The Importance of Hedge Funds

Bill Sjostrom —  16 May 2006

The current issue of The New Yorker magazine includes an article about hedge funds (click here). The article mentions that hedge funds have been called locusts of the global economy, disasters waiting to happen absent regulation, and instruments of Satan. It notes that hedge funds are easy to hate. “They’re secretive, rarely making public disclosures about their investments or their performance, and so are fertile terrain for fraud and incompetence.�

The focus of the article, however, is not on bashing hedge funds. Instead, it highlights the importance of hedge funds to the financial markets.

Markets work best when investors are drawing on diverse sources of information and relying on many different kinds of tools to figure out what’s going to happen next. The sheer variety of investing strategies that hedge funds use—in contrast to mutual funds, whose managers mostly just buy stocks and bonds—enhances the diversity of markets. In the U.S. stock market, hedge funds’ willingness to sell stocks short also makes the market smarter and more efficient.

Paradoxically, some of the characteristics of hedge funds that make them seem frightening also make them valuable. Secrecy, for instance, makes it harder for hedge-fund managers to imitate what their peers are doing, a common flaw among mutual-fund managers. And, because investors in hedge funds typically have to give notice of a month or more before withdrawing their money, managers are freer to pursue contrarian trading strategies that may work only over the long term.

As the article points out, “hedge funds have been far more of a boon to financial markets than a bane.”

3 responses to The Importance of Hedge Funds

    Bill Sjostrom 17 May 2006 at 6:36 am

    One possible explanation consistent with ECMH is that some of the retuns are generated from trading in inefficient markets. Additionally, even in an efficient market, someone is first. Of course, it’s unlikely that either point provides a full explanation for the success of many hedge funds, so I agree that they could shed light on the ECMH.



    I agree that the active trading of hedge funds provides better evalutions in the equity markets. Is that possible that the growth of the hedge fund industry is evidence that the ECMH has been overstated? Many hedge funds use quantitative algorithms derived from historical information (think chartists), and the returns are often extraordinary. Perhaps the chartists just needed more digitized data and larger computing power, something that has occurred only in the last decade or so.

    Of course, these arbitrage opportunities only persist if the traders keep them secret; hence, the best hedge funds cap their investments in order not not to move the market and reveal their strategies.

    I really think that hedge funds shed considerable light on EMCH–the kind of light that won’t necessarily show up in academic journals.

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  1. Abnormal Returns » Blog Archive » Ripped from the headlines - May 18, 2006

    […] Bill Sjostrom at Truth on the Market also weighs in, emphasizing the positive role hedge funds play in the operation of the financial markets. […]