By Kit R. Roane  

	Illustrations by Brian Cronin

With several other hedge fund managers and traders ensnared in the insider trading scandal, Rajaratnam’s Galleon Group epitomizes hedge funds as far as the greater public is concerned—sitting with Bernard Madoff, Amaranth Advisors and Long-Term Capital Management in the hedge fund industry’s hall of shame. It doesn’t appear to be the end of the bad news either. The Securities and Exchange Commission and congressional investigators—now reportedly focusing on trades made at SAC Capital Advisors—seem to be gaining steam every day.

“Galleon was an extreme case. But that is a lot harder for the public to believe now than it was five years ago because of all the fundamental market lapses we’ve seen before, during and after the financial crisis, from Madoff on down, associated with hedge funds,” says Columbia Law School professor Robert Jackson, a former Department of the Treasury adviser and deputy special master for TARP Executive Compensation. When people “see hedge fund managers boldly executing obviously illegal insider trades during a time when ordinary investors suffered massive losses, they wonder whether markets are designed to protect investors,” he adds.

Bashing hedge funds is so easy that even institutional investors who see their value are still loath to argue the point. As Kathryn Graham, investment director at the UK-based BT Pension Scheme, stated at May’s EuroHedge Summit in Paris, hedge funds just aren’t “respectable enough.”

There certainly are reasons for concern. Hedge funds remain largely unregulated, opaque, expensive for investors to enter and sometimes a crapshoot in terms of returns. A number of hedge fund managers have committed fraud, others have attempted to manipulate markets or leveraged themselves to dangerous heights, and scores have closed up shop every year after blowing someone else’s inheritance or retirement. But for all the industry’s failings—and it certainly has them—many of its members actually do what they promise, helping shore up sagging institutional portfolios, broadening portfolio choices and providing less-correlated risk. Just as important, despite the industry’s seemingly single-minded pursuit of personal profit and lack of a broader edict to do anything worthwhile at all, hedge funds are arguably indispensable, if parasitic, participants in our economy that do more good than harm.

“Hedge funds are the tip of the spear when it comes to new investment opportunities. They are also the canary in the coal mine when things start to break down,” says Professor Andrew Lo, who runs both MIT’s Laboratory for Financial Engineering and an absolute return fund called AlphaSimplex. He adds that hedge funds helped put a floor under the market in the most recent crisis. “If you take out the bottom feeders, then you are taking out the bottom of the market.”

Even Princeton economist Burton Malkiel, while skeptical that most hedge funds are usually good investments, doesn’t want to see them disappear from the financial landscape. “I actually believe that they provide liquidity and could play a role in combating bubbles,” says Malkiel, who authored the classic investment book “A Random Walk Down Wall Street.” “I would say that in terms of the financial crisis, it wasn’t the hedge funds that caused the systemic risk, although a lot of them did go under.”

The outlaw image of the industry—the idea that managers are all cowboys levered to the hilt and playing fast and loose with other people’s money—doesn’t completely jibe with reality. “People forget that hedge funds manage money for real people and that hedge funds perform a service that people purchase,” says Darcy Bradbury, a managing director of D.E. Shaw who also chairs the Managed Funds Association, the industry’s lobbying association. “The more we explain that, the better off the industry will be,” she adds, noting that the MFA needs to dispel some of the biggest myths about hedge funds, including that they may be systemically dangerous or the mainspring of crises.

LTCM is the hedge fund industry’s dark star, and uncontained, that fund’s implosion could have caused dangerous ripples throughout the economy. But hedge funds have been unfairly blamed for plenty of other crises as well: Black Wednesday in 1992, the Mexican peso and the European bond crises of 1994, the Asian currency meltdown of 1997, the housing crisis of 2007–2008 and Europe’s most recent sovereign debt calamity, to name just a few.

Sometimes, as in the case of the quant crash of 2007, hedge funds have exerted influence—piled on, if you will. But generally, hedge funds have been more a valued and prescient messenger than the deadly disease itself, often going counter to trend. Looking at crises through the 1990s, Professor Bill Fung, currently a visiting research professor of finance at the London Business School, and Professor David Hsieh of Duke University’s Fuqua School of Business wrote that there was “no evidence that hedge funds were able to manipulate markets away from their ‘natural paths’ driven by economic fundamentals.”

