Financial Crisis

The Truth About Hedge Funds and the Financial Crisis

Separating economic fact from economic myth

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Editor's Note: Reason columnist Veronique de Rugy appears weekly on Bloomberg TV to separate economic fact from economic myth.

Myth 1: Hedge funds are highly leveraged.

Fact 1: The market exposure of most hedge funds is less than twice the percentage of assets under management.  

Contrary to commonly-held belief, highly-leveraged hedge funds are the exception rather than the rule. Hedge funds use short sales and derivatives to manage risk and reduce losses when the market is performing poorly. In addition, hedge funds often borrow funds or use other forms of leverage to magnify gains.

Furthermore, hedge funds take no part in the process of underwriting new securities. Nor do they serve as brokers or dealers of securities and derivatives. These funds have a single line of business—asset management—and they typically use relatively small amounts of leverage to finance and profit from their investment activities.

A 2007 study of hedge fund leverage by Adrian Blundell-Wignall,  a deputy director of the Organization for Economic Co-operation and Development (OECD), which included leverage from borrowed funds and implicit leverage from derivatives, estimated that average hedge fund leverage was 3.9-to-1 (which means that for every $3.9 in hedge fund assets, $1 was equity and the rest was borrowed (or the economic equivalent of borrowing was achieved by using derivatives), with the bulk of the leverage coming from derivatives. In 2008, the International Monetary Fund (IMF) estimated that average global hedge fund leverage from borrowed funds had a ratio of 1.4-to-1.

The chart above is based on data from the McKinsey Global Institute; note that it measures leverage in a slightly different way than the OECD does (gross leverage here is assets plus liabilities divided by assets) but the overall outcome is quite similar. As you can see, even at its peak, total leverage in the hedge fund industry was not more that 3.5 times the level of assets under management—far below the leverage ratio of banks.

For context, consider that banks are typically leveraged at least 10-to-1 and investment banks are usually leveraged at least 20-to-1. In the case of investment banks, this means that for every dollar actually held by the investment bank, it had borrowed between $20 and $30.

More interestingly, as New York Law School professor Houman Shadab notes in his article "Hedge Funds and the Financial Crisis," the contrast between the levels of leverage in these different components of the financial sector became even more pronounced in the lead-up to the financial crisis. For example, banking sector leverage usually ranged from 12-to-1 to 17-to-1 while major U.S. investment bank leverage became as high as 33-to-1 in recent years.

Myth 2: The hedge fund industry's tendency to take excessive risks, combined with a lack of regulation, was an important cause of the financial crisis.

Fact 2: Not only did hedge funds not precipitate the financial crisis, they did nothing to exacerbate it. If anything, hedge funds have helped the economy to recover more quickly.

It is a fact that hedge funds are not as heavily regulated as other financial institutions. Also, they are not required to register with investment authorities or report on their activities. As a result, it is often alleged that hedge funds played a role in the emergence of the credit crisis, contributing to volatility through short-selling and by selling shares as a result of de-leveraging and redemptions.

The data, however, does not support such theories. While hedge funds have often seen greater payoffs than the larger financial industry, they have done so while taking fewer risks.  

McKinsey Global Institute research shows, for instance, that a significant portion of hedge funds have delivered higher and less volatile returns than investments in public equities and bonds over time, including during the financial crisis.

McKinsey also found that since 1990 investors in hedge funds have earned higher returns than investors whose portfolios contain only equities and bonds. Between 1990 and 2008, an index of hedge funds outperformed a range of blended portfolios of U.S. bonds and equities. The hedge fund index produced 12 percent average annual returns over the period, compared with 7.8 percent for a portfolio of only equities and 7.2 percent for a portfolio of only bonds.

More importantly, hedge funds fared relatively better during the financial crisis than other firms in the industry. In 2008, as losses from the U.S. mortgage market turned into an international financial crisis, global equities dropped 42 percent. Yet hedge funds suffered worldwide losses of just 27 percent.

As the following chart from Shadab's "Hedge Funds and the Financial Crisis" shows, hedge funds have systematically outperformed the stock market in downturns.

