Democracy in Tea Party America
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J. Bradford DeLong
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30 August 2012
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BERKELEYWhen the French politician and moral philosopher Alexis de Tocqueville published the first volume of his Democracy in America in 1835, he did so because he thought that France was in big trouble and could learn much from America. So one can only wonder what he would have made of the Republican National Convention in Tampa, Florida.
 
 
 
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For Tocqueville, the grab for centralized power by the absolutist Bourbon monarchs, followed by the French Revolution and Napoleon’s Empire, had destroyed the good with the bad in France’s neo-feudal order. Decades later, the new order was still in flux.
 
 
 
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In Tocqueville’s imagination, at least, the old order’s subjects had been eager to protect their particular liberties and jealous of their spheres of independence. They understood that they were embedded in a web of obligations, powers, responsibilities, and privileges that was as large as France itself. Among the French of 1835, however, “the doctrine of self-interest” had produced egotism no less blind.” Having “destroyed an aristocracy,” the French were “inclined to survey its ruins with complacency.”
 
 
 
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To the “sick France of 1835, Tocqueville counterposed healthy America, where attachment to the idea that people should pursue their self-interest was no less strong, but was different. The difference, he thought, was that Americans understood that they could not flourish unless their neighbors prospered as well. Thus, Americans pursued their self-interest, but in a way that was “rightly understood.”
 
 
 
 
Tocqueville noted that “Americans are fond of explaining [how] regard for themselves constantly prompts them to assist each other, and inclines them willingly to sacrifice a portion of their time and property to the general welfare.” The French, by contrast, faced a future in which “it is difficult to foresee to what pitch of stupid excesses their egotism may lead them,” and “into what disgrace and wretchedness they would plunge themselves, lest they should have to sacrifice something of their own well-being to the prosperity of their fellow-creatures.”
 
 
 
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For Tocqueville, France’s sickness in 1835 stemmed from its Bourbon patrimony of a top-down, command-and-control government, whereas America’s health consisted in its bottom-up, grassroots-democratic government. Give the local community enough control over its own affairs, Tocqueville argued, and one “will see at a glance the close tie which unites private to general interest.” It was “local freedom which leads a great number of citizens to value the affection of their neighbors and of their kindred, perpetually brings men together, and forces them to help one another, in spite of the propensities which sever them.”
 
 

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Nearly two centuries have passed since Tocqueville wrote his masterpiece. The connection between the general interest and the private interest of individual Americans has, if anything, become much stronger, even if their private interest is tied to a post office box in the Cayman Islands. Indeed, no private-equity fortunes were made over the past generation without investing in or trading with the prosperous North Atlantic industrial core of the world economy.
 
 
 
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But the mechanisms that individuals can use to join with their immediate neighbors in political action that makes a difference in their lives have become much weaker. If, say, 25% of the 1,000 households in the 30-block Brooksidefiberhood” in Kansas City, Missouri, pre-subscribe, Google will provide all 1,000 with the opportunity to get very cheap, very fast Internet service very soon. But that is the proverbial exception that proves the rule.
 
 
 
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And the Republicans gathered in Tampa to celebrate the rule – to say that the America that Tocqueville saw no longer exists: Americans no longer believe that the wealth of the rich rests on the prosperity of the rest.



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Rather, the rich owe their wealth solely to their own luck and effort. The rich – and only the rich – “builtwhat they have. The willingness to sacrifice some part of their private interest to support the public interest damages the souls and portfolios of the 1%.
 
 
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Perhaps the moral and intellectual tide will be reversed, and America will remain exceptional for the reasons that Tocqueville identified two centuries ago. Otherwise, Tocqueville would surely say of Americans today what he said of the French then. The main difference is that it has become all too easy “to foresee to what pitch of stupid excesses their egotism may lead them” and “into what disgrace and wretchedness they would plunge themselves.”