Also, hedge funds can become economic casualties like everyone else, as 2008 proved. Perhaps the worst that could be said about the alpha generators then was that they weren’t as smart as claimed and did not see the train wreck coming.

Perhaps the biggest overriding concern is whether hedge funds now pose systemic risk. That is pretty much anyone’s guess because regulators lack enough data about funds’ trading and leverage to make such a call. Some of that data will be collected due to the Dodd-Frank Wall Street Reform and Consumer Protection Act. Still, it is hard to argue that hedge funds are the leading edge of risk, given the industry’s $2 trillion size is smaller than, say, BlackRock, which manages $3.65 trillion.

Leverage is the key to calamity, and somewhat surprisingly, evidence suggests that hedge funds were reducing leverage into our most recent difficulties. Adding to similar studies, a recent National Bureau of Economic Research paper to be published in the Journal of Financial Economics found that hedge fund leverage was “counter-cyclical” to leverage taken on by investment banks and other financial intermediaries, that it decreased “prior to the start of the financial crisis in mid-2007,” and was “lowest in early 2009” when investment banking leverage was greatest.

One problem with hedge funds is their presence in an extraordinarily complex and interconnected financial system where many groups other than hedge funds—banks, insurance companies, brokers—choose to engage in hedge fund–like trades and crowd into hedge fund–like instruments. “Too interconnected to fail” is how Citadel’s Ken Griffin put it during a congressional hearing after the crash of 2008. But Griffin, whose own levered funds were rumored to be in serious trouble at the time, still argued against more regulation of hedge funds.

The issue, according to Lo, is that a huge number of sudden fund failures could bring down those that lend to hedge funds and create “an enormous shock in the financial system.” He argues that the simplest way to keep hedge funds from posing inexorable problems is to better regulate and track the top 25 broker/dealers. “That would go a long way in revealing systemic issues and providing transparency,” he adds. That would also help to limit leverage, and as Marc Lasry, chairman and chief executive of Avenue Capital Group, points out, “Hedge funds that are not levered pose zero systemic risk.”

Solving these risk issues is important because hedge funds, although a small part of the financial system, have nosed their way into important functions of our economy. Without hedge fund involvement in markets like convertible arbitrage, distressed debt, and bridge and mezzanine financing, it would be a lot harder for many corporations to rebalance their balance sheets, say experts.

One study, co-authored by Professor Stephen Brown of New York University’s Stern School of Business, found that through their involvement in the convertible market (where they provide more than 73% of the financing for new privately placed securities), hedge funds have helped firms distribute “equity exposure to well-diversified shareholders” without the companies encountering the “significantly higher issue costs” that would come from using seasoned equity instead.

Hedge funds, which are seen as among the most rational arbitrageurs, also play an essential role in keeping markets efficient and reaching some form of competitive equilibrium by spotting arbitrage opportunities within and between markets, and then eliminating them. For instance, by trading on their own extensive research, hedge funds help to reveal some of that information to less-informed investors, which brings assets closer to their fundamental values and increases competitive pressure on spreads. When informed investors, like hedge funds, retreat, the prices for assets can fall well below “plausible fundamentals,” researchers say, pointing to the 2007 dislocation.

While some funds can profit from volatility, others, like relative value and market-neutral funds tend to dampen it. Lo recalls that after money flooded into statistical arbitrage funds in the 1990s, equity market volatility declined to an all-time low. Even hedge funds’ merger arbitrage has a function because it takes on risk premium and provides liquidity to the target firm’s shareholders.

Hedge funds are important at providing liquidity in many markets. But they sometimes run in herds, particularly in the case of quantitative strategies, and when highly levered or facing redemptions, can exacerbate downturns when they retreat. That was exactly what happened during the summer of 2007, with the infamous quant crash.