Why? These outcomes are attributable in large part to the legal regime under which they occur. First, federal law enables hedge funds to pursue innovative investment strategies through leverage, short sales, and derivatives. Second, contract law and the hedge fund structure provides fund managers with incentives to innovate while maintaining a relatively healthy balance between risk taking and risk management.

Take 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 frequently 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. 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. 

Basically, it is a myth that hedge fund managers are risk takers who seek to maximize returns.   

As Shadab notes, "a general lesson from the law and economics of hedge funds is that when a legal regime permits financial intermediaries to be flexible in their investment strategies and aligns the incentives of investors and innovators through performance fees and co-investment by managers, financial innovation is likely to complement investor protection without wide-ranging regulation."

Myth 3: Most hedge fund managers are billionaires.

Fact 3: Who cares? But if you must know, the average hedge fund manager's yearly earnings are $336,000.

We hear all the time that hedge fund managers are billionaires. This belief likely stems from a highly-publicized survey which revealed that in 2009, the 25 highest-paid hedge fund managers earned a collective $25.3 billion, beating the old 2007 high by a wide margin. Yet this number is not representative of the larger hedge fund industry.

The chart above uses data collected from a series of confidential surveys of fund managers and employees across a variety of firms, large and small. Average compensation of hedge fund managers in 2009 was around $336,000 with roughly 50 percent of this compensation paid as a bonus. Importantly, since compensation is so closely tied to performance, managers have the incentive to maximize performance and take judicious risks. In other words, they have some skin in the game.

While much has been made of super-rich hedge fund managers such as George Soros and David Tepper, compensation actually varies widely within the profession. On the low end, earnings fall within the $50,000 range; on the high-end, certain well-publicized partners, principals, and fund managers make over a million dollars annually. The majority of hedge fund managers surveyed in 2008 reported compensation in the $100,000 to $300,000 range. Less than 2 percent of hedge fund managers report earnings of over a million dollars.

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

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  1. I’d like to leverage Veronique’s hedge fund, if you know what I mean.

    Even if she does pronounce “ratio” like a foreigner.

    1. Veronique seems to have been very libertarian about cocaine before this interview.

  2. This is a good article but it does leave out one fact that many who are critical of hedge funds complain about — the managers are paid on the “carried interest” method instead of normal income tax rules and thus avoid billions in income taxes.

    1. Re: shrike,

      the managers are paid on the “carried interest” method instead of normal income tax rules and thus avoid billions in income taxes.

      Oh, the humanity! I shred my garmets! People avoiding being robbed!

      What has the world come to when State thieves cannot be successful???

      1. What has the world come to when State thieves cannot be successful???

        So when a certain class of people gets to exempt themselves from the income tax system, you’re OK with it, even if it means more of the burden falls on everyone else with earned income to pick up the slack.

        Your logic only makes sense if:
        1) You believe that less revenue will cause less spending, which can’t be farther from the truth.
        or
        2) You think social engineering is awesome when you relate to the beneficiaries.

        1. So am I evil for contributing to a 401k and IRA, claming my children and deducting my son’s tution from my taxes last year?

          Before you answer that IS EXACTLY YOUR ARGUMENT. My deductions increased the tax burden for someone else.

  3. Oh hell, I just noticed the Soros picture…

    In will come the Beckerhead conspiracy idiots who will insist the great communist-fighting capitalist is a “socialist” simply because Beck said so and he fought creeping GOP fascism 2001-08.

  4. I’m reading “The Big Short” right now, which barely mentions hedge funds. It was the big banks appetite for creating mortgage backed bonds, built on loans they didn’t understand. They’d extend bad loans (indeed created entire industries to collect them) so that they could bundle and sell the bonds. Then they started doing credit swaps, so they could create another layer of profit on top of the same loans. AIG was dumb enough to insure the swaps that it didn’t understand, and when the loans started defaulting (as housing prices levelled) the resulting need to pay off those huge bets resulted in a cash crunch that caused the whole thing to go tilt. I’ve explained it poorly, but it is a great read.

