Socialist Standard  
February 2009
Published since 1904 - Journal of  The Socialist Party of Great Britain - Companion party of  The World Socialist Movement

  Smoke and Mirrors: The Bend Some and Hedges Effect
.continued from previous page..influences within the market economy
Hedge fund structures

In truth, the risk hedge funds present to the operation of the market economy’s financial system isn’t solely because of what they do, though it is true enough that regulated investment vehicles like unit trusts and investment trusts are legally unable to adopt many of the strategies hedge funds use. The main issue with hedge funds, exposed once and for all by the Madoff scandal, is that they are largely unregulated entities for the secretive and super-rich, and as such are open to all sorts of abuses, attempting to bend the investment ‘rules’ at will under the guise of innovative practice.

Most hedge funds are restricted to investors – who on investing usually become limited partners – with at least $1,000,000 (excluding their main residence), i.e. they are for capitalists only. They are also limited in terms of the number of investors who are allowed to join the fund. This is to avoid the restrictions and regulations placed by governments on other investment vehicles designed for mass participation and has been a way for hedge funds to slip ‘under the radar’ of the regulators. Most hedge funds – registered offshore for tax reasons and run as private investment partnerships – are covered by little in the way of investor protection and are barred from advertising or being sold to retail investors. Aside from withdrawing their investments (there are often restrictions on this too) hedge fund investors have little practical control over the managers, usually even less so than other collective investment vehicles like investment trusts which have shareholders and an elected board of directors answerable to them and which have to issue transparent annual reports, regular trading updates and so on.

The basic hedge fund structure appears to have changed little since they first appeared in the early 1950s, having been pioneered principally by Alfred Winslow Jones in the US, though many others – such as Warren Buffett before he developed his huge publicly quoted Berkshire Hathaway investment vehicle – established comparable private funds at a similar time. Annual management fees are high, typically 1 or 2 per cent of capital under management, with another 20 per cent of annual returns over and above an agreed threshold, explaining why in recent years many high-flying fund managers working for the big investment banks have been so keen to leave and set up their own hedge funds.

The role of hedge funds

Hedge funds, like private equity, have emerged in the present economic crisis as some of the ‘bad guys’ of the financial world, almost as if a capitalism without them would somehow be sane and humanitarian. Small investors in retail banks in the UK that have had to be nationalised or merged railed last year against the hedge funds for shorting bank stocks, driving their prices ever lower. It was clear that this would have happened anyway though as was illustrated when the share price slides didn’t stop when the shorting of financial shares was prohibited by government order.

There is always a place in capitalism for scapegoats, especially those as rich as most hedge fund managers have been (and as unpleasant as some of them no doubt are). But this detracts from the real issue which is the instability and chaos that lies at the heart of the money/prices/profits system itself. Capitalism without hedge funds is just as brutish and nasty as capitalism with them – and the irony is that if you accept the rationale of the capitalist economy, hedge funds and other speculators, contrary to much popular opinion, play a useful role.

Capitalism’s financial markets are the lubrication for the entire capitalist economy. These markets depend on liquidity and frequent trading to accurately match buyers and sellers at any one moment in time. If trading is thin, this matching of trades becomes difficult if not impossible, whether in shares, bonds, commodities, or more complex financial instruments. If, for example, shareholders investing via the stock market all used a ‘buy and hold’ strategy and didn’t generally sell their shares for long periods after buying them, the equity markets would be stifled and trading difficult. This is why hedge funds and speculators more generally perform a useful role for the system – they are one of the main ways of ensuring sufficient liquidity for it to be able to function properly. 

Their growth in size and influence, especially in the last 15-20 years, has been phenomenal, explained by their potential attractiveness to capitalist investors aiming for a steady but above average return, and their attractiveness to fund managers because of their flexibility and fee structures. The number of hedge funds in existence now runs into the thousands, with London’s Mayfair being nick-named ‘hedge fund alley’. According to the Financial Times (31st December), hedge fund assets under management have grown from less than $50 billion in 1990 to around $1,900 billion last year, making them a hugely significant economic force.

The current financial turmoil, however, has seen the biggest outflow of assets invested in hedge funds for decades, a sum estimated at $400-500 billion from January to November 2008. Lack of credit and high interest rates have meant that a great many hedge funds have had to de-leverage, reducing their debt as quickly as they can and selling their assets at the best prices they can get in falling markets. And as investors withdraw their money on the back of faltering returns, this has had the knock-on effect of hedge funds also having to sell their assets to meet redemptions, creating a vicious downward spiral for equity prices in particular, called ‘forced selling’. This was the cause of much (if not most) of the massive waves of selling on world stock markets last September and October, with quite unprecedented levels of market volatility over a sustained period.

Due to this de-leveraging and forced selling at low prices, several hedge funds have already gone bust and there will surely be more to come. In addition, because they were so highly leveraged, the unpredictable volatility in equity, bond and credit markets has ensured that some funds have just folded under the onslaught, including some of the macro and quant funds that should, in theory, have been able to capitalize on these situations.

As hedge funds operate in such a competitive market, those that don’t perform get shut down or merged with others (so much so that around 60 per cent of hedge funds are no longer around within five years of their inception). The financial crisis will almost certainly ensure that this figure increases further. Also, there are already indications that hedge funds will be the next target of the regulators and so it would seem that the great hedge fund bonanza is over, at least for now.

As for Mr Madoff, he will have done the cause of hedge funds no good either as their lack of transparency has been illustrated as starkly as it could possibly have been. Many capitalists will no doubt now be looking elsewhere to invest their wealth – so long as another Mr Madoff hasn’t made off with it first.

DAP
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