But even though hedge funds can be users of liquidity, they also tend to be providers of it simply because they are more willing to trade again sooner than others and trade when others won’t.

Recently, hedge funds were among the first to reenter Japan following the ruptures of nuclear reactors at the Fukushima plant, according to Société Générale, with a $330 million net short on Nikkei futures prior to the crisis becoming a $464 million net long the week after.

Even during the credit crisis, hedge funds moved back into distressed markets while many regulated financial buyers were still licking their wounds. For instance, “by taking troubled assets off of banks’ books you can argue they reduced the crisis,” says Brown. He adds that hedge funds would have served their liquidity function better had they not been hit by investor redemptions and had the government not responded to “popular passion” by limiting “the ability of hedge funds to take short positions in the market, which would have had the proper effect of providing liquidity when it was needed most.”

The liquidity hedge funds provide in all types of markets is really a function of their willingness to take on and try to profit from market risk when others either can’t or won’t. “It may sound to some like theoretical hocus-pocus, but in the real world they make a difference,” says Christopher Geczy, a hedge fund expert at the Wharton School.

Derivatives are one area where they take on that risk. Critics sometimes bring up hedge funds’ use of them to show that the funds are bad actors. Derivatives do carry risks and can be used for “less lofty purposes,” as risk management guru Rick Bookstaber noted in testimony before the Senate Agriculture Committee in 2009. For instance, total return swaps can help people avoid transactions taxes, index-amortizing swaps can help insurance companies take on mortgage risk even when they are barred from taking on mortgages, and derivatives in general can be used by companies to quietly lever up or hide risk.

Both Bookstaber and hedge fund master George Soros are particularly critical of naked credit default swaps, which hedge funds often use to short corporate bonds and which, through their connection to debt covenants, can impact corporate financing. Buying these “truly toxic” instruments, according to Soros, is not unlike “buying life insurance on someone else’s life and owning a license to kill him.”

But derivatives can lubricate the wheels of the economy, and transparent derivatives markets have generally functioned well. Because hedge funds are willing to act as counterparties, investors can insure against negative outcomes and companies can manage things like currency, fuel price and insurance risks that might otherwise force them to turn off their research and development, ground their planes or stop them from writing insurance policies in areas hit by disaster.

“A derivative contract is like a chainsaw, and you wouldn’t want to put it in the hands of a 12-year-old,” concludes Lo. “But these are incredibly important tools in allowing investors to redistribute risk.”

Hedge funds’ flexibility to profit from danger and instability also leads them into frontier markets, such as North Africa, where traditional financing is scarce, and into the developed world’s distressed debt markets. “We are willing to take the risk when a bank or somebody else will say, ‘I need to be secured,’ ” says Lasry. “I think this is massively beneficial to a company. And it enables economies to work because not everybody can borrow at Libor.”

He notes that Six Flags Entertainment is among the distressed-debt success stories that hedge funds engineered. The theme park company emerged from Chapter 11 bankruptcy last year after being taken over by a group of hedge funds, including Stark Investments. The funds invested $725 million to recapitalize Six Flags after the reorganization helped it shed about $2.7 billion in debt. “That saved the jobs,” says Lasry.

Despite the argument that hedge funds look to unhinge floundering companies with draconian terms and are licking their lips for “loan to own,” investing in these companies does carry uncertainties that other investors refuse to bear. “When you buy the debt at a cheap price, it’s because nobody else wants the risk,” he explains.

And there is little evidence that hedge funds tend to originate the problems, although solving them can certainly mean pain for everyone from the company’s soon-ousted CEO to the fired workers and retirees who may have their pension benefits cut to the bone. Usually, it is a leveraged buyout that creates excessive debt and puts a company in default, not the hedge funds, argues Jason Mudrick of Mudrick Capital Management.

“We don’t create the situation—we come in and clean it up,” he says. “In order for us to make the most value of our investments, the enterprise value of the underlying businesses needs to go up, and these companies need to flourish. This is good for employees, customers, suppliers and the economy as a whole. Our interests are often very much aligned with the health of these businesses.”

