The Wild, Wild World of Hedge Funds -- New York Magazine

The Running of the Hedgehogs

Investment banks are morphing into hedge funds.
If you can’t beat ’em, join ’em, right? More and more, Goldman Sachs and its ilk are making their money from proprietary trading, which means, simply, the managing of their own assets rather than, say, yours. These operations now dwarf many traditional investment-banking practices, like mergers and acquisitions. Goldman Sachs produces hedge-funders like the Dominican Republic produces shortstops. About one in five of the world’s top hedge-fund managers used to work at Goldman. So, hedge funds really are something of a cabal.

Given hedge funds’ uneven performance of late, why has the flood of money not tapered off?
Well, for one, the appetite for risk among investors seems to be at some kind of historical high. But paradoxially, it’s also a desire for downside protection. The popularity of hedge funds still has a lot to do with how they performed five years ago. Seriously. During the bear market of 2000 to 2002, when the market fell 40 percent following the dot-com collapse, the average hedge fund didn’t lose money. With severe losses still fresh in their memories, pension-fund managers and other institutional investors are perfectly happy to shave a little off the top for that kind of downside protection. The question is in how many funds it still exists.

The limelight awaits.
Many successful managers are doing what anyone with a newfound fortune does: trying to get close to political power (via donations) or the social elite (via philanthropy and art-world involvement). Marc Lasry of Avenue Capital recently hired Chelsea Clinton as an analyst.

And now for the doomsday scenario.
The only year that assets under management declined in the history of hedge funds was in 1994. Why? Rising interest rates and the digestion of the massive growth of the previous few years. Sounds familiar, doesn’t it? A sharp spike in interest rates could be devastating to an industry that relies so heavily on borrowed money. Citadel, for example, had balance-sheet leverage of 11.5x last year—meaning it had borrowed more than eleven times more money than it actually had at the time, ballooning its gross-asset exposure to some $150 billion. This level of leverage adds tremendous risk. One prominent hedge-fund manager told me that any single hedge fund, other than three he could think of, could blow up and not really have any effect on the broader markets. But if one of the three did—and he named Citadel in that group—then the dominoes could start to tumble.

So, in the end, when someone blurts out, “Hedge funds are a venal get-rich scheme that we’ll all end up paying for,” should you nod solemnly like you agree? No, don’t do that. Try instead to crib the argument of an actual hedge-fund manager: “The proliferation of hedge funds has both decreased volatility in the market and increased the long-term risk of a systematic collapse. In the first case, it’s because hedge funds are more nimble than traditional long-only funds and can swoop in and correct market mispricings before they can get extreme. But it also means opportunities become fewer. And because hedge funds need good returns through the cycle, this reduced opportunity forces them to take more and more risk, increasing their exposure to risky investments, which, in the long term, will increase the likelihood of a systematic panic in the market.” In their report, the Dresdner Kleinwort analysts had their own term for just such a panic; they called “the great unwind.” You’ll know when it happens because in addition to dire headlines and more histrionics than usual on CNBC, the value of your Manhattan apartment will suddenly drop by half.

Don’t worry too much, though.
While the Dresdner analysts termed the likelihood of it inevitable, they concede that it’s not exactly predictable. Which means that it will happen, but it could be tomorrow or it could be in 100 years, when all of Manhattan will be underwater and your apartment won’t be worth anything anyway.