Demystifying Hedge Funds

July 26, 2005

Unedited transcript prepared from a tape recording.

1:15 p.m.	Registration
1:30	Discussants:	Tanya Beder, Citigroup
		John Makin, AEI and Caxton Associates
		Chester Spatt, Securities and Exchange Commission
	Moderator:	Adam Lerrick, AEI and Carnegie Mellon University
3:30	Adjournment

Proceedings:
MR. LERRICK:  [In progress] --this is first in a series organized by AEI on hedge funds.  When Gordon Gray who organized the conference said that possibly 100 people had signed up and that that was quite unusual for this time of year, I attribute it to the air conditioning, free drinks and free cookies more than our panel and myself, though we have a very distinguished panel.
 
First I'd like to give a little bit of background and then introduce the speakers and then each one will talk for 10 to 15 minutes, and then we'll have a series of questions for the panel and open it up for the audience to post questions as well.
 
One of the things about hedge funds is that once they were just the preserve of a very few, very rich people and, therefore, they passed unnoticed in the financial world and in the public attention.  But now there is over $1 trillion in assets under management of hedge funds, there are more than 8,000 funds, and if you take into account leverage and derivatives, they're actually controlling a multiple of that amount.  Now they've become a major component of the financial markets with dominant positions in a number of sectors.
 
Their investor base has expanded from just a high net-worth individuals to large institutions, and now with a new structure which is called fund to funds which we'll talk about during the conference, they are now reaching investors.  The minimum amount of investment which used to be $1 million has now fallen to as low as $25,000, and in number of the fund to funds, and there are actually products from Charles Schwab where the minimum investment is $2,500.  So we're now reaching into what we would call ordinary investors.  These fund to funds just to give you a benchmark now account for 45 percent of total hedge fund assets, and approximately 60 percent of the new inflows into the industry.
 
From this now we have media attention and we actually have fledgling efforts by the SEC to regulate hedge funds.  There is a recent proposal.  Has it been enacted yet, Chester, or will soon be enacted for the registration of hedge funds?
 
MR. SPATT:  It was adopted last year.
 
MR. LERRICK:  It was adopted last and it will be enacted in February 2006 simply for registration, but many view this as the first step to regulation.
 
Outside the United States the view is even less sympathetic.  If you've watched what's happened in Germany and Japan, they're viewed as predators and parasites by leading politicians.  This came to a head in Germany only approximately a month or 2 months ago when the Chairman and the CEO of Deutsche Boerse which is the stock exchange in Germany and controls the entire clearing and settlement system were forced to resign because of an effort organized by two foreign hedge funds.  This led to an outcry by the Chancellor of Germany himself and by the head of the Social Democratic Party.
 
That's why we decided to organize a series of conferences, the one being just to demystifying hedge funds.  What are hedge funds?  What do they do?  What role do they play?  And over lunch, Chester, John and I talked about it and we actually got more confused than when we started when you try to define what hedge funds do because they've changed.
 
Hedge funds do almost everything that can be done in the capital markets.  They trade, they speculate, they now lend directly to companies in distress in the place of commercial banks.  They are corporate activists, and that is a whole new meaning.  So when you start thinking what is a hedge fund, and that's one of the questions I'm going to pose to the panel, it becomes in my view anything that a pool of capital can do in the capital markets today.
 
We're very fortunate to have this panel.  I'll start on my far right with Tanya Beder.  Tanya is CEO of Citigroup Alternative Investments.  The Wall Street Journal recently described this as a bionic hedge fund, so I guess that means Tanya is the bionic woman in the industry.
 
Formerly she was managing director and head of strategic and quantitative investments at Caxton Associates which is one of the oldest and most successful hedge fund institutions.  In an industry that's so young, institution means 10 to 15 years old which has $10 billion under management.
 
She is the past chairman of the Board of Directors of the International Association of Financial Engineers.  She is going to tell us her views of the industry and what Citigroup's plans are, I hope.
 
Next to Tanya is Chester Spatt.  Chester is Chief Economist of the Securities and Exchange Commission.  He told me before the meeting that only his text, but his slides have been cleared by the General Counsel of the Commission.  Before that he was my colleague at Carnegie Mellon University where he was the Mellon Bank Professor of Finance at the Tepper School of Business and Director of the Center for Financial Markets.  And he's certainly one of the leading scholars in the field of financial economics.
 
Next to me is John Makin who is a resident scholar at Caxton Associates, again, one of the most successful hedge fund management companies.  Prior to that he was a professor of economics at the University of Washington and has been a consultant to the U.S. Treasury, the Federal Reserve, the Bank of Japan and the IMF.  The last one, I don't know whether that's good or bad to be a consultant to the IMF, but I'll leave that for the audience.
 
Finally, I'm Adam Lerrick.  I'll be the moderator today.  I'm a Visiting Scholar at AEI and a professor of economics at Carnegie Mellon, and Director of the Galliot Center for Public Policy there.  I serve as adviser to the Joint Economic Committee on International Economic Policy, but my background is investment banking.  Before public policy I was head product development at Salomon Brothers and then Credit Suisse First Boston.
 
The great appeal of this conference to me is that for one of the few times in the last 3 years I get to talk about something else but Argentina which has taken up most of my time over this period as they completed their debt restructuring.
 
There are certainly plenty of hedge funds, so I may not succeed in escaping altogether, even together.
 
Tanya, why don't you start off?
 
MS. BEDER:  Thank you for having me.  I'm going to actually pick up on one of the comments that Adam made in the introduction which is how young this industry is because while we're talking about the regulators coming in and doing more and there's tremendous interest and there's 8,000 hedge funds and they run a trillion dollars in assets under management, this is a really nascent industry.  Just to put it in context, the big funds that we all associate with the founding of the industry are really the Caxtons, Morris, Tudor, Tiger, Soros, and they were all really founded in the mid-1980s for all intents and purposes.  And even at the end of the 1980s, they were running about $1 billion each which is not very much money in the grand scheme of things, and that was 20 years ago.
 
We sit here today with this industry that's running a trillion dollars and we have institutional interests that's going to go to $3 to $5 trillion.  I'd like to first comment on hedge funds and a little bit about portfolio theory because I think that on the one hand while we're trying to figure out if we regulate or what information do we collect, if we're a market participant, how do we think about this industry, I tend to think that the industry is going to go through some really massive change and that we shouldn't be surprised by that.
 
To put it in context, I know that I have several economists on the panel here with me.  I am not an economist, but economic theory is 250 years old, and economic theory has been turned on its head many times since economic theory started.  You can just think about when supply side economics came on board and what was white became black, and what was black became white.
 
I think it's important to think about where we stand in hedge funds from that perspective because I quite liken where we are to the time that we switched from driving around with horses and being a buggy whip manufacturer to being faced with people producing cars.  There were some people who held onto the old paradigm, they went out of business, sadly, but the people who embraced and went with the economic change and the massive changes that came along with that were quite successful and, in fact, were able to do things on productions lines that were never possible before.
 
I think this industry is standing at a point like that, and one of the main motivators for why we're at a point like that is because you can't really get there from here.  You can't go to a $5 trillion industry building capacity the way that we're building it.
 
Just to give you a couple statistics, this is an industry that runs about a trillion dollars with 15,000 people, 8,000 hedge funds.  The average size of a hedge fund in the United States is about $150 million, the average size in Europe is $100 million, Asia is $50 to $75 million.
 
Contrast that to traditional asset management which runs about $18 trillion with 9,500 employees.  You can see that it's a wildly fragmented industry and it's very tiny.  The global equity markets are $30 trillion, the global bond markets are $40 trillion.  We trade every single day close to $3 trillion in the currency markets.  So this is an industry that in order to get into the leagues that it needs to to meet the demand and also to become established has to do things very differently.
 
So putting that next to also one of the other big changes, I think it's quite an exciting time, let's also look at portfolio theory which many people in the room, myself included, have studied a lot.  We've all read about sharp ratio.  That was in the 1980s.  The capital asset pricing model.  Even options models were very fledgling in the 1970s and sort of took hold in the 1980s along with getting technology and along with getting data series and things like that.  That's another field that, frankly, has been one where we've driven forward looking in the rear view mirror, and as we've driven forward looking at these past data series behind us and trying to predict what we should do in the future, we all know we've seen these academic studies, you can't invest in the top 25 percent and be successful the next quarter.  That's another area that's going to be turned on its head I think over the next few years.
 
I wanted to make that as opening comments and then I'll go on and we'll discuss what is a hedge fund, what do they look like, what do they do, but I wanted to set that backdrop because I think it's a time that would be very dangerous to try to analyze this industry in the context purely of its existing paradigm because this industry I do not think will look anything like it does today in a short time frame, in 2 to 3 years.  The good news is it's almost like a renaissance period.  I think we're going to have a lot of really new and fascinating ideas to think about.  But I think it's important as we think about how do you do something like regulate an industry like this and how do you actually analyze it and participate in it whether you're an investor or like myself, a manufacturer of the product, I think you have to have a pretty healthy dose of caution, again, looking back to how much other theories that are much more established have changed as they've evolved.  Again, this industry is only 20 years old for all intents and purposes, so it's a baby, baby industry.
 
MR. SPATT:  It's a pleasure to speak this afternoon as part of the panel on hedge funds hosted here at AEI.  It's such an important topic of broad interest in our marketplace.  I'd like to begin by thanking Adam who I've known for several years at Carnegie Mellon for the invitation to participate today.
 
