Hedge Funds Are Running Out of Reasons to Exist: Matthew Lynn

Defending hedge funds isn’t the easiest way to make a living. It ranks somewhere between the tobacco lobbyist who tries to convince people that smoking isn’t so bad for you, and the automobile manufacturer who pretends that cars have nothing to do with melting polar ice caps. Jobs don’t come much more thankless.

Even so, the way the hedge-fund industry has been defending itself in the past few months has been truly lamentable.

As it comes under closer regulatory scrutiny, the trade associations that are meant to be fighting in their corner have been working from a script that sounds increasingly ridiculous.

An industry that doesn’t know how to defend itself, and has forgotten how to justify its existence, is in crisis. Hedge funds are now in that position.

They need to find a way of showing that they somehow help the global economy -- and they need to do it fast.

On both sides of the Atlantic, hedge funds have been busy trying to hold their own against the tide of fresh regulations sweeping through capital markets.

The Washington-based Managed Funds Association, the U.S. hedge-fund industry’s biggest trade group, has been campaigning against proposed curbs on high-frequency trading. That would, it says, reduce liquidity and increase costs for all investors.

‘Increases Liquidity’

Likewise, the London-based Alternative Investment Management Association is trying to hold the line against European Union regulations on short-selling. It claims selling shares you don’t own increases liquidity and aids price discovery, which means there should only be more transparency, not a clampdown.

Please, guys. This script just won’t work anymore. If you want to defend the industry, you need some new lines.

These two representations, by themselves, don’t matter much. They are just a couple of examples. But there will be dozens of proposals for new rules from the U.S., the EU and U.K. regulators in the next few years. The problem is that the arguments put forward by the hedge funds haven’t moved forward at all. It is as if the credit crunch never happened.

First, stop going on about “liquidity” all the time. It just isn’t plausible that holding stocks for milliseconds -- which is all that high-frequency trading amounts to -- makes the market work better in any way. There is, of course, a disadvantage in highly illiquid markets. You may well be reluctant to buy shares in a small Ukrainian minerals company, no matter how great its prospects look, because you don’t know if you can sell them again. But Vodafone Group Plc? Nestle SA? Citigroup Inc.?

High-Frequency Trading

Can anyone seriously say investors are deterred from buying these stocks because the market in their shares isn’t liquid enough? Do we really need a lot of high-frequency hedge funds buying and selling their shares several times a minute to ensure there is a market in them? Of course not.

Likewise, short-selling. It’s perfectly legitimate in certain circumstances to short-sell a share. Occasionally, it will make the market a bit more efficient if there are more buyers than sellers. But again, none of the major markets is hard to trade. Nor are any of the big stocks really mispriced -- and, even if they were, it’s not much of a problem. If your sole contribution to humanity is that you help the share prices of large banks collapse over a morning rather than a whole day, it isn’t much of a justification for your existence.

Next, stop talking about how hedge funds help make markets, or aid price discovery, or smooth out differences in prices.

Bigger Isn’t Better

The key problem here is the basic assumption. The hedge funds are taking it as a given that a bigger and busier capital market is a better one, and one that creates a healthier economy. But surely the main lesson of the last two years is that this isn’t true. The capital markets got bigger and bigger, trading became more frenetic -- and we ended up with the worst financial crisis since the Great Depression.

So, what the hedge-fund industry needs to do is start making a case that it is channeling funds to productive investment. It has to demonstrate that it is providing the capital that ultimately allows roads to get built, products designed, and jobs created. And it must show it is doing so in a more efficient way than banks and stockbrokers did 30 years ago.

How? If they were collecting money from the wealthy and investing it in industries or countries where capital is short, that would be a good argument. Or if they were creating markets in commodities or asset classes where none existed before, that would work. If they were smoothing out returns so people’s pensions were protected, or swapping currencies so they got cheaper mortgages, that would also make sense.

True, it may be impossible. The industry might well be a giant parasite that does nothing more than siphon vast wealth from the economy, while doing little in return.

But it should at least try. Just bleating about liquidity isn’t going to work. And if it can’t come up with a better way of justifying itself, it deserves to get hammered.

(Matthew Lynn is a Bloomberg News columnist and the author of “Bust,” a forthcoming book on the Greek debt crisis. The opinions expressed are his own.)

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