Research bears this out. Studies of about 600 Chapter 11 cases from the mid-1990s to 2009 show hedge funds both deeply involved in distressed markets and also more likely to work through a company’s issues than heavily secured creditors, such as banks, which have limited ability to hold equity and often prefer liquidation. Adding to earlier research, one recent study of 184 financially distressed firms by Jongha Lim, a doctoral candidate at Ohio State University’s Fisher College of Business, found that the “probability of a successful restructuring” is nearly 35% higher when hedge funds are involved, predominantly because, as other studies also show, hedge funds are willing to inject new capital in companies when others won’t.

“Overall, you can point to examples where they play a very positive role,” says Professor Edith Hotchkiss, a distressed-debt expert at Boston College’s Carroll School of Management. “In many cases they are providing additional capital exactly when the capital markets need it most.”

Even when there is no distress, hedge funds are well suited to engage company management in bids to increase shareholder value through their role as activist investors, with evidence showing their activism also leads to longer-term improvements in both return on assets and operating profit margins at target companies. Some worry that such hedge fund activism might lead companies to load up on debt to increase share prices and pay out large dividends even as workers are shown the door. While those arguments are “intuitive,” Jackson says there has been “scant hard evidence” to support the claim.

As with mutual funds, hedge funds can sometimes promote ill-conceived mergers, with the difference being their ability to do it through so-called empty trades. Perry Capital’s maneuver during the 2004 Mylan Laboratories–King Pharmaceuticals merger illustrates this issue.

Despite market skepticism of the merger’s benefits, Mylan announced its intention to tie the knot with King, if shareholders approved. Presumably in order to influence the vote, Perry Capital, a large shareholder in King, bought up a stake in Mylan, then hedged out its economic exposure on the shares by entering into equity swaps with investment banks. In the end, the merger plan was canceled when King restated its earnings. But Perry’s trade elicited howls from many corners, and in 2009, the firm settled SEC charges that it failed to follow reporting guidelines, paying $150,000 in penalties but neither admitting nor denying the violation.

Still, hedge funds are particularly important in this area because a lot of other shareholders have little or no incentive to be involved in corporate governance issues. Some exchange-traded funds, for instance, explicitly avoid voting at all, leaving their shares up for grabs; institutional investment managers meddle less because they don’t personally gain; institutions themselves face regulatory constraints and don’t hold enough shares to be effective; and mutual funds don’t want to cause a fuss with a company that could become a client down the line.

But arguing the benefits of hedge funds is sometimes like arguing those of the bounty hunter, the bill collector or the repo man. What they do may be necessary, but it’s not always pretty and generally implies somebody else has lost something dear or may soon lose it for a song.

This is nowhere more true than when the subject of shorting comes up. Take John Paulson’s winning bet against the U.S. housing industry. He was able to undertake it only after convincing Goldman Sachs to set up a synthetic collateralized debt obligation, which Goldman then sold to two European banks. Michael Lewitt of Harch Capital Management has called the trade morally and ethically bankrupt. Asked if he still believes this, Lewitt says he does not think shorting liquid securities is bad but that creating securities crosses the line. Such trades against housing “exacerbated the price fall and made it happen in a much more volatile way. Just because you can make money on certain trades doesn’t mean you should do it.”

Roger Martin, dean of the Rotman School of Management at the University of Toronto, has gone further, publicly arguing that pension funds should not invest in hedge funds because they short stocks. “If a pension fund has 90% of its assets in traditional investments, in which a big chunk of them are involved in long positions on equities, what the hell are they doing funding hedge funds to short those same long positions?” asks Martin. “They are working against their basic investment strategy. You are encouraging the market to go down when it is in your long-term interest for the market to go in the opposite direction.”

The anger against shorting is striking in that it hits against perhaps the most socially redeeming thing a hedge fund can do—keep us honest. Shorting by hedge funds provides ballast against the immense positive bias of the market and has helped to uncover fraud and other accounting sleight of hand at innumerable companies from Enron on down. “As individuals may be expected to act in their self-interest, the short seller is the only market participant who can provide the investing public with an alternative perspective to balance the otherwise overwhelmingly bullish information coming into the marketplace,” says David Rocker, former managing partner of Rocker Partners. “Every other participant, including shareholders, company management, corporate directors, investment bankers, commercial bankers, analysts and even the government, has an economic interest in having stocks rise and therefore bias their comments accordingly.”

