Wednesday, April 08, 2009

Hedge Hog "Hogwash" — Part IV: The Bottom Line

This is the conclusion of Chris Clair's four-part answer to my questions about the "worth"of hedge funds (Do they actually contribute to society?) and their exorbitantly paid managers (How much is enough? How much is simply obscene?) continues.

For a review of my original post, which inspired Chris, go here. The first three parts of his response are here, here and here.

As noted previously, Chris, a friend and former student, writes for Hedge World, an industry newsletter.

Part IV — The Bottom Line

Hedge funds are like bogeymen. They are little understood by anyone outside the investment world. They have operated under exemptions from regulation. Some managers make lots of money.

Going forward they, and the rest of the financial system, will likely be more tightly regulated. There will be fewer managers and assets.

Already, hedge fund assets are half what they were in late 2007, when the industry topped out at $2.8 trillion. For reference, when I started covering hedge funds in 2001, they had about $800 billion in assets, compared to mutual funds with $8 trillion. As more investors sought positive returns after the bear market of the early 2000s, hedge funds became popular. Assets flowed in from foundations, endowments, pension funds and the nouveaux riche.

Lots of people started hedge funds to capture some of the inflows. Not all were qualified, and many are now out of business, having lost not only their own money, but their investors' money as well.

A smaller hedge fund industry, with fewer high-quality managers fed by knowledgeable investors is a better scenario. This business isn't for everyone. Done correctly, hedge funds smooth out price inefficiencies and can contribute to better functioning capital markets. Done incorrectly, hedge funds can exacerbate market declines and add to volatility.

At the end of the day, hedge funds are like any other industry – their contribution to society (or the economy or whatever) is only as great as the individual contributors.

Are there some greedy bastards out there? Yes.

Are there also managers who sincerely believe in a mission of fulfilling a fiduciary responsibility to their clients - which include pension funds? Absolutely.

None of this is meant as a defense of the industry at large, only as a partial explanation of a very complex corner of the investment world and a rebuttal to the contention that hedge fund managers, as a group, contribute nothing and therefore should be paid nothing. Some … most, even … do contribute and should be paid something.

How much? Everyone can make his or her on judgment on that, but the way the system is set up now the question of “how much” is settled by supply and demand and this annoyingly elusive concept of “quality.” Now that would be a fun and high-level discussion. What is quality? Robert Persig wrote a whole book (Zen and the Art of Motorcycle Maintenance) about that. And I’ll stop now before this reaches book-length.

Back to you, Rick....

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