I am pleased to include in this issue the following guest essay from David Ikenberry, Professor of Finance and Associate Dean for Executive Programs of the College of Business, The University of Illinois at Urbana-Champaign, who brings unique perspective on hedge funds and their particular role in the recent financial meltdown.
It’s funny when you come across phrases where their underlying meaning conflicts with what we know their commonsense interpretation to be. One such oxymoronic phrase in the financial world is the “Hedge Fund.” Hedging is normally thought of as reducing or limiting risk. We hedge our bets all the time when we buy insurance. The cost of hedging is one we willingly pay to avoid the economic shocks of life.
It’s striking then that that these two little, innocent words, hedge fund, have recently become the bane of our economic existence. Embattled leader, Edward Libby, CEO of AIG Corporation, recently conveyed to Congress that the insurance firm had grown into an internal hedge fund overexposed to market risk.
How did the concept of insurance and risk reduction get twisted into risk acceleration? In their earliest days, hedge funds were indeed risk reducing investments. Managers of these funds did what nearly all good investors do, they made what they felt were good investments. The hedge concept came about as managers used techniques to trim unwanted exposure to the broader markets that was otherwise necessary for holding their good investments. To accomplish this, these funds needed a legal structure allowing the risk reducing trades to happen, something that normally was not possible.
When we hear the phrase hedge fund, we should instead think of this rule structure. Yet the same financial agreements needed to reduce risk also allowed hedge funds to magnify it. Soon, managers would search for investment opportunities and use leverage to amplify those gains into what was intended to be handsome profit. After all, if hedging comes at a cost that reduces returns on average, leverage was a way to restore it. That lens of financial magnification was the distortion needed to transform us off the primrose path. And of course, if a little is good, a lot must be better.
Over time, many hedge funds used complex strategies to identify persistent pricing mistakes or anomalies in the marketplace. Others went on statistical scavenger hunts, looking for small discrepancies in our financial veneer. As long as those relationships were stable, the strategies worked. But just as the optical magnifier can bring fire to the printed page, the same could occur for these funds.
If only a few such funds existed, these disturbances would not have affected all of us so broadly. However, many of our largest endowments, each pursuing good social purposes in their own right, were unknowingly walking around with these magnifying lenses, some with a lens in each hand. Many of our formerly grand investment institutions held similar positions. A blip in our economy diverted us from the key statistical assumptions needed in those hedge fund models – this was clearly the case at AIG. Boom, our economic world erupted in fire.