I should also emphasize at the onset of my remarks that the views that I'm going to express don't necessarily reflect the views of the Commissioners of the Securities and Exchange Commission or my colleagues on the staff of the Commission, several of whom in fact are in the audience today.
 
I further wish to emphasize that I'm not going to address the registration requirements for hedge fund as adopted by the SEC last fall or related implementation issues.  Instead, as an economist who happens to have a senior position with the SEC, I want to offer an economic perspective on the role of hedge funds in our capital markets, and also comment on why there are important policy issues associated with hedge funds.
 
I first want to emphasize the importance of the efficiency of America's capital markets.  The relatively efficient price signals that prevail in the marketplace are important for both enhancing productive efficiency and economic growth by enhancing capital allocation, and facilitating the ability of relatively uninformed investors to make suitable portfolio choices.
 
Consequently, these uninformed investors in fact benefit from the arbitrage process and enhance competition in our financial marketplace.  While the asset valuations in our marketplace reflect considerable information, at the same time, it's important for there to be strong incentives to engage in the costly analytic and trading activities that result in information in fact being embodied in prices.  In my view, it's precisely the high-powered incentives that are possessed by many hedge fund managers which serves to enhance the quality of asset valuation by encouraging such activities.
 
While economists tend to focus upon the efficiency of the marketplace and the competitive paradigm, in recent years there has also been more attention paid to the limits of arbitrage, emphasizing the role in fact of arbitragers and hedge fund investors with high-powered incentives.  Even my own experience as an academic economist has been such to point to potential violations of efficient markets pricing.  That is, even as a professor on some occasions I was able to identify seeming violations of the market efficiency paradigm.
 
A key ingredient in producing relatively efficient prices is the competitive market forces large investment and the tremendous sums of capital in the marketplace.  The ability I think of hedge funds to operate across different market sectors makes hedge funds I think so useful for ensuring the fairness of prices across different market contexts because the hedge funds can operate across different margins in the marketplace.
 
While the competitive paradigm is a very useful and powerful one in financial economics, hedge funds and arbitrage of capital I really think play a crucial role in the process by which relatively efficient prices emerge.  High-powered incentives are crucial to ensuring that there's sufficient search and analysis to limit the extend of mispricing that prevails in the marketplace.
 
Indeed, to the extent that there are some sophisticated asset managers that can predictably earn superior risk adjusted returns, you would expect that those managers in fact would be in a good position to earn much of the associated economic rents.  An interesting theoretical analysis that focused upon in this particular case mutual fund flows and also the competition in the managerial labor market and the ability of managers to capture rents from superior skills in fact was recently offered in the Journal of Political Economy, one of the leading academic outlets.
 
In practice, the very structure of hedge fund compensation allows the general partner to share significantly in the economic rents that it creates so that I'm referring specifically to the option like payoff structure where the general partner earns 20 percent of the return above a baseline return.
 
One of the factors that limits in practice the ability of managers to collect rents from their strategies is the difficulty of determining and documenting truly superior risk adjusted performance.  As a result of the large variability and some would say noise in the cross-section of returns, it can be difficult to detect truly superior performance.  In sort of technical parlance, there is insufficient statistical power to distinguish truly superior performance.  To a degree, this can limit the ability of a manager in some cases to appropriate his past track record.  In particular, the problem is does the superior historic record simply reflect chance variation, frankly, in some cases it does, but obviously not in every case.  The discussion of statistical power in historical records also emphasizes the importance of selection and survivorship effects in interpreting historical returns.
 
Empirical estimates of historical hedge fund returns in fact I think substantially overstate prospective investable returns as a result of such effects, and in fact, perhaps many of you saw the very interesting discussion of exactly this issue in this morning's Wall Street Journal on the editorial page that was co-authored by Burt Malkiel.  The precise magnitude of these of these types of biases depends of course upon how returns are being measured and the underlying data generation process, but this does suggest even apart from issues of adjusting risk the need for caution in interpreting historic returns.
 
This conclusion complements an observation in the paper a few years ago by Getmansky, Lo and Makarov, that argued that liquidity issues in the underlying holdings of hedge funds tends to inherently smooth their returns, and, consequently, understate the risks associated with hedge funds, and by extension, overstates their attractiveness.
 
One of the important reasons for concern about hedge funds by some policy makers is the presence of a variety of incentive conflicts in which the incentives on the one hand of the principal and the other of the agent who acts on his behalf in fact diverge.  Of course, only in some instances do the resulting behavioral differences violate acceptable norms and in fact become problematic.
 
There are several natural illustrations I think of this divergence of incentives and the principal/agent conflict that seems relevant in the case of hedge funds and some other asset management contexts.
 
For example, just the very structure of the compensation contract, this option like payoff structure so that the general partner shares in the upside above a contractual return but not the downside, has I think sort of both good and bad aspects to it.  On the one hand, the manager then has incentives to assume relatively more risk than otherwise because he owns in effect an option like payoff structure, that arguably in fact perhaps he has too many incentives.
 
One of the things it does do is it overcomes to the extent that the manager would be naturally risk averse, this potentially overcomes the manager's natural risk aversion.  Given the investment adviser's interest in the fees that he might receive over time, many advisers of course are quite naturally very interested in growing their business perhaps even beyond the size that their investment ideas might support.  On the other hand, if one grows their business of course too much, then you dilute your return stream and eventually you dilute your carry that you can earn.
 
Along related lines, financial economists have observed a strong relationship between investment flows and, therefore, both the size of the fund and the fees relative to the investment performance.  However, a strong implication of this perspective is that advisers may possess incentives to substantially add to the risks that their funds bear if those risks are not fully understood or detected in the marketplace.  I think this reflects the value in the competitive market for new investments and assignments to those whose performance wins the tournament that's implicitly taking place along funds of various types.  I think it also illustrates the importance and value of trying to create track records for new products, indeed, why some advisers discard less successful track records and why the track records of products being evaluated by institutional clients often substantially exceed the subsequently realized performance.
 
As a digression, a number of years ago I sat on an institutional committee and I must say the track records that we were always presented with up front looked far superior to the track records that we subsequently observed ex post.
 
An additional dimension to the agency problem with fund management is that in some contexts the fund adviser, in effect the agent, is working for many different principals or in many cases many different accounts at the same time.  In particular, there can be an allocation problem when the same securities are being purchased or could be purchased for different vehicles.  In some situations with separate accounts this can arise as a result of the separate account structure if the accounts aren't treated equivalently.  So in some cases it may be very natural of course to just treat the accounts as the same, they would really be invested side by side.  But in some contexts, there may be situations in which the fund manager is working for a variety of products within the same fund family and there can be different sensitivities to various accounts due to the form of incentive compensation, to different fee rates as in the case of a hedge fund versus a traditional mutual fund, also impacts of past performance and the complexity of the flow for performance relationship.  So for a variety of different reasons, the adviser could have different economic incentives in the performance of different products and potentially this can set up a situation in which there are important conflicts.  In such circumstances I certainly feel that it's important for the manager to have an objective and well-defined process for allocating positions because the potential for problematic conflicts of interest in such contexts is considerable.
 
At the same time, I want to emphasize that it's certainly appropriate for the manager to have multiple clients or to work with multiple funds.  There are natural economic scale economies in the generation of information and import folio decision making.  This is frankly just basic economics in business.  The issue in my mind is the role of the manager's self-interest in making such decisions across clients.  To the extent that academics have identified situations at times even just by looking at aggregate data in which the agent's self-interest appears to be drive decisions does give one some pause for concern.
 
One forthcoming paper in the Journal of Finance in fact documents strategic cross-subsidization of high family value funds compared to lower value ones within a mutual fund context.  The study explicitly links the differential performance with the fund context to both preferential allocations of IPOs and the extent of cross-trading within a complex.  I find it somewhat surprising that one can detect in fact indicators of conflict of interest with that type of aggregate data which I think certainly suggests that there are some real issues about this.
 
Of course, there are other illustrations of potential types of incentive conflicts in asset trading.  For example, even on an ex ante basis, it's important to make sure that one has a fair way to allocate trades.  For example, if you're executing a whole series of orders on behalf of a variety of clients, the clients whose orders get executed first are systematically going to tend to have more favorable executions because their orders will have less price impact.  So obviously it's important to have an appropriate process for handling those kinds of allocations.
 
Perhaps even more fundamentally, it's obviously very important for the managers to avoid exploiting in fact the illegal look back option that they would possess in trade assignment if they didn't make contemporaneous assignments.  In fact, I think it's really crucial to make contemporaneous assignments of positions to avoid being in that kind of situation.
 
While in the second portion of my remarks I focused upon issues associated with conflicts of interest, I should just note that systemic risk or the possibility of correlated defaults across the economy is another facet of why hedge funds have received attention from policy makers.  Many hedge funds often invest on the same side of a position.  For example, they tended to be on the long side of the credit spread across markets.  As the example of Long-Term Capital illustrates, there can be strong external effects across hedge fund investors due to price effects when a major player needs to liquidate significant positions.
 
As I conclude, I want to observe that the preferences of the general partner and limited partners about additional monitoring can diverge.  The limited partners on the one hand certainly would bear much of the cost as investors to fund, but they would also derive much of the benefit in fact if conflicts and incentives between the general and limited partners are important.  Such monitoring in fact might be attractive to the limited partners to the extent that the associated monitoring costs are below the costs of the conflicts of interest that are avoided.
 
