July 31, 2014
All generalisations are false, including this one

"Hedge funds - the most greedy, unscrupulous, short-termist financial subspecies out there" - David McWilliams

An article in the Irish Independent by David McWilliams caught my eye this week, not least because of the quote above.  The gist of the article is that the Irish Central Bank, on the back of a consultation paper issued this week, is moving towards allowing hedge funds to lend in Ireland. In a country where lending to homes and businesses continues to decline even 6 years after the financial crisis, this might look like a way of bringing in more capital to an under-banked part of the economy. Not so, according to Mr McWilliams, it will instead 'completely destabliize the economy' and make boom and bust worse in a country that has had its fair share of economic volatility.  

It is not for me to comment on the state of the Irish economy. There are many actual economists out there who can give you a better steer. However two things bothered me about the commentary. 

The first is the quasi-tabloid treatment of ‘hedge funds’ as a homogeneous group.  The ‘hedge fund’ classification is a catch-all term encompassing such a broad range of legal structures, strategies, styles and asset classes as to render it largely meaningless. What is more of a surprise is that David McWilliams, despite having spent some years in the hedge fund industry, subscribes to this reductive approach and then adds in fear and suspicion for good measure. 

To his allegations of avarice and lack of scruples (not to mention the emotive use of ‘subspecies’) he describes this non-specific group of financial companies as being “the most highly speculative, profit-driven" and asserts that "the aim of the hedge fund is to maximise profits in the very short term”. This may be true of the specific hedge fund experience that Mr McWilliams has had, but having reviewed well over 500 managers (and many more individual funds) as an end-investor I take issue with the generalisation, as would most informed hedge fund investors. 

Hedge funds lie on a spectrum, with a broad range of investment styles, risk appetites and investment horizons. At one end of the scale are managers so conservative as to make the most traditional ‘long-only’ managers look racy while at the more speculative end of the range use of leverage and volatility can be high. The truth is that the majority of managers that fall under this classification fall somewhere in the middle. Similarly time frames for investment differ wildly across strategies and managers. I have placed money with managers that hold positions for only a day and with those who are making direct loans with tenors as long as 7 years.  A manager looking at an investment with a 7 year time frame is not ‘maximising profits in the very short term’. That manager has to do extensive underwriting work to protect capital for his investors and to protect his own business.  

Which leads me on to the second point, which is that it is unclear from the article why David McWilliams views this as such an destabilising force. He cites hedge fund incentive structures as a reason, because ‘when the only objective of the lender is to make lots of money, you can be sure this is not good news for the borrower’. 

I haven’t checked recently (bad Lady FOHF!), but I’m fairly sure banks are not charities lending to businesses out of the goodness of their hearts. More specifically, banks do not lend to SMEs, for example, for free. There is inherently a profit incentive.  The critical point here is that bank lending is declining, which is why this initiative is being proposed. As a small business owner, given the choice of ‘no loan’ or a loan from a financial entity working under a scheme regulated by the Central Bank, where do I go? 

Finally, I don’t buy the argument that the hedge fund incentive structure means that managers are ‘always incentivized to take big bets and are less concerned about losing money than making it’.  Hedge fund managers are business owners too. Yes, their income is inextricably linked to the performance of the fund (else, why run the fund in the first place) but the vast majority are required by their investors to be co-invested in the funds that they manage. This alignment of interests with their investors is critical, giving investors the confidence that managers ‘win’ and most importantly ‘lose’ alongside them. Similarly, I am yet to meet a hedge fund manager who is looking to make all of his money from a year’s fees, blow up his fund, move on and set up a new one. Suggesting that people who have invested their careers, reputations and personal capital in a business are ‘short-termist’ seems somewhat reductive. 

If there are structural reasons why bringing new types of lenders (leaving the ‘hedge fund’ nomenclature out of it) into the Irish market might be a destabilising force, I would be interested to learn, but generalising in order to make an entire section of the financial services industry into the villain of the piece doesn’t seem the right way to calmly assess the potential risk.  

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