What Do Hedge Funds Do?

Michael Giberson

If you, like J. Bradford DeLong, are wondering “what the hell they are doing that is worth that kind of money,” then Bookstaber’s book can help.

One point of Bookstaber’s argument is to illustrate the problems with the term “hedge fund.” While “hedging” has a particular meaning, and “fund”, too, is well defined, turns out that the joining together of two well-defined words gets you what has become an ill-defined conglomeration. Or, as Bookstaber puts it, hedge funds are the universe of possible investment firms, except for traditional firms. This part of the book should be required reading for anyone urging increased regulation of hedge funds. (Yes, New York Times editorial page, this means you.)

But, to the extend it is possible to generalized about what hedge funds do… well, the long answer to the question is “read the book.”

In short, however, I’d say the answer is taking risks while providing liquidity to the market at a lower cost than is offered by less sophisticated investors. What all the high-powered computation buys you as an investor is an understanding of clever ways to offset the known risks of various kinds of transactions. The transactions generally remain risky, but by structuring deals to minimize known risks and often leveraging investments to high degrees, hedge funds can take on positions that otherwise would promise too small of a reward given the risk involved. The presence of sophisticated investors lowers the cost of capital and makes it cheaper for non-financial firms to invest in physical assets.

This is not a zero-sum game; facilitating commerce has real benefits for the economy.

And while I don’t want to totally discount the problems caused by the occasional market meltdown, or the possibility of systemic risks, it seems obvious to me that we are better off now with all of this rampant financial innovation and lucky hedge fund billionaires than we were back when the economy would suffer a financial panic that spilled into the real economy with much more force on a regular basis.


One thought on “What Do Hedge Funds Do?

  1. When would that have been, exactly?

    One would like to keep an open mind about reducing barriers to commerce, even if some instruments purporting to do this end up transferring very large amounts of wealth to very small numbers of people. The thought occurs, though, that some “knowledge economy” enthusiasts may be too easily seduced by facile comparisons to the financial environment of the 1920s.

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