Of course, these aren't the only reasons for enhanced monitoring.  Indeed, externalities associated with systemic effects could make enhanced monitoring desirable from a policy perspective without the general partners, who ultimately bear much of the cost of the monitoring necessarily, being favorably inclined.
 
As I conclude, let me just also say that I'll place the text of my comments on the SEC website later this week.
 
MR. LERRICK:  Chester, thank you very much.  John?
 
MR. MAKIN:  Thank you.  First, let me just say that my observations on hedge funds here may be a little bit idiosyncratic in the sense that I work at one, and so therefore I'm in the unaccustomed position of looking at something from the inside out.
 
My hedge fund involvement is my third career.  I started off as an academic where I looked from the outside in, and then as a think tanker where I continued to do it here in Washington at AEI and continue to this day.  But now I have to talk about demystifying hedge funds and I guess my appeal should be I've been there, so I can tell you all about it.
 
But in a sense, hedge funds are such a heterogeneous population that I'm not sure all the things that I have to say will generalize, but let me suggest a few observations.  I'd like to just do four things here, do a little background on where did hedge funds come from, what are the features of some hedge funds today, what do hedge funds do in the sense it's fascinating to be an economist and watch the Valrasian (ph) search for equilibrium when an event hits the markets like the China reval last Thursday.
 
Then finally I want to suggest along the lines of the excellent article that Burt Malkiel has in the Journal today that there certainly is a major moral hazard issue attached to hedge funds and their structure, but, of course, not to our hedge fund.
 [Laughter.]
 
MR. MAKIN:  By the way, we're not seeking new investors. 
 
Where did hedge funds come from?  Good question.  My guess is that if I look at the big funds that started up in the early 1980s, George Soros, Bruce Kovner, Louis Bacon, these guys were very good at what they did.  They were very skillful traders and they generated tremendous rents and they were slightly capital constrained.  That is, they could trade and earn a very high rate of return on more money than they could lay their hands on.  So out of the woods came these very wealthy people who said please take my money and double it for me.
 
I think that's not a bad description.  I don't know where the term hedge fund came from.  I've certainly read a lot of stories, and the term really has been applied ex post.  In the 1980s I don't think the term really existed.  Some guy is supposed to have invented back in the 1940s, but that's not really what was happening.
 
So you had people who were very good at trading.  A lot of them started out trading commodities, maybe some specific area.  I know that the founder of our fund has a portrait of Jimmy Carter on his call and he thanks Jimmy every day for all the stupid things he did in the markets that made it easy to earn very large profits.  We need another Jimmy Carter now.
 [Laughter.]
 
MR. MAKIN:  But these were people who were very good at what they did.  They attracted capital.  They were able essentially to name a fee structure as Chester discussed.  The 2 and 20 fee structure is typical.  That says that the hedge fund manager gets 20 percent of what he earns and there's a 2 percent service charge to cover fixed costs.  Often times it covers more than fixed costs, often times it doesn't, but that was the deal.
 
So you had people wanted to get a piece of this very attractive management technique.  These people were demonstrably superior traders.  They earned large rents, they made money year after year at 20, 30, 40 percent a year, and probably did help to make markets efficient.  My academic colleagues said it was impossible, but it isn't.  I've seen it done.  So where somebody has a different approach, they can rents.
 
How do they earn rents?  Essentially, they earn rents by offering an alternative to the mutual fund industry or sort of we put a sign on the door that says we buy stocks and we're long only.  That's the mutual fund industry, and after a couple of decades of very poor performance, the mutual fund industry always tries to make distinctions like we buy value stocks, we buy growth stocks.  I have no idea what the difference is.  I always thought that when you get somebody to manage your money, and that's the industry that the hedge funds are in, that you wanted them to make as much as they could and there's no particular reason to concentrate on any area.
 
But the management of money for households and pension funds prior to the 1980s was remarkably unimaginative.  They simply had a long only strategy.  They distinguished their product by saying we buy bonds or we buy stocks or we do this or we do that, and they congratulated themselves on a benchmark criterion, that is, the market went down 10 percent and they went down 8, you were supposed to congratulate them.
 
The hedge fund industry started out as an industry that said we're going to make as much money as we can.  We'll be long, we'll be short.  We're not constrained by a sign on the door that says we don't trade commodities.  If commodities are moving, we trade them.  So it was a less constrained approach to money management than had been traditionally followed, and actually the returns to most hedge funds were different from mutual funds, these were the big ones initially, they weren't more volatile than mutual funds, they were just a lot bigger.  The problem was that they said you have to have at least, I don't know, what is it, a million dollars to invest in a hedge fund?  Partly the reason was these were small shops.  They didn't want to have a lot of nickel and dime investors who are going to keep books and all this kind of stuff.  They just wanted big investors.  Our minimum investor at Caxton is something on the order of $100 million, so we don't have a lot of people to pay attention.  I think there was a regulation early on that you couldn't have more than 100 investors or something like that.
 
That was all convenient because a good hedge fund that was earning 40 percent a year didn't have to go out and do a lot of marketing.  They just would prefer to take a large chunk of money from a few people.  It's much easier to manage it that way.
 
So I think hedge funds got started as an alternative to a very unimaginative industry when it came to managing other people's money, but fundamentally that's what hedge funds do, they manage other people's money.  If they earn a better return, they get paid better than mutual funds in terms of the fees.  If they don't, they don't.
 
Next what are the features?  I've covered a couple of them.  The fee structure is typically 2 and 20, maybe higher, maybe lower, depending on which fund you're looking at.
 
I'm talking about the big hedge funders in the first 10 years of the industry, they were all superb risk managers.  People tend to view hedge funds as these guys are cowboys.  No.  These guys are very good risk managers and they're very careful about exposure, very careful about managing risk, and the ones that stick around are the ones that pay a lot of attention to it.  Because when you are actually trading a lot of positions simultaneously, one of the things that you learn is that when they fall apart, they all start to fall apart at the same time and in a highly correlated way.
 
So the good and sustained hedge fund managers were very good risk managers.  Ironically, the end of the Soros hedge fund was probably associated with a lapse in risk management.  Late in 1999 the Quantum Fund threw in the towel and said we can't stay off this tech boom anymore.  They bought a ton of tech stocks, they made a ton of money by the end of the year, and when the tech bubble collapsed they lost a ton of money and they closed the fund.  Something of a moral hazard problem where that is you play for the big stakes and when things go wrong you say, well, okay, we're closing the fund, and that's an issue certainly.  But it's probably a shortsighted approach closing the fund means that the game is over for that particular fund.
 Hedge funds also offer many services that are uncompensated.  For example, anything that goes wrong in any market or any country can be blamed on hedge funds today.  I noticed in the paper today the Chinese official who said we're not going to go to a convertible currency for 5 years because if we did the hedge funds would beat us up.  I think Chester has already mentioned the Germans blame everything on hedge funds--I don't know what to say.  Hedge funds are players in the markets.  If we were responsible for all the naughty things that are attributed to us, we should all be taken out and shot, but somehow I doubt it.
 
The last issue I think is an important one, moral hazard, and I would highly recommend you take a look at Burt Malkiel's article today.  To get into the issue, I would say the hedge fund industry at $500 billion in total assets is a totally different industry from the hedge fund industry at a trillion in total assets.  And if Tanya is right, the hedge fund industry at $5 trillion in total assets will be a totally different industry, I suspect indistinguishable from the old mutual fund industry.  In other words, we will have come full circle back to mass management of money for every man with all the bookkeeping requirements and all the records keeping and anybody with $2,500 can get in and so on.
 
That's where we started, and there will probably be benchmarking for hedge funds.  Then it will be a fee driven industry where the marketing device is simply to say we're a hedge fund and the moral hazard issue that will arise is that the public perhaps begins to conclude that simply putting the sign over the door that says hedge fund is not a guarantee of performance.
 
Part of the rapid growth of the hedge fund industry over the past 2 or 3 years is simply people who are running mutual fund not particularly successfully and saying we could run a hedge fund, or people who are just enterprising and thinking if we could raise $500 million or a billion dollars to run a hedge fund, the fees would be very attractive average compensation, 2 percent of a billion is $20 million, and then we just got to swing for the fences for a few years and if we hit a home run we all get a much larger payoff, if we don't, we just close the fund.  And that happens until the public realizes that putting hedge fund on the door is not necessarily a guarantee of performance.
 
The other evolution I think that both Tanya, Chester and Adam have mentioned is the fund to funds, that is, putting together a collection of hedge funds which somehow is supposed to yield better performance.  I don't know whether it does or not.  I'm an investor in a fund to funds, actually, and I do observe that the returns are more stable but lower than a typical hedge fund.  But that may be an attractive vehicle except you have a very heterogeneous collection of funds which amy be good in the sense that they're not correlated so the volatility of returns is lower, but it may not be good in the sense that the selection process for the fund to funds may or may not be good, so you're betting on a selection process.
 
To demystifying hedge funds, again, they're just operations that manage other people's money.  The style of the hedge fund that we saw in the first 15 years from the mid-1980s perhaps through 5 years ago is probably going to evolve.  It's going to be a much more mass market oriented institution.  So hedge funds will not be hedge funds anymore in the sense that they were.  That's neither good nor bad, it's just an evolutionary fact.
 
