End of the Hedge Fund?
By Sebastian Mallaby
December 18, 2008

For sheer toe-curling embarrassment, it may be a while before Wall Street does better than the Bernard Madoff scandal. Here was a rogue who practically telegraphed his unreliability by hiring a tiny, no-name audit firm, by reporting monthly investment results that never fluctuated and by claiming a trading strategy that could not possibly have been implemented given the billions of dollars he managed. And yet, despite these warnings, the rich, the famous and the supposedly sophisticated entrusted their money to Madoff, who defrauded them with the most laughably crude of methods – an old-fashioned Ponzi scam.

The question this prompts is not really about regulation, though some argue otherwise. Even if you define Madoff’s investment outfit as a hedge fund, which for various reasons is debatable, there’s nothing in this saga that supports clamping down on the industry…

Because it is possible to commit undetected fraud, the industry will attract fraudsters; eventually, investors will realize that they can’t tell the good guys from the bad and yank their money out. If this is going to happen, the Madoff scandal could be the catalyst, especially because it has hit at a time when hedge funds are in trouble for other reasons. Hedge fund strategies depend on borrowing, or "leverage," which is hard to come by now. They often depend on "shorting" stocks – that is, betting that they’ll fall in value – but regulators have restricted that practice. Even before the Madoff scandal, there were estimates that hedge fund assets might shrink from just under $2 trillion a few months ago to perhaps $1.4 trillion.

But it would be wrong to count the hedge funds out. Perhaps half of all funds use strategies about which there is no great secret, so disclosure is possible: The Foster-Young argument does not cut so sharply here. The other half can find ways to signal their honesty without disclosing their tactics: The most obvious is for managers to keep a serious amount of their own money in their funds. Good hedge funds really do know how to make money out of market inefficiencies. After the past 18 months of mayhem, it should be painfully obvious that there is plenty of inefficiency around.

Hands Off Hedge Funds
Sebastian Mallaby
From Foreign Affairs
January/February 2007

Summary:  The massive growth of hedge funds has sparked warnings of instability and demands that the industry be regulated. But the fear of hedge funds is overblown, based on a misunderstanding of their role in the international financial system. In reality, hedge funds do not increase risk; they manage it — and policymakers, rather than clamping down, should make sure hedge funds have the tools to perform this function well…

In the end, the critics of hedge funds would do well to remember why this sector has emerged as such a force. Until the late 1960s, the financial world was quaintly stable: exchange rates were inflexible, interest rates were regulated, and the whole system was anchored by a fixed gold price. But that world collapsed when inflation drove the dollar off the gold standard and currencies and interest rates began to float; from then on, it became impossible to amass savings without facing financial uncertainty. Tools for coping with that uncertainty — deep markets in futures, options, and other derivative instruments — sprang up in response to the newly volatile environment. And hedge funds emerged as the masters of these tools, providing quasi insurance to investors and firms and introducing a healthy dose of contrariness into financial markets. For this, they are accused of generating risk. But their real systemic function is to manage it – and it is their very success in doing so that has generated both their profits and their phenomenal growth.

Hedge fund
From Wikipedia

A hedge fund is a private investment fund open to a limited range of investors that is permitted by regulators to undertake a wider range of activities than other investment funds and also pays a performance fee to its investment manager. Each fund will have its own strategy which determines the type of investments and the methods of investment it undertakes. Hedge funds as a class invest in a broad range of investments extending over shares, debt, commodities and beyond.

As the name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging their investments using a variety of methods, most notably short selling. However, the term "hedge fund" has come to be applied to many funds that do not actually hedge their investments, and in particular to funds using short selling and other "hedging" methods to increase rather than reduce risk, with the expectation of increasing return.

Hedge funds are typically open only to a limited range of professional or wealthy investors. This provides them with an exemption in many jurisdictions from regulations governing short selling, derivative contracts, leverage, fee structures and the liquidity of interests in the fund. A hedge fund will typically commit itself to a particular investment strategy, investment types and leverage levels via statements in its offering documentation, thereby giving investors some indication of the nature of the fund.

The net asset value of a hedge fund can run into many billions of dollars, and this will usually be multiplied by leverage. Hedge funds dominate certain specialty markets such as trading within derivatives with high-yield ratings and distressed debt.

I call "Bottom Feeders" on Hedge Funds!

• They deal only with the wealthy [a private investment fund open to a limited range of investors]
• They skate regulation [permitted by regulators to undertake a wider range of activities than other investment funds]
• They claim to be removing uncertainty by dealing in risk [it became impossible to amass savings without facing financial uncertainty]
• They are gamblers who know the market and its quirks [make money out of market inefficiencies]
• They are fraud magnets [Because it is possible to commit undetected fraud, the industry will attract fraudsters]
• They might be honest, if you look carefully [half of all funds use strategies about which there is no great secret, so disclosure is possible… The other half can find ways to signal their honesty without disclosing their tactics]
• et cetera

You can’t make money unless you are the Federal Reserve Bank or a Counterfeiter. You can earn money or you can take money. But you simply cannot make money. All of this money that the wealthy investors "make" and their managers "make" is taken from somewhere. Sebastian Mallaby wants to be sure that the Hedge Funds survive so the rich can get richer and not have to worry about uncertainty, and the fund managers can get even richer than their clients? Sebastian Mallaby thinks that it’s important to make money out of market inefficiencies? Sebastian Mallaby thinks that the Market will self-correct ["eventually, investors will realize that they can’t tell the good guys from the bad and yank their money out"]?