Edge in hedge
The first hedge-fund manager, Alfred Winslow Jones, took a job on a tramp steamer, studied at the Marxist Workers School in Berlin, and ran secret missions for a clandestine anti-Nazi group called the Leninist Organization. It was only at the advanced age of forty-eight that Jones raked together $100,000 to set up a “hedged fund,” generating extraordinary profits through the 1950s and 1960s. Almost by accident, Jones improvised an investment structure that has endured to this day. The four key features that he combined to spectacular effect are performance fees, avoiding regulatory red tape, hedging and leverage.
Ah yes, that money! By the 1990s, hedge funds birthed a new elite. They earned vastly more than the captains of Wall Street’s mightiest investment banks and eclipsed even private-equity barons. Ken Griffin, the creator of Citadel Investment Group, bought himself a $50 million Bombardier Express private jet and had it fitted with a crib for his two-year-old. Steven Cohen, the boss of SAC Capital, equipped his estate with a basketball court, an indoor pool, a skating rink, a two-hole golf course, an organic vegetable plot, paintings by van Gogh and Pollock and a movie theatre decorated with the pattern of the stars on his wedding night sixteen years earlier.
And what an elite this was. Hedge funds are the vehicles for recluses and contrarians, for individualists whose ambitions are too big to fit into established financial institutions. Jim Simons of Renaissance Technologies, the mathematician who emerged in the 2000s as the highest earner in the industry, would not have lasted at a mainstream bank: He took orders from nobody, seldom wore socks, and got fired from the Pentagon’s code-cracking center. Ken Griffin of Citadel, the second-highest earner in 2006, started out trading convertible bonds from his dorm room at Harvard; he was the boy genius made good, the financial version of the entreprenerds who forged tech companies such as Google.
On the other not-so-glam end, hedge funds have always clashed with the academic view of markets. By the start of the twenty-first century, there were two competing views of hedge funds. Leverage gave hedge funds the ammunition to trade in greater volume, and so to render prices more efficient and stable. But leverage also made hedge funds vulnerable to shocks: If their trades moved against them, they could burn through thin cushions of capital at lightning speed, obliging them to dump positions fast — destabilizing prices.
Then came the crisis of 2007–2009, and every judgment about finance was thrown into question. In July 2007, a credit hedge fund called Sowood blew up, and the following month a dozen or so quantitative hedge funds tried to cut their positions all at once, triggering wild swings in the equity market and billions of dollars of losses. The following year was more brutal by far. The collapse of Lehman Brothers left some hedge funds with money trapped inside the bankrupt shell, and the turmoil that followed inflicted losses on most others. Hedge funds needed access to leverage, but nobody lent to anyone in the weeks after the Lehman shock. Hedge funds were reliant upon the patience of their investors, who could yank their money out on short notice. But patience ended abruptly when markets went into a tailspin.
Surely now it was obvious that the risks posed by hedge funds outweighed the benefits? This conclusion, though tempting, is almost certainly mistaken. The cataclysm has indeed shown that the financial system is broken, but it has not shown that hedge funds are the problem. If the Fed had curbed leverage and raised interest rates in the mid-2000s, there would have been less craziness up and down the chain. Presented with an opportunity to borrow at near-zero cost, people borrowed unsustainably.
The clearest problem is “too big to fail” — Wall Street behemoths load up on risk because they expect taxpayers to bail them out, and other market players are happy to abet this recklessness because they also believe in the government backstop. But this too-big-to-fail problem exists primarily at institutions that the government has actually rescued. By contrast, hedge funds made it through the mayhem without receiving any direct taxpayer assistance.
The very structure of hedge funds promotes a paranoid discipline. Hedge funds tend to be scrappy upstarts with bosses who think nothing of staying up all night to see a deal close. Hedge funds have to demonstrate that they can manage risk before they can raise money from clients. Banks take the view that everything is going wonderfully so long as borrowers repay; hedge funds mark their portfolios to market, meaning that slight blips in the risk that borrowers will hit trouble in the future can affect the hedge funds’ bottom line immediately. Hedge funds live and die by their investment performance. Capitalism works only when institutions are forced to absorb the consequences of the risks that they take on. To a surprising and unrecognized degree, the future of finance lies in the history of hedge funds.