November 28, 2005
The Hedge Fund Craze: Deja Vu All Over Again?
Posted by Matt Bodie

Many thanks to Vic, Gordon, and Christine for inviting me to join in for two weeks.  I'm really looking forward to it.  I'm hoping to spend a little more time on some of the issues that regularly get batted around by the business law blognoscenti, such as SSRN, Eliot Spitzer, and Sarbanes-Oxley.  And the timing seems especially auspicious given the Ideoblog takeover by the "Truth on the Market" folks.  Nice title, by the way -- could we call it "the Truth" for short?  I'm sure Paul Pierce or Carl Williams wouldn't mind.

Hedge funds have been all the rage recently, both for wealthy investors and for blogging profs.  When I saw the New York Times article, my first thought was that hedge funds had officially jumped the shark.  There has been such a craze over hedge funds that we seem to be entering a familar loop: (1) below-the-radar investment vehicle gets above-average returns, (2) the financial press starts to make noises about this great! new! thing!, (3) positive news stories start appearing in the mainstream press, and (4) money from semi-sophisticated investors starts pouring in.  What generally happens after that?  (5) Everyone is talking about this great new investment vehicle, (6) some commenters start making knowing asides with pessimistic predictions, (7) the vehicle gets even stronger, despite the odds, (8) some negative stories start coming in -- fraud here, poor returns there, (9) the vehicle hits an abrupt speedbump, and (10) the bottom falls out.  It happened with "junk" bonds in the 1980s and high-tech stocks in the 1990s.  Frank Partnoy makes a persuasive case that it has happened and will happen again with derivatives.

Hedge funds seem particularly likely to flame out because of the ease of setting up a hedge fund as well as the secrecy associated with them.  Unlike high-tech stocks or junk bonds, you don't need sophisticated Wall Street banks to set up the vehicle or manage the IPO.  All you need are a bunch of rich folks and a dream.  When will we read about a "hedge fund to the stars"?  (Maybe I missed it already.)  You could hedge with Paris Hilton!  I had hoped that the coming hedge fund implosion would only really affect investors who should know better, but the NYT article dispelled some of that hope for me.  Further evidence that pension funds will be the S&Ls of the new century.

I suppose these stories also include (11) Regulation is imposed after the implosion, but it is criticized as "too late" or "too intrusive".  I agree with Vic that maintaining ERISA's presence here is not a bad thing.  But hedge fund managers hate the new SEC rules, which seem somewhat benign as well.  I'm not sure what the overall answer is.  But I've seen this story before, and it seems fairly inevitable that before too long I'll be able to buy a hedge fund puppet on eBay.

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