Again, as time goes by, I suspect that given the moral hazard problem implicit in entering into the hedge fund industry, over the next few years there will be a lot of hedge funds that go out of business by design.  I don't know what the public policy ramifications of that are, but the information flow needs to be improved in the sense that people know--the ads I see are very scary, it's a hedge fund, you got to buy, and you'll get rich.  That has to go away.  I suspect it will as the performance of some of the hedge funds does not live up to expectations.
 
MR. LERRICK:  Thank you, John.  I'm going to exercise my prerogative and ask a couple of questions that interest me and ask for the panel's comments.
 
I actually can remember when they weren't called hedge funds.  When I left MIT, and going to back to what Tanya said and what John said, I wrote my dissertation at MIT on the fact that markets were inefficient and my adviser was Franco Modigliani and while we were going to choose the third reader, I suggested Fisher Black and Franco said, no, no, no, no, no, you'll never graduate if you choose Fisher Black because Fisher doesn't believe markets are inefficient and so he'll keep sending you back until he shows that you were wrong to show there all these millions of dollars to be made risklessly out in the capital markets, so Bob Schiller was my third reader, and he liked that idea.  So what is unusual is that Fisher Black then left MIT shortly thereafter to go to Goldman Sachs felt there were inefficient markets.
 
I do believe there are inefficient markets.  When I was head of product development at--my largest client was John Merriweather's proprietary trading desk.  Whatever strange structure I could come up with, the first call I made would be to walk across the trading floor to John Merriweather and say, what will you pay me for this?  If it was a 15-year cap on Libor (ph).  We didn't even call them derivatives then.  If there are options on Schwab's, what we now call derivatives, John Merriweather was my first call.
 
This is in the early-1980s, and I think at that time I described what he did as he had a unique position.  He had a lot of money, a lot of capital, and he had a technology that was different than most other people.  He's created a team of very highly trained academic, theoretical, financial economists that could model things that very few other people could.  He was collecting the rents.  That's how he made his money, on mispricings in the market.
 
The question I have is, as time went by, more and more people, some of them become hedge funds, others were just proprietary trading desks and investment banks, got the same technology and the same capital and those discrepancies went away.  Looking at Long-Term Capital which was the hedge fund that had evolved from Salomon Brothers' own proprietary trading, the question I ask is, their view is that they just were hit by lightening, just a random event, were hit by lightening, and had nothing to do with any defect in our hedging, our risk analysis, our risk management or anything else.
 
I had dinner with Peter Fisher who had been at the New York Fed at the time and who had been in charge of the bailout, in essence.  Peter said, the question is, were they hit by lightening?  Is it totally by chance?  What if you make your business of walking around in thunderstorms carrying large metal poles in open fields?  Is it purely by chance that you get hit by lightening?
 
The first question I'd ask the panel is, if you have so many hedge funds, so much capital, so many people with the similar skills, what happens to the pricing of these inefficiencies, and in order to maintain the returns, do you just have to assume more risk?
 
MS. BEDER:  Let me answer that question two different ways.
 
I'll give you the argument for efficiencies coming out of the market which they should.  Let's just take a look at businesses like statistical arbitrage.  For those of you who aren't familiar with it, I'll describe it briefly.  Statistical arbitrage is simply the business of taking a price series and then decomposing the price series, say the movement of the price of stock into what portion is explained by the movement of the market, say by the S&P general movement, what's explained by the movement in the price of gold, by the price of crude, by the price of industry factors, whether you have a 50 factor model or a 5 factor model, all of a sudden the size of the error term that was not explained by those factors started to approach zero.  And the smaller and smaller the error term was, combined with the fact that we got to decimalization and you could no longer trade securities for an eighth, was sort of the death knell at the time for the statistical arbitrage business, and I think it was a good example of a circumstance where the early entrants came in, there were few people doing it, there were a lot of opportunities.  You could in fact be quite sloppy with your trading, you could enter your trades a day, 2 days, 3 days late, you held the trades for a long time.  Later on it became a business where unless you got into the trades within milliseconds and achieved the profits and got out, you couldn't make any money.  And then even doing that for a while, you couldn't make any money.  So it's a perfect example of the markets doing what they're supposed to do which is arbitrage out the inefficiency both through a combination of huger volumes and just more people knowing that it is, and it also proves the adage that secrets could only be kept by one person because there were a lot of people.
 
By the same token, you have to pat the hedge fund industry on the back--
[End of tape 1A, begin tape 1B.]
 
MS. BEDER: [In progress] --in the market.  The interesting thing is though that if you look at that and you say that much mean that returns are over, my answer to that is that actually the fascinating thing was we went through a period of a couple of years with diminished returns and then a whole bunch of people sat down and said let's really actually study why we're not making any more money at this.  What were we missing?  What is it that was driving these returns down to zero?  In fact, today there are quite a number of very successful statistical arbitrage books, but they're doing things a big differently.
 
I think that's really what it's all about in trading in general.  Hedge funds tend to put a lot more resources on finding new things to trade.  They tend to I think bring to bear not only the technology, but the--and the academic talent to probably do it better.  It's expensive to have that talent.
 
But today if I had to just enumerate a few of the markets of huge opportunity, one of them is certainly technology leveraged trading, high frequency trading, what's going on in the catastrophe space, the credit arbitrage market is very interesting, and lo and behold, there are also some markets that everybody thought was dead like Global Macro 5 years ago that are probably at the top of everybody's list for where you can make money in the next 12-month horizon here.
 
My answer is that I don't think by any stretch of the imagination we've even begun to fully exploit what all the opportunities are in the market, but you have to look in different places.  That's what hedge funds do.  They perform an extremely valuable role in the marketplace in accomplishing that.
 
So I for one am very happy to see lots of smaller funds who frankly don't have the resources to do the kind of exploitation and study that's necessary to find the trading opportunities because the more people who look in the same places are that many fewer people who are looking where we're trying to look.  And I think that's another thing that will set apart the future of the industry from the past, which is that it will become increasingly difficult to look in those places if you are one of those tiny hedge funds.  Unless you have pretty massive scale and can afford $50 or $100 million on your upfront technology followed by pretty serious, talented people, because it's all about talent, I don't think you will be able to compete effectively and keep the trader's edge going forward.
 
MR. SPATT:  I'd like to begin by referring back to the initial portion of what Adam was describing, namely, the case of LTCM and Peter Fisher's remark about if you're walking around with a pole you're going to attract lightening relatively more often.
 I think it's helpful to just step back and reflect upon the type of overall position that LTCM was holding.  Broadly, their ideal was to be leveraged about 30 to 1.  The positions that they were carrying, they were looking obviously across lots of different markets, but the types of positions that they were viewing as attractive invariably were positions where they were long the credit spread and long the liquidity spread.  That was the common characteristic across all the types of trades that they were doing.
 
Then you have a situation as happened to them where credit spreads moved dramatically and credit spreads were historically wide.  Credit spreads moved upward by about 75 basis points.  Suppose a typical instrument has a sensitivity to the credit spread of let's say 4; 4 is, for example, the duration of a typical mortgage backed security.  So suppose your sensitivity to the credit spread is about 4, you've got a 75 basis point move, then without any leverage your account is down 3 percent.
 
They were leveraged 30 to 1.  Voila, you're down 90 percent.  In fact, there's some sort of slight of hand in this arithmetic because, of course, as the spread is widening and the market is moving against you, if you're not scaling back the size of your book, and they were not scaling back proportionately, certainly, what's happening is your leverage is increasing because you're losing money, so your leverage inherently increases, which means that what's happening at the back end of that process becomes particularly important to your return.  This is very much in the spirit of Peter Fisher's remark to Adam.  I'm not sure it was really quite an accident in terms of ultimately what happened, whether it happened that year or whether it happened 5 years later.
 
If you look back at what was happening before in the prior several years, typically LTCM was earning returns of I think on average about 40 percent or so.  Let me take my little story.  They were leveraged about 30 to 1, so on a unit basis they were earning an excess return of about 100 basis points, again, roughly about the size of the sort of credit spread that I'm describing.
 
With respect to the broader issues that Adam raised, I certainly agree with Tanya's remarks.  I think it's important for hedge fund investors to be looking in different ways from one another.  If they do look in different ways, it does seem to me there's lots of different dimensions in the marketplace and folks can potentially bring different skills to bear.
 
To the extent that folks, however, look in largely similar ways, there's a lot of herding with respect to the kind of approaches that are used, then clearly there's lots of capital out there that's competing with one another and the potential to earn huge returns is going to be limited.  I do think it's important for players to bring different kinds of skills to bear.
 
I think it's also difficult for investors in many cases to really evaluate ex ante many of the products, especially newer products, because of either lack of track records or because of issues about the credibility of track records.  If it's a very low cost to create a track record, and you hear about these stories about how organizations, they pluck a bunch of million dollars down behind a strategy and they invest and in effect they're creating track records and they see if it works.  And guess what, the ones that didn't work, they don't market those, and the ones that did work historically they do market.  That's a process that seems to me to ultimately produce a situation where lots of investors are going to be disappointed.
 
MR. MAKIN:  I think I'm probably going to take a slightly different tack.
 
First, on Long-Term Capital, it should have been allowed to fail.  They were undertaking a highly leveraged strategy.  The reason that the bailout came along is that 17 institutions paid $300 million each to look at their book so that they could get out of the way when they unwound the positions, and the moral hazard implications are powerful.  If you're a very aggressive hedge fund following a single strategy and there's a three or four standard deviation event, the government is going to bail you out, not a good idea.  So in my lunch with Peter Fisher I told him that and we agreed to disagree.
 
