Hedge Funds

In today's NY Times, David Swensen worries about small investors' taste for hedge funds, and argues for restricting hedge funds to the most sophisticated investors.  So much so that he would regulate "funds of funds" (mutual funds that offer portfolios of hedge funds) out of existence.  Swensen is thoughtful, as usual, but I find it hard to agree with anything in the op-ed piece.

In the first place, if investors want to invest in something it is hard to stop them.  It may be wrong to stop them too.  Swensen and I might think consumers/investor are wasting their money on technical analysis of stocks or on sugar-coated cereals, but we hesitate to ban consumerism that puzzles us.  But let's put free choice and morality aside for now.  It is hard to stop small investors because they can find their way around our regulations.  If funds of funds are banned, nothing will stop investors from buying stock in a corporation which has factories but also invests in portfolios of hedge funds.  There are many other ways to avoid whatever regulations we generate, and it normally takes years to plug such loopholes. Overall, it seems counterproductive to put an inefficient layer between investors and their goals.

Swensen seems frustrated with investors who have but a modest chance of striking it rich through hedge funds, when these funds extract serious fees.  But of course that is true of a good deal of investment.  Economists have been telling small investors, and perhaps all investors, to diversify-and-hold for decades now, and yet a good fraction of the market chooses to be ignorant of the evidence about their chances of success, prefers to enjoy making investment decisions, or chooses a path that is likely to make investors worse off but holds some chance of a respectable means (better than the lottery) of gaining real wealth.  It's not what I do, but then I don't use a stock broker either.  Millions of investors think they or their agents can outperform the market, and the race to hedge funds is just the latest piece of this picture. The more investors read that the smartest business school graduates are heading to hedge funds, the more they think that they do not want to miss out on the action.  If the smart money, or at least business talent, was in Silicon Valley and is now in hedge funds, then we should expect small investors to follow them, first to one place and then to the other.  It is difficult (and perhaps unwise) to regulate against these tides.

Swensen may also have his eye on the danger of regulatory over-reaction.  If more and more small investors go the hedge fund route, and that market produces not small losses for six-sevenths of them (as his op-ed implies) but eventually huge losses for many, with some scandals in the mix, then a legislative response might go so far as to take hedge funds away from sophisticated investors like Yale (and Swensen).  And if we believe that hedge funds do not just move wealth around but also also improve markets or otherwise generate some real social benefit, then the possibility that they will be regulated out of existence, or made much more expensive with disclosure and other requirements, should worry us.  But suggesting that only the rich and powerful should have access to them seems like the wrong way to avoid this.  It is not politically attractive, it is inconsistent with how we regulate most other parts of the market (there are exceptions), and it is impractical.