A lesson from 1929 for the hedge funds

The current credit crisis has many reaching for their history books, seeking to find out what lessons might be drawn from previous financial disasters. There is a rich history of bank failures. What can history tell us about the $2,000bn world of hedge funds?

Some say the turmoil in financial markets could be a boon for shrewd hedge fund managers, allowing them to pick up assets on the cheap from distressed sellers. Others argue hedge funds are in a potential death spiral, with redemption demands from investors prompting asset sales which lock in losses, in turn prompting further redemptions and so on.

While hedge funds seem to capture perfectly the zeitgeist of contemporary capitalism, they actually have parallels in investment companies that flourished on Wall Street in the late 1920s. By 1929 a new investment company was being launched every day amidst frenzied demand from investors. These investment companies had a number of similarities to modern hedge funds.

First, the marketing of investment companies was based on promises investors would benefit from the investment expertise of highly skilled professional managers and advisers. Various investment companies even recruited noted economists and finance professors to provide investment expertise.

Second, investment companies, as with hedge funds but unlike modern day mutual funds, regularly had access to borrowed capital that enabled them to turbocharge their equity investors’ returns.

Third, investment companies were free to compensate their managers on the basis of high-powered incentive contracts, and often did so. The senior Goldman Sachs partners who managed the market leader in the late 1920s – the Goldman Sachs Trading Corporation – contracted to receive 20 per cent of any net profits above 8 per cent.

Fourth, restrictions were frequently imposed on the ability of investors to withdraw capital. Pre-crash investment companies typically operated as “closed-ended” funds, meaning investors had no discretion to demand redemption of their investments. Hedge funds typically impose on investors fixed minimum investment periods and redemption penalties, and have begun during the current market crisis to “close the gates” – put caps on redemptions.

Fifth, the investment companies of the late 1920s, as with today’s hedge funds, operated in great secrecy, revealing little about their trading strategies or manager remuneration.

The 1929 Wall Street crash prompted dramatic changes for the investment companies.

The investors who piled into the sector typically suffered devastating losses. Shares in closed-ended investment companies traded at a premium to underlying asset values prior to the crash but when share prices fell, liquidity dried up. Since investors could not force redemptions, they had no option but to sit and watch as their investments plummeted in value. The bitter experience meant closed-ended investment companies were shunned and new investment funds had to be marketed on an open-ended basis permitting redemption at any time.

Regulation also followed. Following Congressional investigations of investment companies in the 1930s, the Investment Company Act of 1940 and the Investment Advisers Act of 1940 regulated investment companies, or “mutual funds” as they came to be known. Mutual funds were, amongst other things, subjected to prudential regulations that inhibited their ability to use leverage. A requirement of a fairness review by the Securities and Exchange Commission for self-dealing transactions also impeded the use of high-powered incentive compensation for their managers.

However, all was not doom and gloom in the investment company sector in the 1930s. There was money to be made by those able to spot the right opportunities amidst the market wreckage. Floyd Odlum became a multimillionaire by buying control of 22 investment companies – including the Goldman Sachs Trading Corporation – at prices substantially less than the value of the securities they owned.

The basic themes of the investment company story resonate for today’s exemplars of the free-wheeling leveraged collective investment vehicle. First, a prolonged downturn in returns could prompt hedge funds to market themselves to bruised investors afresh, with steps such as downplaying their use of leverage, cutting fees and offering more attractive exit arrangements.

Second, new regulatory controls cannot be far off. Hedge funds may cater almost entirely to sophisticated investors but they will not be able to sidestep fresh regulation when they trade assets in ways that potentially affect the viability of the entire financial system.

Third, there no doubt are present-day Floyd Odlums among the current crop of hedge fund managers. Those with the right combination of courage, skill and timing will have a golden opportunity to turn today’s turmoil into tomorrow’s profits.