Going forward, I don't share Chester's optimism that if a bunch of smart guys keep looking they'll find more strategies.  Most of the big hedge funds today are already fund to funds.  They have every strategy that is available; self-contained fund to funds, every strategy available is very carefully worked over.  Obviously there will still be discoveries, but I think probably we will see some atrophy of the rents that the category of financial institutions called hedge funds are earning, but it will oscillate.  There will be good years and there will be bad years.  Average returns will be better than less imaginative approaches such as mutual funds or savings accounts.  But it is probably in the sense as Tanya says, the hedge fund industry, the hedge fund concept, is going to be expanded a great deal and it will be difficult to keep ahead of the pack and for that category to earn superior returns.
 
But hedge funds are a far more heterogeneous collection of money managers today than they were 10 years ago, and so the definition of hedge fund will change over time.  There will still be people who can earn rents with the new strategy.
 
MR. SPATT:  Just one clarification.  I hadn't intended my comments to be viewed as optimistic that there's huge amounts of value that the industry would necessarily create.  In fact, to some extent, I intended more a sort of skepticism, and particularly with my comments about some of the issues associated with the ability to create track records and some concerns about the sustainability and investability of the purported track records.
 
MR. LERRICK:  Tanya raised a very interesting anecdote which was the speed, and when you talked about statistical arbitrage or return to elimination of aberrations, one of the first proprietary trading desks at Salomon Brothers which I set up just did arbitrage between the euro/dollar market and the U.S. dollar/bond market, and we just went back and forth between two sets of bonds of the same issuer, same coupon, same maturity.  On average the differential on yield was zero.  It could get as high as 300 basis points.  The time which was even more startling to get that discrepancy to go away when we started it was 4 to 6 weeks that you would sit there watching it, and so just had two clerks sit there and go back and forth between the two bonds, and two clerks sat there and after a year they made $35 million just sitting there doing that every day.  After 18 months this was gone.  It went down from 4 weeks to 2 weeks, to 2 days and finally to zero, and that's exactly what Tanya was talking about.
 
I think one thing that I'd like the panel to talk about which is this is the American Enterprise Institute for Public Policy, what are the public policy aspects?  Chester touched upon them briefly.  In my personal view, and I'd like the panel to comment on this, there are only two rationales for potential regulation of hedge funds, or really and financial instrument.  One, that you need to protect unsophisticated investors.  That's one source.  And Chester and John talked about the adverse selection process, the information process, how do you choose fund managers.
 
The second is protecting the stability of the financial system.  This is the public good aspect of hedge funds.  There's a great debate on are hedge fund activities stabilizing, are they destabilizing?  Do they provide liquidity or don't they provide liquidity?  Do they provide what I call fair weather liquidity, meaning that they provide tremendous amounts of liquidity when markets are functioning well, but when they don't function well which is when you want the liquidity, they're the reverse, they're destabilizing and they actually drive liquidity away?
 
I would like the panel to discuss those aspects because one of the things about the hedge fund industry is though it's not regulated now, almost everything around it is in the sense that its lenders that provide the leverage, if they're banks, they're regulated by either the Federal Reserve or the central bank of the country or the controller.  If they're investment banks they're regulated by the SEC.  If they're dealing in exchange listed derivatives, they're regulated by the CFDC.
 
So the question is, do you need to regulate the hedge funds or do you just need to regulate the people that are providing services or leverage to them?  I'd like the panel to talk about some of those issues.
 
MS. BEDER:  I think LTCM is a really, really good example to us to discuss some of those issues.
 
As to the question of whether people were hurt or unsophisticated, there were actually no court actions after LTCM unwound by the investors against LTCM and the reason was because there was no harm.  None of them lost any money.  They just didn't make as much money anymore.  I think that's a pretty important observation.
 
The second I'll make is that I don't think this was about whether or not LTCM needed to be regulated.  We can discuss all day long whether or not it's a prudent business decision to have high leverage when there's a positive probability of a 20 standard deviation move of something that you need to stay in your direction, because I think just the same way as if anybody spends more money than they earn, at some point it has some pretty dire consequences because you don't have enough money in the bank to tide yourself through a bad spot to keep paying your mortgage or anything else.  Similarly, funds have to make sure that they have enough money in the till so that when there are bad market events that they can weather those storms because the consequence is that they should go out of business if they don't, and I totally agree with John's viewpoint that they should have been allowed to fail.
 
I don't think, however, this was about saving LTCM.  If you want to talk about the public policy side of it, I think what the reality was in the LTCM case is that you had an awful lot of counterparties, banks and other people who were involved against LTCM who weren't even following their own policies.  The number of counterparties, for example, who were actually doing credit reviews of the exposures they were taking against LTCM, the number of parties who were following their own internal policies with respect to actually going through their normal approval processes, was kind of falling apart and had fallen apart.  And I think that there were a lot of people who because of their failure in following their own prudent policies in exposure towards a single counterparty needed to have some regulatory assistance to make sure that they didn't get into trouble.
 
So I think the real safety and soundness aspects of LTCM was a lot less the positions or, as I said, the poor business judgment that might be inferred on someone who takes more leverage than they can handle in a time of stress, that it really had a lot more to do with the counterparties.
 
Let me go to the second question.  I'm a big believer in good public policy.  I think that regulation is a good thing for the markets in general.  I think it needs to be reasonable regulation and regulation that accomplishes the safety and soundness that people are after.
 
As to whether or not hedge funds provide fair weather liquidity, I'll just make two quick remarks.  One is that I always found it fascinating during periods of high volatility to watch them.  I've always actually been involved with a fair amount of trading that involved as much electronic executions as possible.  It's a cheap way to do things, it's a fast way to do things in general, and it's something certainly that's taking an increasing portion of the markets.
 
The interesting thing is that during periods of high volatility which are the times that arguably it's the most dangerous to trade but also the times that there's the most opportunity to trade because, after all, if we don't have volatility of price movement, there's no way to make any money because if everything stays at the same price, you can't take any risk or make any money.
 
It's interesting to me that when there's high volatility it's really hard to get dealing desks on the phone, but the electronic executions just keep going through.  So counter to the intuition that people have which is that you actually need the people on the other end of the telephone during times of market crises, those are actually the market makers that evaporate, it's really hard to get them on the phone, whereas the electronic stuff goes through.
 
I point that out just to say that I think there are some things happening in the market in general that certainly improve liquidity, but the bigger piece is that all this technology and all this trading and all these people trying to exploit these arbitrages I actually believe are really lowering volatilities.
 
And one thing, actually I mentioned it this morning during a talk with some folks, is that right now we have an interesting dilemma in the marketplace.  Vols, volatilities, for those of you who follow them, let's just pick the equity market, they're down at 10 year lows.  You look around the world right now and you could argue that we have more intrinsic risk than we've had.  You've got the threat of nuclear warfare or bombs coming out of North Korea, you've got the huge financial uncertainties of what happens with continued revals with the Chinese currency, you've got a lot of unrest on the Asian seaboard, we've got a war in the Middle East, we don't know whether the new range for oil is 55 to 75 or something else, and those are all real risks that should manifest themselves in higher volatility levels which then again would increase the prices of options.  Nevertheless, vols are very, very low.
 
I tend to think that one of the factors that's causing that is all of this hedge fund arbitrage activity because people now are using computers and using a lot of rocket science to look at all these anomalies in the market, and the minute they see one to put the trade on and to force it back to the reversion that it should take, and that lowers vols.
 
So I think it will be interesting going forward whether or not volatility actually takes on a huge nature, but certainly the folks who are the most active in terms of forcing those reversions and dampening the volatility is the activity of the hedge funds.  I tend to think that makes much more stable markets.
 
MR. SPATT:  I think I agree both with Tanya's remarks and also the premises in Adam's questions.
 
I think to some degree at least some of the liquidity--on the one hand I think that in sort of relatively stable periods of time, it is in fact the hedge funds and the other investors who are operating across different margins and different markets who because of the arbitrage process are helping to smooth things out, smoothing things out because to the extent that only limited anomalies can really develop across different margins and I think it does have the effect of dampening volatility.
 
But I also agree with the perspective that some of this is fair weather liquidity.  Obviously a classic example of this were aspects of how things developed during the crash of '87.  That's obviously a dated example at this point, but I think the liquidity involved the role played by these sorts of pools is less clear-cut, and some of it frankly is related to our prior discussion of the LTCM anecdote.  The problem is if a lot of the pools are on the same side of a position and it's that sort of direction and position that's under stress, there may be no natural way to bring things back.
 
In a slightly different context, I remember talking about 15 years ago to folks in the mortgage backed securities industry and they were telling me about some huge mispricings at the time involving interest only securities.  I said, how did these mispricings develop?  Why isn't there more capital coming in to arbitrage that away?  They said, the problem is that the spreads had already widened to such a degree that a lot of folks have now reached a point where their willingness to continue to bear the so-called risks associated with this, they were now saturated with respect to this, and at times even the head traders who didn't understand the positions said I don't care what the value is, I know how much this position has cost me, let's go ahead and get rid of it.
 
So sometimes in fact I think the process doesn't work quite the way we hope, and in fact the way it works most of the time, but ultimately that does create opportunities for folks to step in.
 
