The Corner

On Hedge Funds and Their Managers

Over the weekend, the Wall Street Journal ran an interview with hedge-fund manager Paul Singer in which he warns regulators about  the next financial crisis. It’s not Singer’s first warning to lawmakers. At the height of the housing bubble, he was shorting subprime mortgages and sounding the alarm, in vain, about that crisis. Today, the founder of Elliott Management sees the biggest banks headed for another credit meltdown — among other reasons because of our very risky monetary policy. I find this very interesting:

The largest financial institutions, he says, are “a random collection of survivors. Almost none of the survivors exist because of their perspicacity, risk controls and sound management—even the ones that are vaunted along those lines. . . . How and why do they exist? Mostly an accident, meaning who got bailed out first and who was saved next and how did people feel and what did people say the weekend Merrill was under pressure [in September 2008].”

Mr. Singer says he does as little business with big banks as possible. “Aside from a large position in Lehman as part of our bankruptcy investing, we have no significant positions in global banks.”

“We institutionally have tried to—way before the crisis of ‘08—tried to insulate ourselves in every way we can from the counterparty problem,” i.e. getting involved in a trade with a partner that might not be able to make good on its obligations down the line. But the nature of his business, he says, means that he can’t sever all connections. “We’ve removed as many assets from the Street as we possibly can, and we think we’re pretty well insulated. . . . If we could completely avoid being subject to the financial condition of any large financial institution, we would do so.”

This statement by Singer confirms my view that, contrary to common belief, hedge funds tend to be relatively prudent in their investments. For instance, highly leveraged hedge funds are the exception rather than the rule. Also, even though hedge funds are lightly regulated, they systematically outperform the stock market during downturns. I talked about this issue last Wednesday on Bloomberg with Carol Massar and Matt Miller.

An explanation for this trend is that the legal regime under which hedge funds operate allows them to pursue innovative investment strategies through leverage, short sales, and derivatives, but the entity and contract-law governance of hedge funds provides the managers with incentives to be innovative while maintaining a relatively healthy balance between risk-taking and risk management.

Take, for instance, the hedge-fund compensation scheme. Hedge-fund managers are compensated by charging a management fee based upon the size of the fund (typically 1 to 2 percent for hedge funds) but they also charge an annual performance-based fee, typically 20 percent of profits. In addition, they often invest their own money in the funds they manage. This compensation structure generally leads hedge funds to be more prudent in risk-taking than other financial companies. Interestingly, in the 2-and-20 model (up from 0-and-20 or 1-and-20), which provides managers with significant net management fees (i.e. fees over and above the costs of running the business), most hedge fund managers seek to maximize asset size and put much more emphasis on low volatility at the cost of returns so that they can optimize assets under management and asset-management fees.  

A script of my Bloomberg appearance is here. Thanks to Matt Mitchell for sending me this interview.

Veronique de Rugy — Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.

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