• Hedge fund chiefs appear before US Congress today
• ‘Hellish’ industry comes under fire from all sides
Like urban foxes, they dislike the glare of lights and avoid the human gaze. But the stealthiest, wealthiest billionaires in America’s hedge fund industry will reluctantly show their faces today to deny that they have wrecked the global economy.
At a hearing of Congress’s house oversight committee called by the pugnacious Democrat Henry Waxman, five top hedgies with a combined wealth of $29bn (£19bn) will be called to account on the activities of their secretive, high-risk, barely regulated industry.
John Paulson, George Soros, Jim Simons, Ken Griffin and Philip Falcone are the cream of a crop of financiers who, to their enemies, are the robber barons of the modern economic order.
The world’s richest man, Warren Buffett, has dubbed their fees “grotesque”. Italy’s finance minister has called for the funds to be banned, branding them a “hellish” industry of “absolutely crazy bodies”. Germany’s former deputy chancellor once compared them to swarms of locusts.
For a decade, hedge funds have seemed to be a licence to print money with returns comfortably beating the stockmarket. Some 10,000 funds globally manage more than $2tn. But for many players in the industry, the gravy train has come to an abrupt halt.
According to Chicago-based Hedge Fund Research, more than 350 hedge funds have liquidated this year. The average fund has lost 15% its value with five successive months of decline and some believe that as the shake-out accelerates, the industry could shrink by a half. So what has gone wrong?
Roger Ibbotson, a Yale University finance professor who chairs a US fund, Zebra Capital Management, says firms have been hit by a double whammy of a financing squeeze and dismal returns.
Traditionally, hedge funds have borrowed heavily on the back of their clients’ money to increase their leverage and to give them more chips to gamble. But banks, wounded by the credit crunch, have become more risk averse and with the failure of Bear Stearns and Lehman Brothers, two leading servicers to the industry have disappeared.
“Hedge funds have had to de-leverage and they’ve all had to do it at the same time,” says Ibbotson. “That has been catastrophic for a lot of firms.”
Hedge funds hurriedly exiting positions have been blamed for aggravating extreme stockmarket volatility. Meanwhile, many have been exposed as simply lacking the cunning to compete in a fast-moving, crisis-stricken economy.
John Godden, managing partner at London-based hedge funds consultancy IGS, says the industry has expanded too far and too fast, at the cost of quality.
“Barriers to entry have been too low,” he says. “People have been able to start funds with a minimum amount of capital, they’ve been able to get set up with service providers and they’ve been able to do so with a sub-par skill level.”
Among those suffering the most are “long-short” funds that buy some shares and bet on drops in others. Godden says many such funds have been found to be lacking.
“As a total strategy, equity long-short has failed miserably this year because, frankly, many of them weren’t equity long-short – they were equity long,” says Godden. “They’ve ridden the market wave over the past few years and they didn’t have the skill set to do what they’re supposed to in a downturn.”
Just this week, a $10bn Connecticut-based former high flyer, Tontine Capital, shut two of its four funds after slumps of more than 65%. A number of funds have frozen investor withdrawals, including Platinum Grove Asset Management, run by the Nobel Prize winner Myron Scholes. Even Ken Griffin’s massive Chicago-based Citadel Group is suffering, with falls of 35% in two of its key funds.
Longstanding critics of the industry claim vindication. Peter Morici, professor of business at the University of Maryland, says hedge funds originated in a lucrative niche that has simply become too crowded.
“There were some very smart guys who would find seams in the market – inconsistencies in pricing on different markets,” says Morici. “But if a lot of people do it, they end up competing against each other for very small opportunities. The concept of a hedge fund was simply not scale-able.”
To opponents, the vast growth of the hedge fund industry has contributed to a culture of risk and aggression that has infected traditionally staid banks in the Square Mile and on Wall Street, with catastrophic consequences as the credit markets unwind.
“They were, in part, responsible for creating this culture,” says Morici, who predicts that hedge funds will recede to cater for their original client base of sophisticated, wealthy investors before boom times arrived at the beginning of the decade.
But insiders beg to differ. The crisis, they believe, presents a long-term opportunity. As the likes of Goldman Sachs and Morgan Stanley retreat to become commercial banks, hedge funds will fill the “risk-taking” space on Wall Street. Hedge funds themselves, say advocates, are victims, rather than villains, in the present crisis.
“Hedge funds are the product of a world that demands higher returns,” says Adam Sussman, director of research at the US financial consultancy Tabb Group. “It’s human nature to fulfil that demand.”
At today’s hearing, congressional figures are likely to quiz hedge fund bosses about the likely impact of greater regulation. One possibility is that firms could be required to disclose information about their holdings. There could also be longer-term restrictions on short-selling shares – a phenomenon blamed by some for destabilising troubled banks.
Sussman expects the fee structure of hedge funds to take a knock as clients prove harder to come by, with earnings to becoming far more modest in years to come. But he doubts that government oversight will kill off the industry. “There will always be hedge funds – but they might not be called hedge funds. They’ll come up with a new entity that will allow them to make more money.”