Hedge Funds: Important Liquidity Providers and “Small Enough to Fail”
Sebastian Mallaby, author of More Money Than God, spoke to delegates at the 65th CFA Institute Annual Conference about the role of hedge funds in our financial system, making the case that their pursuit and exploitation of mispriced assets makes them critical providers of liquidity to markets and capitalism. Properly aligned incentives, the use of short positions and leverage, and trading flexibility, Mallaby said, are what allow hedge funds to deliver alpha. Posing much less risk to the financial system than “too big to fail” banks, hedge funds are, in contrast, “small enough to fail.”
Recounting the evolution of hedge funds, Mallaby noted that Alfred Winslow Jones created the first “hedged” fund in 1949, using short positions to offset his long positions. Jones also claimed 20% of his fund’s profits, reportedly modeling his compensation after Phoenician merchants, who retained a similar amount of profits from their ventures and distributed the balance to investors. Like Jones, most hedge fund managers today have significant personal stakes in their funds. Having real skin in the game separates hedge fund managers from more traditional asset managers, and Mallaby sees this as an important governor on risk-taking.