    1. Indipolitic|3.18.11 @ 7:26PM|#
      “I’m reading “The Big Short” right now, which barely mentions hedge funds.”

      That’s not all it doesn’t mention.
      From a review:
      “But Lewis does not use his 264-page book to even apply one word – not one single utterance – against the malignant government policies behind much of this malaise.”
      http://www.amazon.com/Big-Shor…..233&sr=1-1

      1. Quite true, and the book would be better with a policy discussion. However, it should be read anyway, he’s provided an educated template — you can insert the policy failings of your choice.

  5. I predict this will be over 400 comments.

    1. No. This is something we can all agree upon.

      You need something about Palin, gay marriage, or the Ground Zero Mosque to rile up those kind of numbers.

  6. Eat something, Veronique, and keep it down.

    1. Like what I would do with Obama’s man seed.

  7. Interesting.

  8. Agree that this is a great post.

    Whenever I read Veronique’s posts on fiscal conservatism, I’m reminded of a post from yesteryear by one of our resident Team Red trolls.

    Enjoy


    Karl|4.12.08 @ 8:05AM|#
    Veronique de Rugy – who is this clown, must be French with a name like that. Crawl back into your institutional echo chamber with your theory’s and numbers. Talk about Hit and Run, come back to me when the US has been attacked again but this time by Iranian made dirty bombs after the Democratic Surrender Monkeys have left Iraq. Sadly these events will probably take place in big cities like LA,Philli, NYC, DC, Boston, filled with unexpecting people and mostly of liberals. Us gun toting, bitter church goers with pray for you. I certainly don’t need numbers and charts to identify who the enemy is and what they want to our country.

    1. That oldie-but-baddie was both funny and yet also left me bereft of several IQ points.

      Though it is a relief to see Team Red admit that it has little regard/penchant for annoying numbers-n-charts-n-facts-n-stuff (which are evil al Qaeda inventions designed to convert our Christian children to homosexuality or some such).

  9. The only thing that needed to be said is that no hedge fund was bailed out by the federal government.

    That is proof enough that they had nothing to do with it.

  10. Golly gosh,
    It wasn’t fault of the hedge funds,
    Wall Street, Fannie, Freddie, & the banks weren’t at fault either. They all say so.

    So nobody’s at fault. It all just happened, like a meteor strike….

  11. The primary cause of the crises was wanton printing of debt by world central banks. Hedge funds egged this on by lobbying for more printing of credit, so they could borrow it cheaply.

  12. I don’t know where to post this but when is Reason going to publish an article supporting the bombing of Libya? I know that’s not an opportunity that fake libertarians would pass up… I guess it’s related to this article considering the amount of taxpayer money wasted on it that we could just give back to the people that earned it which would help with the economy.

  13. The richer get richer and the poor get poorer. Nobody cares. It’s all about survival of the fittest.

    1. Spoken like a true progressive.

  14. http://online.wsj.com/article/…..7884e.html

    Yeah ok Hedge funds are so good! What a load of bull! They short commodities meanwhile driving them up to make them more profit! Who do you think is contributing to up tick in oil prices! The measly 1.5 million barrels exported from Libya is just a capitalization market!
    http://money.cnn.com/magazines…../index.htm
    Fools!

    1. How exactly do you short something and drive up the price? You’re out of your element. Also, completely ignore that the BRIC economies were raging in mid ’08 and merely slowed down but did not recess (also it was not clear that the US was in big trouble at the point). Speculators can only artificially support a price for so long before it corrects.

      Also, what is a “capitalization market”?

      As for VDR. “Basically, it is a myth that hedge fund managers are risk takers who seek to maximize returns.” No it’s not. That describes every capitalist (even mom and pop). I believe you meant that it’s a myth that they seek to maximize returns without regard to risk. It’s minor but there are a few spots where your points are not quite clear (in the nuke article too). I’m just suggesting a little more thoughtfulness in your arguments.

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  17. very nice article on hedge funds and interesting too..

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