 
 
 
J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau for Economic Research. He was Deputy Assistant US Treasury Secretary during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in designing the bailout of Mexico during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies, and cemented his stature as a leading voice in economic-policy debates. .
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Copyright Project Syndicate - www.project-syndicate.org

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August 30, 2012 7:13 pm

How to protect EU taxpayers against bank failures



On September 15 2008, Lehman Brothers filed for bankruptcy protection, tipping the world into a financial and economic crisis of nearly unprecedented magnitude. Four years and much regulatory work later, financial markets have become a safer place.
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Yet Europe’s efforts to draw the right lessons from the crisis will have amounted to little if we do not get the next step rightthe creation of a truly effective European banking supervisor to enforce a robust single rule book for the sector.
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The key lesson of the crisis, one sadly confirmed by the recent Libor scandal, is that self-regulation and light-touch supervision just do not work in the financial sector. Without adequate rules and careful policing, the interests of individuals and those of the system will invariably diverge. Left to its own devices, the market will self-destruct.
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Under a mandate from the EU heads of states and governments, the European Commission will shortly unveil proposals for the creation of a Europe-wide supervisory system for banks. This new supervisor is widely expected to be housed at the European Central Bank.
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Setting up such a system will be no simple undertaking and doing so within a reasonable timeframe will require not just hard work but also courage, for it implies a big step towards more European integration – a genuine transfer of sovereignty and a significant strengthening of European institutions.
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It is crucial that the new system be truly effective, not just a façade. We must eschew yesterday’s light-touch approach for good and endow this supervisor with real and clearly defined responsibilities, coercive powers and adequate resources.
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This also means that it should focus its direct oversight on those banks that can pose a systemic risk at a European level. This is not just in line with the tested principle of subsidiarity. It is also common sense; we cannot expect a European watchdog to supervise directly all of the region’s lenders6,000 in the eurozone aloneeffectively.

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In addition, if the supervisor is to reside at the ECB, decision-making in supervisory and monetary policy matters should be strictly separated so as to pre-empt conflicts of interests between the central bank’s supervisory and monetary mandates. The presence of such a Chinese wall would also make it easier for EU members that do not use the euro to participate in the supervisory system, thereby protecting the coherence of the single market.
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Crucially, it would endow the supervisor with the necessary degree of accountability to the European Parliament and Council, with no additional risk to the independence of the ECB in monetary matters.
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A supervisor, of course, can only be as good as the rules it enforces. Work on equipping the EU with a single financial market rule book is far more advanced than that on setting up an EU-wide supervisor. But we are not quite done yet.

 
 

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Indeed, the centrepiece of the rule book – the translation of the Basel III capital requirements for banks into European law, also known as CRD IV – is still being negotiated between the member states and the European parliament.




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I think the final compromise should give national authorities some discretion in imposing capital surcharges on systemically relevant banks beyond the requirements of Basel III – as the G20 members have already agreed to do for globally systemic banks.




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I also support the suggestion of the MEPs to embed common language on variable pay into the CRD IV directive. Immediate cash bonuses for top bank executives should not exceed their fixed pay. And why not give a large quorum of shareholders the last say on setting these executives’ long-term variable pay as soon as it exceeds a given level?




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Just as we need to set incentives for managers to act in the long-term interest of their banks, we must set the right incentives for the creditors and shareholders that finance banks.




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This was the goal of the German law on bank restructuring introduced in 2010 and of the EU directive, now under discussion, which should allow failed banks to be wound up at no cost to European taxpayers.




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Bail-in instruments and mandatory haircuts should make this possible and ensure that banks’ financiers price the risks of their investments realistically. Entry into force of these instruments, currently set for 2018, should be brought forward to 2015.

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After Lehman Brothers’ collapse, the international community agreed not to let another systemically relevant bank fail. This was the wise decision at the time. But we have to move further. Only if it equips itself with a credible supervisor and strong rules will Europe ensure that its taxpayers are adequately protected against such failures.

 
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The writer is federal finance minister of Germany


 
Copyright The Financial Times Limited 2012



Europe’s Crisis Goes to Court
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Edin Mujagic, Sylvester Eijffinger
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30 August 2012
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TILBURG – Throughout Europe and beyond, economists are debating potential solutions to the eurozone’s sovereign-debt crisis. But these discussions often neglect, or at least downplay, one crucial element of any resolution: the German Constitutional Court (Bundesverfassungsgericht) in Karlsruhe, which is responsible for determining whether measures taken by Europe’s leaders are legal under German law.
 


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On September 12, the court will determine whether the European Stability Mechanism (ESM), Europe’s permanent emergency fund, complies with Germany’s constitution. Although German policymakers backed the ESM in June, ratification is on hold until the court’s ruling.
 
 
 
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While other eurozone countries have similar courts, these tribunals have significantly less clout. The Supreme Court of Ireland, for example, has referred such matters to the European Court of Justice.