With respect to the rationales for regulation, I tend to agree that it's issues involving the stability of the markets and other kinds of external effects on the one hand, and also protecting unsophisticated investors.
 
In the case of hedge funds, on the one hand there are obviously various restrictions in terms of who can invest.  There are accreditation rules, for example, in terms of accredited investor standards and the like in terms of who can investor.  But I think also the reality is that there's been in different forms a fair amount of retailization of the product.  This occurs in a variety of ways.  It occurs in part through fund to funds structures, it occurs in part through things like public employee pension plans, purchasing the product so on the one hand you can argue that the purchases are very institutional, but the decision makers themselves may not be that sophisticated, and in particular the consequences are definitely borne by investors who aren't sophisticated.
 
You could also argue that there could be a variety of issues that that raises, that maybe the problem is in the due diligence with respect to how those investments are actually being made.  But I do think that often the products are not well understood at least by the investors who are the ultimate beneficiaries, even if they are understood by directly the folks who are making the decisions.
 
MR. MAKIN:  On the regulation issue, I think the most effect way to regulate hedge funds would have been to allow a Long-Term Capital--the message is clear, the public sector is not there to reward poor risk management.  And I mentioned earlier that the successful, long-lasting hedge funds are those that are superb risk managers.  From what I can gather from Long-Term Capital, their own risk management parameters were violated and as the fund began to lose money, they abandoned arbitrage and went into outright trades and made the situation worse.  If you reward that kind of behavior, you'll see more of it.
 
Protection of unsophisticated investors, I assume you mean CalPERS and most pension funds.
[Laughter.]
 
MR. MAKIN:  What I've heard from those people, I've heard them say things like, well, we're wary of risks with hedge funds so we want to go into an Asian hedge fund.  Huh?
[Laughter.]
 
MR. MAKIN:  Protecting unsophisticated investors is impossible.  The only way to protect them is to show them what happens to people who really do their homework, that is, they lose their money.  And the notion that somehow investing in anything can be made riskless by regulation is one that does certainly bear scrutiny.
 
Let me tell you how to make money.  One, you have to have positions.  You have to be long or short.  Two, prices have to go up and down.  Those are necessary conditions.  The sufficient position is you have to be on the right side of the trade.
 
MR. LERRICK:  I thought that's a necessary condition also.
 
MR. MAKIN:  It's necessary and sufficient, yes, and some people are and some people aren't.
 
So anybody who thinks that through regulation or SEC pronouncements or other messages to investors you can protect unsophisticated investors is simply smoking something, you can't.  The universe of unsophisticated investors is very large and it involves many people who manage other people's money such as pension funds.
 
MR. LERRICK:  Now you understand why I expressed surprise when John told me he had been a consultant to the IMF when he keeps talking about that there shouldn't be bailouts.
 
MR. MAKIN:  I was in the research department.
 
MR. LERRICK:  You were in the research department.
[Laughter.]
 
MR. LERRICK:  I will not get to escape Argentina even day.  I'll give you an example of unsophisticated investors.
 
In touring Japan I met with a number of institutions that had invested 80 percent of their assets in Argentina bonds.  They had investment committees, they had boards of directors and they had gone in and invested, these were banks and insurance companies, that had put 80 percent of their assets in the bonds of the Republic of Argentina.  They at least did lose their money and their boards resigned, so there was some penalty.
 
Now I'd like to open up the floor to some questions either for all the panel or for specific members of the panel.
 
MR. BERLAU:  John Berlau, the Warren Brookes Journalism Fellow at the Competitive Enterprise Institute.
 
My question is what effects do hedge funds have on the market for corporate control?  That's a term Henry Mann, an economist used.  I think the Wall Street Journal op-ed may have gone into a little bit about this.  We hear a lot about entrenched corporate management in general, and that's what Sarbanes-Oxley and pension fund activism is supposed to combat, yet all those things seem to do just make entrenched management more bureaucratic, whereas we had things like hostile takeovers in the 1980s that really did scare management and made management more accountable to shareholders, but there were barriers put up to that.
 
I'm wondering are hedge funds now because CEOs and executives just don't know what they're going to do, whether they're going to buy more stock, whether they're going to short the stock.  Are the having the same type of effect on the market for corporate control making executives more accountable?  Then that goes into the question of are hedge funds the true shareholder advocates?  Are they acting to make executives accountable without some of the social agendas of some of the state pension funds?  Then that question is, is the SEC then at cross-purposes with some of the other reforms in trying to put extra costs on the hedge funds through hedge fund registration?
 
MS. BEDER:  Shareholder activist funds are certainly growing in popularity.  They really started over here.  There's one fund in Europe called Nightvinki (ph) that's done a lot of pretty active stuff.  They've gone after Shell and a couple of other folks quite successfully in the European space. 
 
I think that's a space that, you asked whether or not that's the appropriate mechanism to let's just say oust management who isn't necessarily maximizing shareholder value, I think that's a really difficult mechanism.  There are so many regulations about how you can take positions, the tools of the proxy are pretty limited, you have to fight a great portion of the battle in the press, the holding periods are extremely difficult relative to the normal investor period, so my prediction would be that that would not be the way of the main correction of corporate behavior that people haven't liked in the marketplace.
 
I think a lot of the stuff in the Sarbanes-Oxley is very good, but I can tell you that as someone who is part of a large financial institution, I have close to 10 percent of my staff who just does things like Sarbanes-Oxley testing.  It's hugely expensive, and I tend to question whether or not the ultimate benefit won't be far outweighed by the costs of the implementation.  I think that may be not quite the right way to solve it either just looking at what it does to the bureaucracy of an organization.
 
But the corporate activist stuff, I think that will always be a small part of the marketplace, and also it's fraught with huge challenges because most of the people who have the real bucks that they could put behind that are so conflicted in their ability to put the money into that process because they have so many other business dealings with those entities that I think there has to be a different way.
 
MR. SPATT:  I think that large shareholders are potentially important to the firms and potentially can exercise an important disciplining role, but I think it's difficult in part for many of the reasons that Tanya laid out.
 
For decades folks have been talking about the free rider problem associated with governance.  One of the real difficulties, if I invest a little bit of money to form a better portfolio, I'm going to reap the benefits of that.  If I invest some money as a stockholder to have my company be a little bit better managed, but I only own 1 percent of the stock, I'm only going to reap a tiny fraction of the total social benefits that I create.
 
To the extent that some hedge funds have an appetite for an activist role with respect to trying to enhance value, I think that's very healthy, but, frankly, there's a lot of awkward aspects of the proxy process and the disciplining process.  So I don't know that I see it as necessarily a kind of full solution to the problem, but I'm certainly personally sympathetic to trying to enhance the potential role that shareholders have, but I think it's a difficult and awkward process.
 
MS. RUKTEL:  My name is Bonnie Ruktel (ph).  I'm in the investment business.
 
I have one question on Long-Term Capital and one on derivatives, and the intersection of these two questions is the person of Warren Buffett.
 
Mr. Makin, with respect to your comments which I believe were echoed on the panel about Long-Term management should have been allowed to fail, it's my understanding that Berkshire Hathaway and AIG had a bid on the table to buy the assets of LTCM highlighting that Buffett shows up through the years as the guy who does almost everything right.  There he is to pick up the pieces when the Nobel Prize winners fail.
 
So I'm not sure quite what different would have occurred if it had been allowed to fail.  It's not as if John Merriweather would have gone into personal bankruptcy.  Everybody associated with the firm still goes, gets a good job.  The investors, they had had to put up more money in order to do this smooth bailout.
 
The real message I wanted to state is it seems to me that that experience was shattering of that paradigm, Long-Term Capital Management, the way it occurred, and especially the idea that a bunch of math whiz kid, Nobel Prize winner, computer jocks could be relied upon to produce a outcome, and you know how wildly popular that portfolio was on the street of the people investing, and it seemed to me that really was given a death blow.  That's on LTCM.
 
Derivatives.  Perhaps for the woman from Citigroup who was so interesting to listen to, Buffett has comments today about derivatives which in a large way are the province of the hedge funds, and as you said, of the banks that service them.  His view is exactly what you said about LTCM is going on to this day, that you don't have good monitoring of the counterparty risk, that it's all a big accident waiting to happen, and a lot of this risk management is self-insuring against events that only occur occasionally.  So he really poses this as serious concern as to the financial stability of the markets going forward.  What do you think?
 
MR. MAKIN:  I'm not sure what your question was about Buffett and Long-Term Capital, in other words, should they have taken his bid?
 
MS. RUKTEL:  No, would it really have made a difference whether Berkshire--
 
MR. MAKIN:  I think it depends on the price they were going to--I think the terms of the offer were not very attractive to the existing management at Long-Term Capital, but maybe Chester knows more.
 
MR. SPATT:  I think the question on Buffett and the bid raises an important point.  I certainly agree with John's remarks that the bid wasn't as attractive to the partners of Long-Term Capital, but from a public policy perspective and somebody who obviously wasn't in the government at the time, I must say as an academic I've never quite understood why that bid didn't get more serious attention.  I didn't really understand the power that the insiders had.  The business had failed.  It wasn't literally in bankruptcy, but it was--
 
MR. LERRICK:  Insolvent.
 
MR. SPATT:  Yes, but it was a liquidation type of situation where the control rights to the insiders should have been pretty limited, and the fact that the bid wasn't as attractive did seem to me frankly as an academic to be beside the point.  So I'm very sympathetic to the point in your question, that even if one accepts the too big to fail doctrine per se, it wasn't at all obvious why the Buffett, and I think Goldman Sachs may have been directly involved in that bid as well, why that bid wasn't taken more seriously.
 
