Don't believe everything you hear about the clout of hedge funds.
Hedge fund managers are the swashbuckling buccaneers of high finance. Their annals are enlivened by headstrong characters, starting with the founding father of the industry, Alfred Winslow Jones, who, after attending the Marxist Workers School in Berlin, established the first "hedged" investment fund in 1949. (Jones' fund was hedged in the sense that, by taking both long and short positions in stocks, it was insulated from movements in the level of the market. Nowadays the name is applied to private funds open to high-wealth individuals, regardless of investment style.) There is George Soros, the Hungarian émigré whose multibillion-dollar bet broke the Bank of England in 1992. There is Julian Robertson, the muscular Southerner who, when not competing in extreme Outward-Bound-like challenges, made and lost billions betting on global markets.
Some would portray hedge fund managers less romantically—less Errol Flynn or even Johnny Depp than Somali pirates. Hedge funds gang up on weak countries. If toppling their currencies means toppling their governments, then so be it. If you listen to Angela Merkel and Nicolas Sarkozy, the hedge fund "wolf pack" has driven spreads on Spanish and Portuguese bonds to unjustified heights in a calculated effort to dismember the euro zone.
Either way, the story makes for colorful reading. In More Money Than God, Sebastian Mallaby tells it well, if not exactly for the first time. What he brings to the table is unmatched access. One suspects that the masters of the hedge fund universe, seeking to secure their places in the history books, saw the Paul Volcker Senior Fellow in International Economics at the Council on Foreign Relations as the kind of responsible chronicler in whose presence it was safe to let down their hair.
Not that this cocksure breed is reticent about describing how they made money at someone else's expense. I have a bit of firsthand experience with this. In 1998, Malaysian Prime Minister Mahathir bin Mohamad famously accused hedge funds of colluding to destabilize Asian currencies and asked the International Monetary Fund to investigate. * The fund put me on the job. Armed with a corporate credit card and an IMF rolodex, my little team traveled to London, New York, and Greenwich, Conn., to interview the usual suspects.
I assumed our interlocutors would be less than forthcoming, confronted by a posse whose opening was essentially "Hi, we're from the IMF, and we'd like to know whether you caused the Asian crisis." In fact, they were refreshingly straightforward, used as they were to being judged on their results, not their methods. When we asked, "do you and your colleagues at other funds talk to one another about what countries and currencies are vulnerable," we got answers like "Sure, guys are always calling me and asking what other countries we can blow up."
Mallaby's account benefits from this kind of candor. But it also inclines him to give the claims of hedge fund influence too much credence. Other institutional investors take all the same bets—for and against currencies, for and against securities, for and against commodities. And other institutional investors, notably banks, have even more financial firepower at their disposal. They also trade on the same kind of information. Mallaby describes how the event that led Soros to take a position against the Thai baht in 1997 was a meeting in which the Bank of Thailand's No. 2 described his reluctance to use interest rates to defend the currency. In investigating the same episode for the IMF, we found that the real villain of the piece was the investment bank that was advising the Bank of Thailand about how to defend the baht and at the same time using that information to bet against it. Hedge fund managers may be amoral, but at least they're up-front about it.
All of which suggests that the importance of hedge funds in moving markets is exaggerated. Anticipating the point, Mallaby suggests several ways in which they may have disproportionate impact. First, hedge funds are the smart money. The best traders go out on their own where they can make "2 and 20," a 2 percent maintenance fee on the money they manage plus 20 percent of the profits. Given their reputation as the smart money, where hedge funds lead, the herd follows. Thus, even when the bets taken by hedge funds are not large enough to sway markets by themselves, they can send the herd stampeding off in one direction or the other.
But Mallaby's own account casts doubt on the smart-money presumption. For every tale of exceptional profits, there is another of exceptional losses. Soros made a fortune betting against the Thai baht but lost his shirt betting on the Indonesian rupiah. * LTCM had a glorious four-year run but avoided bankruptcy in 1998 only with the help of a rescue orchestrated by the Federal Reserve Bank of New York. If hedge fund managers command a special aura, this is in part because they are more prone to talk about their successes than their failures. Indices of hedge fund performance lend themselves to the same exaggeration. As unregulated private partnerships of wealthy investors, hedge funds can choose when to start publicly reporting their returns. New funds generally start reporting when their returns are favorable. Old ones falling on hard times close up shop, dropping out of the population of funds being tracked. Both biases inflate the rate of return of the industry as a whole.
Even if hedge fund managers are not smarter, Mallaby notes, they may still be able to move markets by their adaptability and speed. Unlike pension funds and mutual funds, they don't have restrictive covenants and mandates limiting them to particular investments. They can go short as well as long. When circumstances change, they can turn their portfolios upside down, upending markets with them.
But proprietary traders at big banks have more or less the same freedom of action. A prop trader's only mandate is to make money. The positions of the proprietary trading desk may be only a small part of the typical bank portfolio, but the bank of which they are part may be many times larger than even the largest hedge fund. It is this, and the worry that prop trading creates volatility, that has led the Obama administration to propose prohibiting commercial banks from engaging in the practice.
Barry Eichengreen is George C. Pardee and Helen N. Pardee professor of economics and political science at the University of California–Berkeley. He was senior policy adviser at the IMF in 1997-98.