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And the recent ruling by France’s highest court that the ESM complies with the country’s constitution received little media attention, highlighting its relative insignificance.
 
 
 
But Germany’s court is far more powerful, making it a decisive player in determining Europe’s agenda. And, given that the court’s verdict regarding the ESM’s constitutionality is crucial to the eurozone’s survival, its authority extends beyond the legal domain, into economics and politics.
 
 
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Arguments about the euro crisis that disregard the “Karlsruhe factor,” therefore, amount to little more than sterile intellectual debate. For example, most proposals involve some kind of fiscal union, which would inevitably entail the partial transfer of fiscal sovereignty from national governments to the European Union. But the court, not German policymakers, has the final say regarding further fiscal integration.
 

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Recently, some economists and politicians have begun to take notice of the Karlsruhe factor, but most of them mistakenly expect the court to create rules for resolving the crisis. In fact, guidelines were established last September, when the court ruled on which aspects of the European Financial Stability Facility (EFSF) – the precursor to the ESM and the eurozone’s current temporary emergency fund – were unacceptable, and laid out criteria that any potential solution must meet.
 
 

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For example, the court determined that the German parliament would have to be consulted each time a member country requested assistance, asserting that fiscal sovereignty forms the core of national sovereignty. Otherwise, German voters would be rendered powerless, constituting a breach of the German constitution.
 
 

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Likewise, the court has prohibited the creation of a permanent European stability mechanism that would entail financial obligations over which Germany’s parliament had no direct control. As a result, decisions taken by European politicians during their regular or emergency meetings may be reversible, particularly if they would undermine the German parliament’s fiscal authority.
 
 
 
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It would be a mistake to assume that Germany’s government could ignore or circumvent the court’s decision. Given strong public support for the constitutional court, no German policymaker would consider challenging its verdict. A ruling against the ESM in September would solidify further the court’s central role in determining Europe’s future.
 
 

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To be sure, the German judges have not overstepped their bounds by defining what action Germany must take. Rather, they have established parameters within which German – and thus Europeanpolicymakers are obliged to remain. Simply put, all proposed solutions to the euro crisis must be evaluated according to the court’s rulings.
 
 

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Moreover, the court decided long ago that only the German publicnot the government – may transfer fiscal sovereignty to Brussels. Neither Chancellor Angela Merkel nor the parliament may decide; every viable proposal must be submitted to a popular referendum.
 
 
 
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Rather than waste time debating proposals that have no chance of being approved, economists and policymakers should be working within the parameters established by the German court. Indeed, saving the euro will require a comprehensive solution that not only meets the court’s standards, but also enjoys the support of the German public.
 
 
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Copyright Project Syndicate - www.project-syndicate.org




August 30, 2012 7:35 pm
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Investing: Hedges on the edge

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In an industry built on high risk and high returns, some of the biggest managers are adopting a more cautious model
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A worker crosses a city of London walkway©Getty
View from the top: hedge fund managers in London and other financial centres have handed money back to investors as the industry attempts to adapt to the post-crisis environment






The Church of England, the Cern particle physics laboratory in Geneva and the Fire and Police Pension Association of Colorado may at first glance have little in common. But there is one thing: they all have hundreds of millions invested in hedge funds.




All three cautious investors are among a wave of institutions – from endowment funds to retirement schemes – that have begun piling into a once freewheeling industry seen by many inside and outside the financial world as emblematic of boomtime excess.



Click to enlarge




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But there is a question mark hanging over the hedge fund rush.



Since the beginning of 2010, the industry has registered net inflows of nearly $150bn from investors. Yet in the same period the average hedge fund has returned just 7.5 per centcompared with 9.3 per cent for global equities and nearly 15 per cent for global bonds.



The contradiction between popularity and recent performance points to a profound reshaping of hedge funds and their place in the financial ecosystem. Hedge fund managers can no longer claim to be masters of the financial universe with financial instruments at their fingertips and thankful clients at their beck and call. Rather, they are facing a future where they differ little from the rest of the more staid, client-oriented asset management world.



The big question though, is whether the taming of the industryseen by many as no bad thing – is also putting its investment magic in jeopardy.



Either way, the shift hints at a crisis of identity. In recent months some of the industry’s biggest names, from George Soros to Carl Icahn, have thrown in the towel.



