. And the culling could even be healthy for the industry, says MIT's Lo, who draws an analogy from biology. "We've just seen a big meteorite hit," he says. "It will kill a number of species. But in the wake of that death, whole new species will arrive." As students of evolution know, the dinosaurs died to make way for something smarter.