MR. LERRICK:  First, a little bit of background of why the bid wasn't taken seriously which was very simple.  The Federal Reserve Bank of New York had told Long-Term Capital that in essence you have a backup.  If you cannot come to terms with the private sector bids, we're going to give you a bailout.
 
Telling a trader of John Merriweather's stature that you have a backup bid and a bailout is going to change his negotiating stance vis-a-vis the private sector counterparty.
 
MR. SPATT:  And it seems to me that that's actually at the heart of the moral hazard issue even in an ex post basis so that I think even if one felt that the situation was too bid to fail, it seemed to me rather awkward the way it was played out in that way.
 
MR. LERRICK:  Tanya, would you like to comment?
 
MS. BEDER:  As I said, I think the LTCM decision by the regulators had a lot of pieces that we didn't read about in the press.  We tended to read about the part relating to the hedge funds and the investors in the hedge funds and the Nobel Laureate part.  And I have to stick up for the math geeks of the world because those guys are all my math buddies.
 
I have to say this is true in crises.  Just as a small aside before I actually went into the hedge fund because at Caxton I ran a firm that really did financial train wrecks and having lived through things like Orange County and doing the Bankers Trust derivatives crisis and a number of other things, what you often read about in the press during the time that it's unfolding is quite different than what the true reality is.  The true reality comes out 2 or 3 years down the road because that's how long it takes for these things to get resolved typically when they're large crises and what's really driving those is of no interest to anybody because everybody is on to the next crisis by then.
 
I think it's unfortunate that we don't do more case study work on these things, and I think LTCM is a class case of one where the biggest lessons that really came out of it I think were for the counterparties, not for the investors.
 
MR. SPATT:  I just wanted to also elaborate on one other aspect of the question.  Probably the one aspect of the question which I would strongly disagree was the criticism, although I think some of it was directed to the LTCM folks in particular, but also I sensed maybe a more generic criticism of what the questioner referred to as the math whiz bangs.
 
I think maybe because my long-term job is as a finance professor, I see that a little differently than the questioner.  My perspective is that the math/finance types have an extremely set of skills that are very important in the marketplace because they provide the skills to break and apart and understand the underlying structure of risks.  I think that's extremely important both from the point of view of an investor's strategy and from the marketplace as a whole and that's at the heart of value in a significant portion of the hedge funds.
 
MR. LERRICK:  I think one of the thoughts that has run through many of the comments here is you have to distinguish when the mathematics goes wrong from when they don't follow the mathematics.  The models are not perfect.  We know the models are not perfect, but the largest losses come from when the portfolio managers' modeling does not follow the risk parameters of the controls that they have in place and just start speculating outright, and that's when the real train wrecks usually occur.
 
MR.         :  I have a question to all the panel members, including Mr. Lerrick.
 
I recently read an article in the Wall Street Journal about a hedge fund's lending practice to Third World corporations.  I think the article said they are lending money to these cash-strapped corporations and at the same time taking a short position on those corporations and that practice is also contributing to the defaults of those troubled firms.
 
My question is, is that really what's going on in the industry, and if that's so, is that a problem?
 
MR. MAKIN:  I'm going to ask people to stop referring to "the" hedge funds.  This is not a homogeneous group that moves in a pack.  There may be a hedge fund or one another hedge fund that's undergoing or undertaking you suggest, I have no idea.  But again, this goes back to the point that I was making earlier, that the hedge funds are responsible for everything that goes wrong in the world; some hedge fund, maybe.
 
As to the specific practice you refer to, again, I have no idea.  If the Wall Street Journal says it, they probably have some basis in fact, but what would be wrong with that?  What's the question?
 
MR.          :  [Inaudible.]
 
MS. BEDER:  Why wouldn't think of that as prudent risk taking, right?  If I'm taking a loan, I have a credit exposure.  If I can do something to remove the credit exposure thereby doing a better job for my investors, my shareholders, for the public safety in general, that's a prudent thing to do.
 
MR.          :  [Inaudible.]
 
MS. BEDER:  Why is that a conflict?  I guess the question is what you think the service is you're providing.  If you think you're providing the service of providing capital to someone who needs liquidity, you should have the ability to hedge the risk you've taken however you want.
 
MR. SPATT:  In fact, I haven't been familiar with this specific issue, but my instinctive reaction is, why is it more of a conflict to be both short and long than to just be short, let's say?  I'm not sure that I quite see the argument.
 
Clearly where I guess something like you could argue that there's a conflict is if there are issues of control rights on one instrument where somebody can act counter to the interests of the one instrument where they have the control rights to favor another instrument, I suppose there could be some issues there and I can imagine that that might even violate statutes about manipulation, but just generically structuring a hedge doesn't seem to be problematic on its face.
 
MS. BEDER:  Go back to a circumstance where before we ever had derivatives or the ability to short and you've just borrowed money from a bank back in the old days of the capital markets.  What was your challenge there?  It was to not have one bank because you didn't want one person who was determining your destiny, and I think in the new world of all the different--it's terrific that risk gets distributed through the markets.  That in general is better for the financial system.
 
But I think as management of a company, it's incumbent upon you to essentially understand the risk.  You have to understand the risk of having one person have all of your debt, as much as you have to understand the risk that someone today can slice and dice things and squeeze you into an uncomfortable position, and I think that's part of your responsibility is the management of a company to understand how you need to do your capital structure in a prudent fashion that doesn't place your investors at risk or your shareholders.
 
MR. LERRICK:  I think one of your questions is that if there's a fundamental difference in outlook is what you're posing between someone who is just a long-term lender only long to a company, and someone who can trade in and out of their position, change their risk profile, and the answer is I think there is a fundamental difference.  The one who can trade is going to make more money and make things more efficient, as opposed to just what you're viewing as the long term, and I think in Japan and Germany it's viewed as the long-term social value of the company.
 
MS. BEDER:  I got to take you on on this one.
 
MR. LERRICK:  All right.
 
MS. BEDER:  Banks perform a very valuable role by making loans, but let's face it, they syndicate them, they package them, they sell them to get them off their balance sheets.  That doesn't make them any more of a long-term--
 
MR. LERRICK:  I agree with you 100 percent.  I'm going to the proposed analogy of a bank that doesn't do any of that, that just keeps the loan on its books in entirety forever.
 
MS. BEDER:  I think the regulator should be in there talking to them about getting better practices.
 
MR. LERRICK:  I agree.
 
MR. EISENBERG:  Mike Eisenberg with the SEC.
[End of tape 1B, begin tape 2A.]
 
MR. EISENBERG:  [In progress] --we're talking about registration of hedge funds and I think it's a small point but it has pretty great implications.  No one at the Commission has said or advocated the registration of hedge funds.  The proposal is for the registration of the investment advisers to the hedge funds.  The concern obviously is this is the camel's nose under the tent and the next step is so and so, and that's the sky is falling theory of all regulation is going to get worse and worse and worse.
 
The problem is that with respect to the trillion dollars out there, actually the registration of the investment advisers is a small step but an important step in finding out where we are and what we're doing and what's out there and what the dangers are.  It's the next step which is used to kill what I would think is a reasonable response to what we've got out there.
 
MR. MAKIN:  May I ask a question?
 
MR. LERRICK:  Sure.
 
MR. MAKIN:  Who are investment advisers for the hedge funds?

MS. BEDER:  The managers.  It's the company that employs you, John.

MR. LERRICK:  Before we started the conference I asked the question of Mr. Eisenberg, every major hedge fund I know has contingency plans that they can move their entire operations within 24 hours.

MS. BEDER:  I don't think that's true.

MR. LERRICK:  And he said, but he said, but we have their passports.
 [Laughter.]

MR. MAKIN:  We are SEC registrants and the view was it's a barrier to entry.  We can afford it.
 
MR. NICKS:  I'm Michael Nicks (ph).  I've done an awful lot of energy work.  On the topic here of regulation, I liked a lot of what you were saying, Mr. Lerrick, about the lack of regulation here, but in the late-1990s I did an awful lot of work with a little company out of Houston called Enron.  I once heard them described as okay, there's thinking outside the box and then there's no believing there's a box.  And a friend of mine who was applying for a job with them said that Houston's Enron didn't really believe there was a box.
 
But yet I did work some with them but more with some of their competitors on legislative issues here in town, and you do really need to open up the market to have all these new entrants to the market, and it is better for consumers to have all these new entrants to the market.
 
My question goes to part of what the gentleman from the SEC was saying and some of the stuff the rest of the panelists were saying, where do you see regulation for this in the future?  Right now the Federal Energy Regulatory Commission has touched on derivatives, commodities futures, the Trading Commission has touched on this.  You've mentioned the registration at the SEC.  We're talking about three government agencies already right there.  Where do you see hedge funds being regulated in the future?  And do you see this multiple regulation?
 
MS. BEDER:  I'll take a shot at that.  My management company, not the fund itself, is regulated by the Securities and Exchange Commission, but the Financial Services Authority, by the Monetary Authority of Singapore because I have activities in all of those markets.  Also because I'm part of Citigroup, I have the Fed and the Office of the Comptroller of the Currency.  Also as does Caxton, I have big position reporting requirements that I have to do, spec limits on futures contracts, I have to do large position reporting on equities.  When I participate as I do through my fixed income arbitrage activities I have to do filings on what I do in the bond markets and particularly new Treasury issues.  Then there are similar filings around the world in all the other markets because this isn't the only market that we trade.  So there's a lot of regulation.
 
