Hedge funds are not the root of all evil

In one of today’s SIBOS panel debates we managed to convince an informed audience that hedge funds are not the root of all evil, and hopefully I’ll be able to convince you.

The market event of this week have brought the issues of risk and exposure to the fore and with that comes the usual witch hunt that has traditionally targeted the high-yielding and more esoteric investment strategies.  In the early 80’s we saw this with futures and we are now seeing the same with hedge finds.

It is only human that we rationalize the world around us and in times of stress and adversity we search for someone or something to blame and history has shown that we have a tendency to attack those that seek to challenge conventional wisdom. Galileo, now considered the founder of modern astrology and physics, was once labelled a heretic for his suggestion that the world earth revolves around the sun and then scientific discovery proved him right.

Similarly, it is wrong that hedge funds are put in the line of fire for the recent unravelling of the financial markets.  The write down of sub-prime assets and credit portfolios is a result of failed valuation, failed ratings models, excess leverage, and poor business practice on the part of investment and commercial banks.  The absurdity of lending practices of mortgage banks contributed to this predictable meltdown – not to mention a massive lapse in personal responsibility of borrowers.  Hedge funds cannot be blamed for the fundamental breakdown in our risk and audit procedures, it has been years of apathy on the part of banks to deal with what they already knew was a problem.

The esoteric nature of hedge finds makes them a target for speculation surrounding their investment practices but if we consider the investment industry, the large fines and enforcement actions relating to fraudulent practices have come against mutual find companies and broker dealers, and related to market timing and other conflicts of interest.  By contrast the largest hedge find failures – Amaranth and LTCM – were caused by bad trades not by manipulative practices or accounting fraud.

Hedge funds, whether they are registered or not, are subject to the same anti-fraud provisions faced by traditional institutions within all regulatory regimes. In fact, to attract more investments from institutions, many hedge funds are voluntary registering and investing in the same technology and trade-processing infrastructure as traditional asset managers.

As brokers have become more risk adverse in terms of putting their own capital at risk, hedge funds have stepped up to become a vital source of liquidity in normal market conditions during periods of stress.  By some estimate, hedge funds now account for 40% of the volume of the NYSE and LSE, 70% of turnover in convertible bonds, and 80% of the volume of distressed debt.  Liquidity is the lifeblood of our industry and the root of all evil is not hedge funds but a marketplace that lacks liquidity.