Collapsing Hedge Fund Industry

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Some managers may harbor secret hopes of reopening with new funds, à la the patron saint of undeserved second chances, John Meriwether, who blew up Long-Term Capital Management before blowing up again this year. But this time, the world won’t be fooled again. At least we hope.

To be clear: Though no group benefited more from the worldwide speculative bubble—not corporate chieftains, not homeowners, not individual investors—hedge funds didn’t cause the credit crisis. Some are doing well, even spectacularly. And many will survive. While hedge funds have been attacked for their risky behavior, in the end they weren’t the causes of systemic collapse. It was the “respectable” outfits—Bear Stearns, Lehman Brothers, A.I.G., Wachovia, Washington Mutual—that went down, bringing the world’s financial system with them. Hedge funds are now feeling the aftershocks.

Which is perhaps how it should be. The truth that’s now becoming clear is that hedge fund managers didn’t have some magical ability to spin wealth while the rest of us toiled at our day jobs. Instead, they made money because markets were predictable, stable, and for the most part, up. Hedge fund managers reached their apotheosis in recent years because of their dazzling performance after the Nasdaq crash. They seemed to have made good on their promise to make money in friendly markets and bad ones. But that was easy. Other than tech stocks and giant blue chips, nearly every possible asset class and sector had become cheap by 2000. Stock hedge funds shorted the obvious garbage and bought the cheap stuff, like real estate and industrials. Over the next several years, the investing world was placid. Prices didn’t gyrate. With interest rates low, it was logical to make more risky investments.

That led to a worldwide bubble. Too much money was chasing the same things. Some people warned of impending pain, like money manager Jeremy Grantham or New York University economist Nouriel Roubini, but they were dismissed as one-note permabears. Former Federal Reserve Chairman Paul Volcker, nobody’s idea of a panicker, sounded the alarm about the fragility of the financial system in a 2005 speech that was widely circulated on Wall Street. And it was just as widely ignored.

Then came the misbegotten ban on short-selling implemented by the Securities and Exchange Commission in the wake of the failures of Bear Stearns and Lehman Brothers. Hedge funds couldn’t unwind bets they had already made. The measure of how damaging that move was is that investors now talk about “political risk” when assessing the United States. Previously, that phrase was reserved for investments in a capricious state like Russia.

Other problems were self-inflicted. Hedge funds have been like lemmings over the past several years. They ran the same strategies. Often, they crowded into the same stocks. In October, Volkswagen soared mysteriously to briefly become the largest company in the world by market cap amid the global economic chaos. The reason? Hedge funds had bought Porsche and sold short ­Volkswagen, of which Porsche owned a piece. Once the market began to crash, they all rushed to reverse the same trade.

In their heyday, fund managers would go to “ideas dinners” at the best restaurants in New York and London and persuade one another to make the same investments. Those excluded from the dinners would peer at the S.E.C. filings of the smarter among them and copy their trades, eliminating the advantages the more intelligent investors had in the first place.

The deeper problem among the long-short equity investors—those using the most popular hedge fund business model—has been Warren Buffett idolization. These investors didn’t worry about having to get out of an investment, because they were buy-and-hold guys, like Buffett. They didn’t worry about overconcentration because Buffett had famously said, “Wide diversification is only required when investors do not understand what they are doing.” Hedge fund managers took it to heart.

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