Hedge Funds and the Financial Market

George Soros (from Flickr)

The Committee on Oversight and Government reform held a hearing titled, “Hedge Funds and the Financial Market” on Thursday, November 13, 2008.

Here you can read some interesting excerpts:

Testimony of Professor David Ruder (Professor of Law Emeritus, Northwestern University School of Law, Former Chairman, U.S. Securities and Exchange Commission 1987-1989)

The definition of hedge fund is unclear. The SEC has acknowledged that the term has no "precise legal or universally accepted definition". The President's Working Group on the Financial Markets has called a hedge fund "any pooled investment vehicle that is privately organized, administered by professional managers, and not widely available to the public".

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Hedge fund managers do not want their investment strategies to become known.

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Although hedge funds have been active participants in the financial markets during the past years, they do not seem to have played a major role in the events precipitating the crisis. [...], the market participants central to the credit crisis were loan originators, investment banks, rating agencies, and sellers of credit default swaps.

Testimony of Professor Andrew Lo (Director, MIT Laboratory for Financial Engineering, Massachusetts Institute of Technology, Sloan School of Management)

If hedge funds are forced to reveal their strategies, the most intellectually innovative ones will simply cease to exist or move to other less intrusive regulatory jurisdictions.

Testimony of Houman Shadab (Senior Research Fellow, Mercatus Center, George Mason University)

First, hedge funds did not cause the financial crisis and are in fact helping to mitigate its damage and save taxpayers money. [...]

Second, hedge funds' short-selling activities have helped draw attention to the poor management and investment decisions of financial companies in recent years. [...]

Finally, existing laws and regulations should be strictly enforced against hedge funds and their managers, but changing how hedge funds are regulated could actually undermine the interests of investors and increase economic instability.

Testimony of Philip Falcone (senior managing director and co-founder of Harbinger
Capital Partners Funds)

Our investment philosophy is very simple; we study, often for months, the fundamentals of companies to identify those that are undervalued or overvalued, and we act decisively when opportunities present themselves. We are not momentum traders, nor are we day traders; we are investors. It is not magic. My analists perform thorough due diligence, rather than relying on ratings agencies or other research reports -- like many of the reports that improperly valued securitized mortgage products over the past few years.

Testimony of Kenneth Griffin (founder and CEO of Citadel Investment Group)

I am proud that in the 18 years since I founded Citadel, it has grown into a financial institution of great strenght and capability, with a team of over 1,400 talented individuals. Citadel manages approximately $ 15 billion of investment capital for a broad array of institutional investors, endowments, high-net-worth individuals and Citadel's employees.

Testimony of James Simons (chairman and CEO of Renaissance Technologies LLC)

Renaissance's investment approach is driven by my background in mathematics. Before I ever entered the business world, I was a mathematician. I have a PhD from Berkeley, won the 1975 Veblen Prize of the American Mathematics Society (given every four years for work in geometry and topology), and taught mathematics at the MIT and Harvard before becoming the chairman of the Mathematics Department at the State University of New York at Stony Brook. Along the way, I spent four years as a code cracker for the National Security Agency. Renaissance, an SEC-registered Investment Adviser since 1998, manages what are termed quantitative funds - funds whose trading is determined by mathematical formulas designed to predict market behavior. Individual trades are generated by computers, based on work continually developed by our researchers. Naturally, human beings carefully monitor the trade execution process, making sure that all parts of the system are behaving properly. We operate in only highly liquid, publicly listed securities, such as stocks, bonds, currencies, and commodities, and do this on exchanges throughout the world. This means, for example, that we do not trade in credit default swaps or collateralized debt obligations, neither of which satisfies the above criteria. In the stock trading of our Medallion Fund, we hold balanced portfolios in each country, i.e., portfolios very close to being equally long and short. Our trading models tend to buy stocks that are recently out of favor and sell those recently in favor.

Testimony of John Paulson (president and founder of Paulson & Co. Inc)

Paulson & Co. Inc is an investment advisory firm that was founded in 1994 and has been registered with the SEC since 2004. We currently manage assets of approximately $ 36 billion using event-driven strategies. We are based in New York and also have offices in London and Hong Kong. We have approximately seventy employees. Prior to founding the firm, I was a Managing Director in Mergers & Acquisitions at Bear Stearns. I am a summa cum laude graduate from New York University and graduated with high distinction, as a Baker Scholar, from Harvard Business School in 1980. Our investors include pension funds, endowments, banks, insurance companies, family offices and high-net-worth individuals in the U.S. and around the world. All of the investment funds we manage are open only to "qualified purchasers", which are highly sophisticated investors with $5 million in investable assets if they are individuals, and $25 million in investable assets if they are institutions. Our investors look to us to protect their capital, and to show positive returns in both good and bad markets. We do this by going long securities that we think will rise in value and going short securities that we think will decline in value. By constructing a diverse portfolio of both long and short positions, we have been able to operate profitably in 14 out of the last 15 years, including this year and the 2000-2002 periods when the NASDAQ index lost 78% of its value. [...] We share profits with our investors on an 80/20 basis where 80% of the profits go to the investors and 20% remains with us. We only earn performance allocations if our investors are profitable. All of our funds have a "high water mark", which means that if we lose money for our investors, we have to earn it back before we share in future profits. Some of our funds also have a "claw back" provision, requiring us to return profits earned in prior periods if we lose money in subsequent periods. In addition, we invest our own money alongside that of our clients, so we share investment losses along with gains.

We are a private company and have no public shareholders. We receive no taxpayer subsidies. All of our investors invest with us on a voluntary basis. We also use very little leverage. Over the past five years, for over half the time our base portfolios were not funded with any borrowed money, and our maximum borrowing as a percentage of equity capital over this period was 33%.

In February 2004, we voluntarily registered with the SEC as an investment advisor.

Testimony of George Soros

The crisis was generated by the financial system itself. This fact - that the defect was inherent in the system - contradicts the prevailing theory, which holds that financial markets tend toward equilibrium and that deviations from the equilibrium either occur in a random manner or are caused by some sudden external event to which markets have difficulty adjusting. The severity and amplitude of the crisis provides convincing evidence that there is something fundamentally wrong with this prevailing theory and with the approach to market regulation that has gone with it.