In Europe, some countries have moved toward much greater transparency of short positions. And in May, the SEC began a public comment phase on plans for some form of increased disclosure of short sales as required by the Dodd-Frank Act. Greater disclosure of short sales, assuming the person doing the shorting is veiled, could help transmit negative information into the market more quickly, which would be a positive.

But such rules, depending on how they are constructed, could dampen the enthusiasm for hedge funds to make bets counter to the market’s general upside trajectory. While Lewitt may be right about Paulson’s bet being a cynical play, were the housing market more transparent and were it easier to short, perhaps the enthusiasm for this overpriced asset would have been tempered much sooner.

Many market participants believed housing was getting overpriced before the market’s collapse. “In 2004 and 2005, things just went completely bananas,” recalls one hedge fund manager. But before the ABX market was developed to trade aggregate subprime-related indices in 2006, the only way to take a short view on housing was to search out thinly traded mortgage-backed securities and CDO debt. By the time the ABX market signaled clear danger toward the beginning of 2007, many hedge funds—and their investment banks—had begun to hedge their subprime exposure. The market was new, though, and only a handful were willing to follow Paulson into such a concentrated negative view on a single asset class.

Regulators have often seemed as skeptical of shorting’s benefits as the companies or countries that have drawn the short-seller’s bead. For instance, in 2010, when the euro came under pressure because of the indebtedness of countries such as Greece, the U.S. Justice Department responded by launching an investigation into whether hedge funds were colluding to push the euro down; months later the inquiry was quietly dropped. Some hedge funds lost money on that trade when European governments stepped in to shore up the finances of Greece and others.

During the most recent financial crisis, just as markets needed stability and honest pricing the most, U.S. and European regulators limited the ability to short shares of certain financials; some countries, including Austria, have continued those bans. In May, European Union finance ministers agreed to new rules that would limit the short-selling of shares and sovereign debt.

The moves are understandable from a politician’s perspective, particularly as debt troubles continue to roil Europe. But they tend to be counterproductive, as was shown when shorting of financial stocks was banned. This ban increased the market’s dislocation. And it wasn’t just the financial stocks that suffered. A study by the French-based EDHEC Business School’s Risk and Asset Management Research Centre noted, “The ban on short selling was followed by a sharp rise in the volatility of the markets,” with the daily volatility of the S&P 500 increasing by 0.09%, compared with a rise in volatility during the credit crisis of only 0.02%.

If hedge funds bear blame, it is for not shorting enough as bubbles develop, even if their reticence ultimately benefited their shareholders. For instance, many piled into a rotating series of stocks during the 1990s technology bubble, riding them up and then presciently cutting back six months before prices collapsed.

Hedge funds saw the danger of standing in front of a tidal wave of investor sentiment and also found it extremely hard to arbitrage positions because shares were either not available or too expensive to short. Because of this, the market’s most “rational arbitrageurs” found it “optimal to ride the still-growing bubble for a while” and profit “at the expense of less sophisticated investors,” say Princeton economics professor Markus Brunnermeier and Stanford finance professor Stefan Nagel.

One hedge fund that did famously short this market, Julian Robertson’s Tiger Management, was brought down by massive investor withdrawals and billions of dollars in losses on both that trade and bad currency bets right before the bubble finally burst in March 2000.

It is important to note that the Tiger funds’ losses didn’t hobble the market or the economy though. Nor did Soros’s $2 billion loss in Russia in 1998 or Amaranth’s 2006 market manipulation and overleveraging debacle. Except for LTCM, large funds have been able to implode or lose billions without creating serious destabilizations outside their own backyards.