I personally am a believer in it.  I've said that before.  I'm a believer in good public policy.  Right now the big challenge is that there is zero harmony, and particularly on the global level.  I know because funds actually file in one market.  They're either SEC registered and then they file for exemptions in other markets or they do it the other way around.  We're by being regulated in these markets faced with some huge challenges.  The challenges don't just come from regulation.  I'll give you one of the simplest ones that really hits home.
 
I'm a believer that the liquidity of the fund that you offer should line up with the liquidity assets that you trade.  Ninety-eight percent of what I trade are the most liquid equities, the most liquid currencies, crosses, futures contracts, fixed-income instruments.  I could do daily liquidity, but I can't because in the United States we have laws on publicly traded partnerships, and so that I don't get on the wrong side of what is a relatively arcane U.S. Tax Code, I cannot offer daily liquidity here.
 
So there are a lot of examples of things where you're trying to do the best thing that's in the fiduciary interest of your investors and you get stopped dead in your track because of all these laws don't line up.  If I do what's the best for U.K. tax codes, I can't do it over here, and similarly, if I do what's the best in Asia, at the end of this month I'm about to start my conversations with the Chinese regulators because I'm putting in an office in Shanghai and I suspect I'll get a whole new dimension to my problem and hopefully won't find that what we found is the best solution for the other three and gets messed up by that one.
 
So I think the solution at the end of the day is that there is a lot of education required.  I think people like ourselves and through these panels I think we actually have to spend a fair amount of time with the regulators doing a few things.  One is that I don't think this industry has been on an education campaign in terms of the kinds of trades we are doing.  I tend to think that's why you get comments like Buffett is a great investor, but I think that some of the commentary that's made about derivatives, they're tragic because he has a good track record, people say then he must be right about that, too.  Derivatives perform a really powerful completion function in the marketplace, so I think it's incumbent on this industry who's on the edge to get out there and make sure that people understand what these challenges are.
 
But certainly on the regulatory front it needs to be harmonized because I know as one who's underneath that, I feel like I'm single-handedly supporting the global law firms of the world trying to come down to an agreement on a tax opinion right now.
 
MS. MAKIN:  I think Tanya's experience is representative of a very large institution that has to deal with all these regulatory.  I'm not sure I see a great deal of evidence of the amount or number of regulators involved in a particular industry bears any systematic relationship to whether or not the public gains or loses from investing in that industry.  In other words, regulation is expensive to implement.  It's not clear to me that it does a lot of good.  And it may actually be a barrier to entry into some of the newer areas because it's very expensive to undertake.
 
It's an advantage that a large institution has over a smaller institution, and certainly Citicorp probably collects rents from the fact that they have a huge organization that deals with these problems more successfully than others which they have to because they're big and heavily regulated.
 
Would Enron have occurred without regulation?  I don't know.  How do you prevent fraud?  It's difficult.
 
MR. LERRICK:  There's a whole school of theory of regulation which has to do with capture.  Professor Stiegler at Chicago said that the greatest advantage of regulation is for the regulatee, not the regulator and the public, because they suddenly managed to capture the regulator and extract even larger rents than they would in a free market.
 
MR. TAFT:  My name is Oliver Taft.  I have a question for all of you, but for Mr. Makin in particular given his comments just now about regulatory burden.
 
You'd said earlier when you were speaking that good risk managers are the ones that stick around.  I was wondering if you could talk a little bit about systemic liquidity risk in general given that you don't seem to believe in a strong regulatory function, and also that there would be failures.  For example, specifically with Long-Term Capital Management you said let them fail.  If all of you could address that, but you in particular given those comments.  Thank you.
 
MR. MAKIN:  I'm not sure what you mean.  Systemic liquidity risk would mean no one will--
 
MR. TAFT:  Market failure.
 
MR. MAKIN:  Market failure, no one will execute a trade at any price?  Is that a market failure?
 
MR. LERRICK:  We've never had a chance to test it because we'd never let it happen.
 
MR. MAKIN:  We'd never let it happen.  I think that we've never really tested the idea that you can let an institution fail without the word coming to an end.  It's must like many governments seem to believe, that if they don't intervene in currency markets the price will go to zero or infinity.  It won't.  Somebody will step in and buy it.
 
I want to answer your question, but I don't know quite what it is.  Is it a hypothetical question?
 
MR. TAFT:  Generally speaking at least in the anecdotal conversations going on about the issue, it comes up often times that liquidity is a big issue in hedge fund markets.  So I'll leave that to you define; the risk of liquidity in particular.
 
MR. MAKIN:  Let me talk about what I think Tanya touched on.  Liquidity is a big issue.  In other words, when you want to do a trade and there's a shock say after 9/11 and you call people up, they're not at the phone, that's a liquidity issue, and that's a systemic issue that is legitimate probably for the Fed to step in and make sure there's enough liquidity available.  It's a judgment call.
 
But whether or not the absence of liquidity over a given period of time would be amenable to some kind of a solution with regulation, I don't know.  Somebody has to be willing to get on the phone and take a position after a big event, and you're starting out a process where the market is going to iterate toward a new price and the people on the desks are reluctant to call out a price on either side of the market.
 
Normally after people have a chance to absorb it, liquidity comes back into the market, people start making prices and the process continues.  The situations I've observed have been remarkably resilient and the market starts to function again.
 
So the question is how high a price are you willing to pay to have instant response in terms of market making a major shock?  I honestly don't think it's possible to get that, and if it were possible through some regulatory or government institution, I'm not sure that would lead you most efficiently to the new equilibrium price.
 
MS. BEDER:  I'll take a little bit of a different tack there.
 
I think that one of the most important services provided by regulation and good public policy is making sure, or trying to make sure, that if you have a dislocation in a market and it doesn't matter what that dislocation is caused by, whether you think of some catastrophe or any market event of a misalignment or whatever, and I think what you're always trying to solve for is, is there some piece of the market in its structure whether it's the banking industry or the individual consumer or somebody who's going to be disproportionately harmed so that we end up with some kind of a systemic crisis.
 
So to me it's really about information.  What is the information that the regulators have to have so that they can keep tabs on that so that they can put in a throttle when they need to to avoid that kind of a dislocation?
 
A recent example of one that was done, you heard my comments before on how electronic trading tends to keep going even when there's a crisis.  You probably all read about after the recent bombings in London that the London Stock Exchange shut down the electronic trading.  That effectively meant when you've got 40 percent of the daily flows going through that there, you effectively just shut down 40 percent of the market because that was going to keep trading and their fear was what would be the price formation on it.
 
I tend to think it probably would have been okay just because if you look at the recovery in that market after the bombings was multiples faster than it was after Madrid, and I suspect that even the next one will probably be even a faster correction with less of a drop.
 
But I think it's a very important thing for the regulators to be able to do, and certainly as hedge funds grow larger in their dominance in the marketplace and certainly in certain sectors of the marketplace, that information has to be provided.  So I think that's all part of the process.  As long as it's something that's information that makes sense versus just information that doesn't really accomplish anything and adds costs, I tend to be a big supporter of it.
 
MR. LERRICK:  I would like to distinguish the difference between a bailout and liquidity.  We have 200 years of practice of liquidity starting with the Bank of England where the concept is there is a crisis, a shock, an insolvent borrower, and the concept is to come in and provide liquidity to the market, which is to lend around the crisis.  You don't come in an bail out the crisis institution.
 
The only example I know of where it actually was allowed to fail, and we have a test case, Drexel Burnham.  When Drexel Burnham went bankrupt, the Federal Reserve followed the exact policy that had been prescribed in central banking for almost 120 years which was it came in and announced we're not going to provide any funds at all to Drexel.  However, anyone else around you in the financial market who is impacted by this who are counterparties and need liquidity can come to us and we will give them liquidity.
 
If you look at what happened at Drexel, Drexel went under in spite of all of the commentary that this would create a global crisis in the financial markets without a blip.  The Fed provided liquidity where it needed to, banks knowing the Fed would provide liquidity, provided liquidity to other counterparties, and so it worked very well.
 
I always liked the anecdote that Alan Meltzer tells, that he had been advocating that banks should be allowed to fail and no one listened to him.  Finally one day there was a small bank in Kansas that was allowed to fail, and Alan called up the Chairman of the FDIC to congratulate him and said, Look, it failed.  Nothing happened.  You did a wonderful job.  The Chairman said, Your congratulations are undeserved.  It's just because we didn't get there in time.  Otherwise, we would have saved that one, too.
[Laughter.]
 
MR. LERRICK:  So I think that's a good anecdote.
 
MR.          :  Going back to the question earlier about the firm that was lending money to a company and then shorting the stock, there were some murmurings up here in the back row.  A couple of questions wondered about that.  It seemed like as a banker would they have had some inside information that could have been passed to the other side?  Is there a potential for stock price manipulation if the banker decides not to renew the loan and lets the other side know that they're not going to do that?
 
And would both sides of this trade be known to the general shareholder who is considering investing or not investing?
 
MR. SPATT:  It's not so much that, but I'm not a lawyer by training and I think I've learned a lot about the law over the last year, but I don't want to be sitting here defining what is a manipulation and what isn't a manipulation.&