Big hedge funds such as New York’s Moore Capital have handed back money to investors for fear of falling into the industry trap of growing too big to succeed. Markets continue to punish anyone displaying the kind of gumption that, before 2008, made a generation of money managers into multibillionaires. As a case in point, John Paulson, who made more money than anyone else in the industry with his 2007 bet against subprime mortgages, has since 2010 lost more than anyone else with his bet on a US recovery.



Most hedge fund managers knew the party ended in 2008, but few expected the hangover to last quite so long. “The thinking that you could hunker down for a couple of years [in 2010 and 2011] and then it would all normalise again – that is going away. And it’s coming as a shock,” says Luke Ellis, the head of London-listed Man Group’s FRM fund of funds unit, which with $19.5bn under management is one of the biggest investors in hedge funds.



People in the industry are waking up to the fact that 2006 was the abnormality, not today,” Mr Ellis adds. “If you ran money in the go-go years up until 2007, you’re going to be asking: ‘Why am I bothering to try and make money now?’ ”



It is not hard to see why institutional investors are so attracted to hedge funds in spite of their recent performance difficulties.




Even though 2008 was the industry’s worst year for performance, it did more than any other to underscore their value. While hedge funds lost, on average, 19 per cent of their clients’ money that year, other asset classes performed far worse. A pension fund with a high allocation to hedge funds did better than one solely allocated to equities.




Since 2008, says former congressman Richard Baker, who now heads the Managed Funds Association, the US hedge fund industry’s representative body, “pensions and endowments place a higher priority on preserving assets than reaching for extraordinary returns and taking extraordinary risks to do so”. He adds: “There is greater reliance on our industry to be a tool to minimise risk and deliver returns.”



Indeed, the returns such investors expect are very different from those that made the industry famous. “We are experiencing that positive uncorrelated returns are more important for institutional investors than large returns,” says Tommaso Mancuso of London’s Hermes BPK, which manages $2.3bn in hedge fund investments for the BT pension fund and those of other institutions. Rather than 15-20 per cent a year, institutional investors are comfortable with 6-10 per cent, a sample of more than a dozen top-flight hedge fund managers told the Financial Times this month.



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Such reduced ambitions cannot be explained only by the fall in key global interest rates – the benchmark to which investors link expectations. High correlation between assets, low trading volumes and the threat of unpredictable political market intervention are also denting returns. “I think there is a recognition that the world we are in now is a very different one,” says one senior executive at a top 20 firm.



What matters to institutions is that returns are stable. “They look at the world differently to the way, historically, Swiss private banks, family offices and high net worth individuals did,” says John Forbes, the chief operating officer of Caxton Associates, a leading New York-based hedge fund. “Institutional investors want lower volatility, reliable returns and well-run organisations that have very good compliance and operational controls,” he says. Caxton has lost money in only one of its 30 years in business.



To boot, some firms have grown increasingly transparent about the reduction in their risk-taking. Winton Capital Management, a UK hedge fund manager, has made clear to clients that growth in the assets under management of its flagship fund has been accompanied by reduced use of leverage and trading algorithms with more cautious risk-taking parameters.



It is an approach that appeals to institutions. In 2011, Winton alone took in a 10th of all inflows into the industry. The firm tells its clients to consider their investments panning out over decades, rather than years or even months.



Sustainability of returns is the holy grail because the average life of a hedge fund is just five years,” says Paul Marshall, founder of London hedge fund Marshall Wace and one of the European industry’s most prominent figures.What’s the point, if you’re an institution, of doing two years of due diligence only to invest in a business that’s not going to last more than another three?”



The problem, as Mr Marshall notes, is that a large part of the industry promises things it can no longer deliver. “A lot of the [equity hedge fund] industry is exactly the same as it was 10 years ago,” he says. “Too often the model is just one talented guy and a few analysts who last a few years but fail to develop a sustainable edge.”



Even at the top end, managers are falling short. “There are quite a number of funds which are just too big for their strategies,” says Mr Marshall. “You get mission creep from the managers: they move into different markets beyond their competency to boost returns. The single biggest area where there should be more scrutiny is capacity.”



Indeed, although some have handed back money to investors in an effort to improve lacklustre returns – and avoid becoming too cumbersome to trade efficiently in today’s low-volume markets – they are exceptions. Large hedge funds still dominate, with the top 20 hedge funds – of about 8,000managing more than a quarter of the industry’s $2tn in assets.




What is more, many worry that institutional investors’ focus on the way returns are generated is having a profound and damaging effect on the levels of those returns.