Because hedge funds tend to focus on research and liquidity dangers, are generally agile, and have their pay largely tied to performance, a case can be made that they often do a much better job managing market risk than many other players. That is one reason pension funds are adding hedge fund investments. In a sense, such pensions are looking for diversification and insurance against tail risk, says Geczy, and because they either can’t or won’t lever up their portfolios themselves, they figure they will let hedge funds do it for them.

Not everyone applauds this trend. Paul Woolley, the firebrand financier who founded the Paul Woolley Centre for the Study of Capital Market Dysfunctionality at the London School of Economics and Political Science, has called for pension funds to flee hedge funds, along with all other alternative assets, saying they are “far from the innocuous side-show they often purport to be,” and that their fee structure fails to penalize managers “for underperformance” while encouraging “short-termism and momentum-type trading.” Even some less strident experts at the London School, such as Professor Jon Danielsson, agree that pension funds may “lack the sophistication to choose between relatively sophisticated product offerings.”

There are real issues with the increasing use of hedge funds by pensions, which are safeguarding money on behalf of less-sophisticated investors. For one, not all hedge funds produce stellar returns. Yes, some hedge funds have extraordinary long-term track records, and the AR Composite index shows a median of 7.69% over the past five years, compared with the S&P’s mere 0.15%. But index returns, in general, suffer from substantial upward bias because of backfilling and other issues, as many experts, such as Professor Malkiel have shown.

More importantly, as Malkiel and Atanu Saha, of the consultancy Analysis Group, have noted in research, the range of returns across the industry and the large number of failures and closures mean that “investors in hedge funds take on a substantial risk of selecting a very poorly performing fund, or worse, a failing one.” Market risk is actually the least of a hedge fund investor’s concerns, given that evidence points to misappropriation, misrepresentation and trading outside of official mandate (particularly in macro and fixed-income arbitrage funds) to be the chief causes of hedge fund failures.

That doesn’t mean hedge funds can’t help pension funds dig their way out of years of underfunding and overpromising. But the more money pension funds put into hedge funds, the more that money will continue to crowd out historic returns.

Then there are the exorbitant fees and terms. During the past decade, fees crept up, lifting all boats, as institutions clamored to get into the best funds. Hedge fund managers got away with erecting gates to keep investors trapped during times of poor performance and could shut down with impunity rather than stick around to meet their high-water marks before charging performance fees again.

But 2008 changed that dynamic. Many hedge funds that erected gates earned investors’ scorn and could not raise more money. The same was true for those who shut down and tried to relaunch.

Meanwhile, competition among hedge funds and negotiations by savvier and more desirable institutional clients is bringing that management fee down in some cases, with hedge funds also allowing clawbacks and other contractual nuggets in order to keep coveted investors on board. The mean management fee dropped to 1.60% by last year, according to Preqin, an independent research firm that focuses exclusively on alternative investments.

Because of the importance of institutional investors—which Preqin estimated accounted for 61% of hedge fund capital last year, compared with 44% in 2008—many managers have also “put increased risk management procedures in place, dropped fees and increased transparency.”

All of this bodes well for hedge fund investors. But when top hedge fund managers have billion-dollar paydays, fees will remain a lightning rod. The government isn’t going to regulate fees, but it could raise taxes. On top of the furor over the Bush tax cuts for the wealthy in the U.S., there is a continuing debate to end the tax breaks that some hedge funds receive through the “carried interest” tax treatment. This allows their incentive income to be taxed as capital gains when the investments are held long enough.

There is a lot of talk on this front—and support for nixing the carried-interest tax break by a few prominent hedge fund managers—but so far Congress has been unwilling to act. Raising their taxes would certainly prompt many hedge fund managers to howl, even though it might soften their public image. But the bigger question is whether raised taxes might cause them to pick up stakes and leave their economic host, or destroy the incentives for hedge fund managers to ply their trade.

“I was with a senator once, and he asked me, ‘What is the impact if we add more taxes?’ ” one manager says, chuckling. “The reality is that nobody is shutting down. So you make 20% less? They may tell you they will stop, but they won’t. One guy may move to Ireland, but the vast majority of people won’t. Anybody who can make what we make will keep on doing it.”

And strangely, that’s good news for us all.