Hedge Funds: Important Liquidity Providers and “Small Enough to Fail”

By
Sebastian Mallaby

Sebastian Mallaby, author of More Money Than God, spoke to delegates at the 65th CFA Institute Annual Conference about the role of hedge funds in our financial system, making the case that their pursuit and exploitation of mispriced assets makes them critical providers of liquidity to markets and capitalism. Properly aligned incentives, the use of short positions and leverage, and trading flexibility, Mallaby said, are what allow hedge funds to deliver alpha. Posing much less risk to the financial system than “too big to fail” banks, hedge funds are, in contrast, “small enough to fail.”

Recounting the evolution of hedge funds, Mallaby noted that Alfred Winslow Jones created the first “hedged” fund in 1949, using short positions to offset his long positions. Jones also claimed 20% of his fund’s profits, reportedly modeling his compensation after Phoenician merchants, who retained a similar amount of profits from their ventures and distributed the balance to investors. Like Jones, most hedge fund managers today have significant personal stakes in their funds. Having real skin in the game separates hedge fund managers from more traditional asset managers, and Mallaby sees this as an important governor on risk-taking.

Mallaby pointed to Michael Steinhardt, George Soros, Paul Tudor Jones, and Julian Robertson as important financial innovators with contrarian instincts, each of whom reaped tremendous profits by uncovering asymmetric return opportunities, in which potential gains far outweigh potential losses. Financial markets, Mallaby contended, have benefited by the liquidity provided by similarly minded hedge fund managers willing to take the other side of the trade. Further, hedge funds’ flexibility, demonstrated by their ability to take on massive bets in short order, is unmatched elsewhere in the financial markets.

Challenging efficient market theory, Mallaby cited the investment performance of Ben Graham disciples (including Warren Buffett) and Robertson’s “Tiger Cubs” as evidence that superior investment performance is not necessarily random.

While their fat fees and profits may have created a public perception challenge for hedge funds, Mallaby was quick to point out that they pose minimal risk to the financial system. The recent financial crisis and resulting government bailouts made clear the systemic risk posed by big financial institutions. Over the same period, hedge funds proved themselves to be “small enough to fail.” The market absorbed the failure of thousands of hedge funds over the past decade with no discernible destabilizing impact and, importantly, no taxpayer-funded rescues.

Mallaby closed by suggesting that with their focus on absolute, rather than relative, returns and their typically low correlation with overall market movements, hedge funds deserve inclusion in diversified institutional portfolios.

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