Investors have been hoodwinked by the myth that somehow hedge funds can offer no risk and a good return,” says Chris Hohn, founder of the UK’s Children’s Investment Fund and one of the industry’s biggest names, best known for his activist campaigns against big corporations. The reality, he and others say, is that by promising little volatility and no losses, hedge fund managers are giving up whatever market edge they might have, even though they may well continue to charge large fees.




TCI, Mr Hohn’s fund, in contrast to much of the industry, takes large, concentrated positions in overlooked or severely out of favour stocks. While it lost heavily in 2008, its long-term record, even including that year, is still comfortably in the top decile. It is up 22 per cent this year, thanks among other things to bold and big stakes in Japan Tobacco and Rupert Murdoch’s News Corp.



“We’re succeeding in a world where many hedge funds do not know what to do,” says Mr Hohn. “The macro guys are lost. The trading hedge funds are lost. The hedge fund index is basically flat over three years. That’s a big thing.”



Referring to the sharp reversals in sentiment that have dominated markets, he says: “The last three years have been risk on, risk off, and to try and cope with that, everyone has just tried to trade markets. There’s no alpha in that – no value added.”



His remarks point to the contradiction at the heart of the industry’s crisis of confidence: should managers focus on taking calculated risks over long periods or should they focus on managing risk in the short term? In other words, are hedge funds risk takers or are they risk mitigators?



Most in the industry have little doubt about what they would prefer. How are things? Things are crap,” says the head of one $5bn equity-focused fund, who declines to be named. “Markets are thin, investors are nervous and there’s no appetite for risk.”




His remarks are echoed elsewhere. Mid-level and junior traders who once shared in big payouts when their firms took the customary 20 per cent slice of hefty trading profits are now being paid out of much-diminished bonus pools. Their pining for the pre-2008 glory days is palpable.


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However, the evidence is that, with more and more money flowing in, the trend towards smaller profits and less exciting trading is not short-term but secular. Rolling 12-month returns in the past two decades show a clear downward trend matched by a growth in assets.


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The pressure from investors to focus on liquidity – or the speed with which they can pull their money out – is, perhaps, the biggest problem. “If you want something akin to daily liquidity in a hedge fund, then you are going to get returns like those you get at a deposit account at a bank,” says Man Group’s Mr Ellis. “Only we don’t give out free toasters in the hedge fund industry.”



Not that hedge funds are going anywhere: “If you’re a fund manager, you can sit there and bemoan how difficult life is, or you can say, ‘this is still the best way to make money’, and have fun doing so. What else are you going to go and do?”
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Under pressure



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To the casual observer, the profound economic ructions currently roiling global markets – from sky-high European sovereign bond yields to whipsawing US equities – might seem like ideal conditions for wily and opportunistic hedge fund managers to make a killing.



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Yet, these are not easy markets at all for most hedgies. Their investment ideas might work in the medium term, but short-term volatility, usually triggered by unpredictable political events, is proving too much for their own risk appetites. With trading volumes in normally liquid markets like equities down as much as 60 per cent, the problem is compounded.


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Institutional investors, the hedge funds’ biggest clients, have little, if any, tolerance for losses. As such, fund managers are constrained by the need to tightly control their bets and ensure they can return money quickly if asked. “Investors are vividly recalling what happened in 2008,” says Toby Young, head of investor relations at hedge fund Caxton Associates.




As a result, hedge fund managers are sitting on portfolios with high levels in cash, hoping that safer opportunities will materialise when markets calm.




One example is in distressed debt, where hedge funds sense that there is a killing to be made in high yielding European corporate bonds as the continent’s banks are poised to offload huge portfolios of debt at knock-down prices. But with politicians intervening to stop the banks from having to do so any possible gains that could be made from that situation will have to wait.


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Caution is not necessarily a bad thing. Some believe it heralds a “back to the futurestep for the industry, with hedge funds returning to their original objectives to hedge and protectaiming for small but consistent and low risk returns – rather than big directional wagers.


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But others worry it is stripping away the real edge that hedge fund managers have as investors.
And in an environment of lower returns, big questions are also being asked about the sector’s notoriously high fees. For fund’s returning just 8 per cent annually, the typical fixed 2 per cent annual management fee looks steeper than ever.


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Funds are now under pressure to cut the fee to 1.5 or even 1 per cent. As always, however, they expect something in return – such as a bigger slice of the profits, when they make them.


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Copyright The Financial Times Limited 2012.