The final element that plays a role here is the funds-of-funds element. That’s where a manager decides to build his own stable of funds by analyzing hedge funds and pooling them. These funds-of-funds can be diversified among many hedge funds to spread the risk, but, like consultants, their managers charge a buck or two for their trouble, and mostly they can’t understand the hedgies’ strategies either. Most funds-of-funds people would not be smart enough to run hedge funds, yet they’re happy to take the money of those who want to invest in them.
The only government regulation we need is a prophylactic one: If you aren’t rich or your clients aren’t rich, you shouldn’t be in hedge funds.
That’s the establishment I blame for the hedge-fund debacles, not the managers at Amaranth, who were, in the end, just doing their job, albeit (very) poorly. Sure, you could say that the marketers of Amaranth got out of hand, telling prospective clients at a meeting at The Four Seasons in New York that they were doing just fine, thank you, even as their bets went sour. But anyone who sought audited results before coming in would have known better. Indeed, the Blackstone Group, one of the most sophisticated investors, by my measure, in the United States, pulled out of Amaranth before the meltdown, assessing correctly that the fund took way too much risk to generate its gaudy returns. Blackstone shouldn’t have been the only one, though, to be wise to such a Hail Mary strategy. Others who invested should have known that any fund that could be up $2 billion for the year going into May and then drop 10 percent in a month was being reckless in its bets.
Of course, various state-government officials, led by Richard “I’d Walk a Mile for a Camera” Blumenthal, Connecticut’s attorney general (Amaranth and many other funds are headquartered there), now want more regulation to stop future Amaranths from blowing up. I am sure we will have the usual federal hearings, and an SEC investigation is already under way, but these are all a waste of time. The only government regulation we need is a prophylactic one: If you aren’t rich or your clients aren’t rich (as defined by a simple suitability rule—do they have more than, say, a million dollars?), they shouldn’t be in hedge funds. That’s how the law was for years. It was changed under Clinton because of heavy lobbying—and giving—by hedge funds, and that’s how Amaranth happened. The other way to regulate hedge funds is to say that you can’t borrow more than, say, 50 percent of the money you have under management to leverage up, if you are running pension money. Either way would be better than trying to police the funds. The government would be even more inept than the consultants and brokers and funds-of-funds people in monitoring funds’ performance.
In the end, the lesson to be learned from Amaranth isn’t about a sole runaway manager who made bad bets on the weather. It’s about broad institutional problems—how hedge funds are run and monitored, and who’s investing in them. Hedge-fund strategies have become so obtuse, their sales pitches so aggressive, and their monitoring so lax that one could question whether anyone should be in these funds, let alone pension-plan managers who have no ability to judge what these funds are doing and are supposed to invest regular folks’ money in relatively safe places. Sure, pension funds that opt out won’t generate the huge returns that hedge funds do in good times, but more important, they won’t get crushed in the bad ones. The simple truth is that only the rich, who can take the hit, belong in these funds. And even they should proceed with extreme caution.