Perhaps it is not the wisest use of resources to write apologetics for the hedge-fund industry in this populist era. Indeed, when both the Sanders-Warren wing of the Left and the Bannon-Trump wing of the Right have chosen the hedge-fund world as a target of ire, arguing for the virtue of the industry might seem like an exercise in futility. But proving the “virtue” of the industry is not necessarily the point; giving an accurate assessment of what hedge funds mean to our economy and how policymakers and the public ought to think about them is.
President Trump does not appear to disdain hedge-fund managers as much as his populist campaign rhetoric suggested. Major Trump donor and Breitbart financier Robert Mercer was the genius CEO of Renaissance Technologies. Trump’s secretary of commerce, Wilbur Ross, is one of the greatest distressed-asset investors in history. Trump’s eleven-day communications director, Anthony Scaramucci, was the founder and CEO of renowned fund-of-funds Skybridge Capital. Even Treasury Secretary Steven Mnuchin founded a hedge fund of his own, Dune Capital Management. In short, the brain trust of the hedge-fund community has a funny way of being very appealing when partisan or ideological interests are properly aligned.
On the surface, why hedge funds are demonized is hardly a mystery: The top 1 percent of hedge-funders make unbelievable gobs of money. Some are far-left in their political orientation (George Soros, Tom Steyer, Jim Simons), and some are far-right (Paul Singer, Bob Mercer), but those who achieve “celebrity status” tend to be exorbitantly wealthy, and are known to flaunt it. Images of Greenwich mansions as elite centers of money and power provoked powerful resentment as many Americans were coping with the financial crisis, and helped feed a narrative of class envy. That well over half of hedge funds do not survive at all, and that a significant number flutter around trying to find their way, goes ignored. The multi-billion dollar success stories are used to paint a picture of oligarchy, facts be damned.
A common criticism of hedge funds is that they charge excessively high fees for increasingly poor performance, a criticism that should warm the hearts of those who hold hedge funds in contempt. Indeed, if the goal was for all hedge funds to disappear, the best way to make that happen would be for them to charge high fees and to fail to justify such fees with performance. The buyers of hedge funds are sophisticated investors, pension plans, sovereign-wealth funds, endowments, and complex institutions — those most intolerant of incompetence. If it were true that hedge funds were failing to justify these buyers’ investments, critics of hedge funds would have nothing to sweat whatsoever — for surely the hedge-fund industry would deteriorate on its own. Perhaps what adherents of the “high fee, low performance” school of thought have not realized is that many buyers of hedge funds are happy to pay higher fees for better downside protection when markets turn south. Or perhaps buyers, rationally, do not compare the performance of hedge funds to that of the broad stock market in the middle of a screaming-bull equity market. Whether one is convinced or not that hedge funds are a valuable proposition, the fact remains that hedge funds operate according to the rules of a free-market economy — value must be consistently validated, or customers will vote with their feet. No hedge fund has made its fees through coercion.
No hedge fund has made its fees through coercion.
So what is the reason to blast the hedge-fund space, once we realize that their fee calculus is actually a matter of market considerations? A popular criticism used to be that hedge funds added to the financial crisis, a theory that drips with irony. In fact, no hedge fund received a dollar of money from the Troubled Asset Relief Program; rather, the beneficiaries of TARP were the mainstream investment and commercial banks that over-levered their balance sheets to the hilt, then received a bailout from Congress when the assets they were holding lost value. Many hedge funds benefited in the aftermath of the crisis (those that bet on a recovery), but many tanked (those that bet the other way). It was an active manager’s playground, and risk-reward laws were well at play. Hedge funds posed no risk to the system whatsoever, and in fact, aided the economy a great deal: They provided liquidity, offered a two-sided market, and aided the process of price discovery when many esoteric derivatives were extremely hard to price. Theirs is a “put up or shut up” world, and access to Federal Reserve discount windows or taxpayer funds has never been available to hedge funds.
The irrational demonization of the hedge-fund industry has already brought about unintended consequences. After the financial crisis, Congress decided to prove that it was doing something by requiring hedge funds to disclose their positions on a quarterly basis in public filings. This increases risk, creating copycat investors, encouraging front-running, and causing other misallocated-capital decisions from those who see the funds’ positions without being privy to the entire thesis that justifies their bets.
The new tax-reform bill is another instance of Congress using hedge funds to prove it is doing something. The bill purports to target the so-called “carried-interest loophole,” whereby “carry” (or performance fees) is taxed as capital gains rather than ordinary income to the manager receiving the performance fee. The issue is a political hot potato, with significant emotion on both sides. Populists have demanded that Congress take away the benefit to money managers, with Trump himself having campaigned on this very issue. So what has Congress managed to do? The real beneficiaries of this provision, private-equity managers, will be largely unaffected, as the tax-reform bill retains the generous loophole for anyone who holds an asset for more than three years (the average private-equity holding period is well over five years). Those barely benefiting from the present law because of their shorter holding period — in other words, hedge funds — will bear the brunt of this provision. As Cliff Asness put it in an op-ed for the Wall Street Journal:
Private-equity managers will retain their large benefit while hedgies and other active managers will lose their small one. It’s the Casablanca approach: Identify unsympathetic parties and hassle them a bit, just to show you’re doing something, even if it’s a complete diversion.
Could the irony of tax reform be that it enhances global competitiveness for multinational corporations, while stifling competitiveness for investors in those same companies?
If our goal is a future investing landscape that rewards good risk-taking and punishes bad risk-taking — a future landscape that is prepared to intelligently allocate capital in what will certainly be a challenging period — then we need to rethink the demonization of the hedge-fund industry. No, these men and women are not all angels, but of course neither are the regulators, politicians, or big banks. However, hedge-fund managers and their firms represent the best innovation that the market system has come up with for providing risk-adjusted investment strategies to investors, without using the American taxpayer as a backstop. The best investment managers prudently seek out inefficiencies in a marketplace that is chock-full of them. That happens to fill major investing needs of the hour. Price discovery, enhanced efficiency, and increased liquidity are just some of the benefits we risk losing by demonizing and diminishing the alternative asset-management sector.
The populist soothing that uninformed hedge-fund bashing facilitates is not worth it.