The financial crisis long ago revealed the blustery truth about the wizards of Wall Street: They could be as self-dealing as they were brilliant. That was the basis, in fact, for the prosecution of Ralph Cioffi and Matthew Tannin, the Bear Stearns hedge-fund managers the government accused of fraud for continuing to plug their wares even as they frantically expressed gloom to each other in e-mails.
They got off, but not without revealing how some hedgies really act around each other. Next up on the docket: Galleon Group co-founder Raj Rajaratnam, whose history of outsize profits may have been based not on a magic investing formula but on a knack for gossip. He’s accused of insider trading.
Rajaratnam’s downfall, and the lifting of the veil on the methods behind hedge-fund profits, signals the official close the hedge-fund era as surely as the 1986 arrest of arbitrageur Ivan Boesky signaled the end of eighties Wall Street. In retrospect, the rise of hedge funds was a hell of a bubble. There were over 9,000 hedge funds in 2008, up from just 400 in 1992. Hedge-fund assets metastasized to $1.9 trillion in 2008 from $592 billion in 2003 and $50 billion in 1993. Nowhere else in the financial industry was there money flowing that fast. A wildly successful investment banker could make perhaps $20 million a year in 2008—minor-league Hamptons-estate money. The most successful Wall Street trader, Citigroup’s Andrew Hall, made $100 million: German-castle money. The most successful hedge-fund manager, John Paulson, made personal-emirate money: $3.7 billion in take-home pay last year, built, according to a new book, The Greatest Trade Ever, through years of insanely stubborn and often losing bets against subprime bonds.
This is as freewheeling as the money business gets. Hedge-fund managers don’t have to disclose much information about their strategies—and nothing about their specific trades—so money flew in and out of funds, nimbly aided by cadres of MIT-educated computer traders. Where the average investment-banking trade reads like a novel, with a beginning, middle, and end, a hedge-fund trade looks like a choose-your-own-adventure book. When one investing strategy fails, hedge funds instantly adopt another, until the biggest hedge funds regularly move in and out of trades so complicated and interlinked that they appear to be modeled on M. C. Escher staircases. Eleven years back, Long-Term Capital Management, the most famous failed hedge fund, lost money on no fewer than eight concurrent strategies all over the globe. The biggest hedge funds maintain dozens of complex strategies. Meanwhile, investors are unable to redeem their money for a year or more. The funds hold all the cards, and hold them closely.
Until now. In the past eighteen months, the hedge-fund industry has nearly halved in size, falling to an estimated $1.2 trillion in assets. The end of the bubble, of course, doesn’t mean the end of hedge funds: They’ll survive in a more modest, more regulated form. Mutual funds, for instance, were at the center of a similar bubble in the sixties and now plod along unremarkably.
What has died is the mythic hedge-fund identity. Managers fervently believe in the purity of their purpose—the unconstrained pursuit of profits. They tend to be Ayn Randians who play in rock bands. Many run their funds in Greenwich, away from the hierarchies of Wall Street. They do their best to exude an air of effortless brilliance.
The lack of transparency provides enough cover to make managers look like geniuses. It also provides cover, surprisingly rarely, for the occasional con man. As Randy Shain pointed out in Hedge Fund Due Diligence, the biggest variable in evaluating a hedge fund is figuring out the character of the manager. The sheer quantity of hedge funds and the intense competition can lead hedgies to quasi-mystical attempts to get an edge, from vitamin B-12 shots (Highland Capital) to, in one case, estrogen pills. But more serious, according to the Feds, Galleon sailed on the power of unscrupulous information.