Of trade the dimensions of indi tendency to overshoot

vidual transactions are not known or understood

"The dimensions of investing in hedge funds have become so big that ... if they were to fail, [they] would create a systemic risk to the banking system and therefore endanger the financial structure of the society."

The tumult early in the year set the stage for the Gonzales hearings in Congress. Those hearings, scheduled to investigate hedge funds in general, now had a specific case before them, suggesting that hedge funds were the number one villain in the financial markets. Congressman Henry Gonzales had been targeting Soros and the hedge funds for a year. It did not seem to matter to Gonzales that Soros had suffered one of the worst setbacks of his career. With the stock and bond markets so volatile earlier in the year, he had enough reason to go after Soros.

And so Mr. Soros went to Washington.

The purpose of the hearings-and Gonzales made no secret of it-was to find out whether the hedge-fund operators were as Machiavellian as they had been painted, whether they were actually influencing the financial markets by their actions, whether they needed more regulating. Gonzales's legislative manifesto, issued the day before the hearings, threatened to make "improper management" in this field "a direct violation of the law" and indicated a desire to "enhance congressional oversight of derivative activities."

That was fine. But before the committee could get around to proposing new regulations, it had to come to terms with a more fundamental problem. Though the committee's province was finance, few committee members knew how a hedge fund worked. Few had any understanding of the esoteric ffnancial instruments they used.

To get some answers-indeed, to get a lesson that could have been called Hedge Funds 101-they invited the Master to appear on April 13, 1994. As the hearing room began to fill, it was clear that the George Soros show was the best one in town that day.

The hearing room was packed, and eventually it was standing room only. Hedge Funds 101 was about to start. The "teacher" opened the "seminar" by reading a statement, putting on the table parts of his financial theories to explain why the legislators were barking up the wrong tree. He turned to his theories to explain why.

He began with the assertion that financial markets could not possibly discount the future correctly, but that they could affect an economy's fundamentals. When they do, markets behave far differently than the theory of efficient markets considers normal. Though they do not occur that often, these boom/ bust sequences can be disruptive, precisely because they influence an economy's fundamentals.

Soros went on to note that a boom/bust sequence can develop only if the market is dominated by trendfollowing behavior. "By trend-following behavior, I mean people buying in response to a rise in prices and selling in response to a fall in prices in a self-reinforcing manner. Lopsided trend-following behavior is necessary to produce a violent market crash, but it is not sufficient to bring it about.

"The key question you need to ask then is, what generates trend-following behavior? Hedge funds may be a factor and you are justi-fed in taking a look at them, although, as far as my hedge funds are concerned, you are looking in the wrong place."

More to the point, it was Soros's view that mutual funds and institutional managers-not hedge funds-had destabilized the market, for both tended to be trend followers. "When money is pouring in, they tend to maintain less-than-normal cash balances because they anticipate further inflows. When money is pouring out, they need to raise cash to take care of redemptions." As a result, "They created part of the financial bubble."

Briefly, Soros then talked about the current market situation: "I

"Lopsided trend-following behavior is necessary to produce a violent market crash."

should like to emphasize that I see no imminent danger of a market crash or meltdown. We have just punctured a bit of a bubble that has developed in asset prices. As a result, market conditions are much healthier now than they were at the end of last year, and I do not think that investors should be unduly fearful at this time." In other words: It was OK to buy U.S. stocks or S&P futures.

Soros assailed the Clinton administration for the hard line it was taking with the Japanese on trade and for trying to talk the dollar down. "That's quite harmful for the stability of the dollar and the stability of the markets. Dollar bashing as a method of dealing with trade policy with the Japanese is a dangerous instrument that we ought not to use." Cynics read a not-so-subtle market message from the Master: Go long the yen and short the dollar until trade negotiations stabilize.

Continuing to try to prevent hedge funds from becoming the focus of the hearings, Soros noted that hedge funds were not that large a segment of the investment world. Even though Soros Fund Management's daily currency trades averaged $500 million, this level of currency trading, Soros told the committee, should not affect the markets, since hedge funds controlled at most .005 percent of the daily foreign exchange markets.

Soros's solution to currency crises and turbulence was not fixed exchange rates. "Too rigid," he said. Not floating exchange rates either. "Free-floating currencies are flawed because the markets always overshoot to excess." His solution: "The monetary people in the G-7 group of seven industrialized nations need to coordinate their monetary and fiscal policies so there are no great disparities where the markets are fundamentally unstable."

It became clear from committee members' questions to Soros that they were still stumped about what exactly a hedge fund did. "Just what is a hedge fund?" they asked over and over again. Soros tried to enlighten them, but he had to admit that the label had become a catchall for a great many things that were originally not within its province. "The term is applied so indiscriminately that it covers a wide range of activities. The only thing they have in common is that the managers are compensated on the basis of performance and not as a fixed

"Free-floating currencies are flawed because the markets always overshoot to excess. "

percentage of assets under management." That seemed an odd way to describe a hedge fund-especially by the King of the Hedge Funds. Soros was not, however interested in conducting a seminar on how to define hedge funds. He wanted to get a message across: that hedge funds-no villains-actually performed good deeds in the financial markets.

Hedge funds, Soros argued, because they were rewarded on absolute performance, provided "a healthy antidote to the trend-following behavior of institutional investors." His own fund, as an example, had a benign effect on volatile markets by moving against-not with-buy-ing or selling trends. "We tend to stabilize rather than destabilize the market. We are not doing this as a public service. It is our style of making money."

In his bluntest comment in defense of hedge funds, Soros said to his listeners: "Frankly, I don't think hedge funds are a matter of concern to you or the regulators." Hedge funds should not be blamed, he argued, for the plummeting prices in stocks and bonds earlier in the year. "I reject any assertion or implication that our activities are harmful or destabilizing."

Soros was asked if it was possible for a private investor like himself to amass enough capital to manipulate the value of a currency such as the Italian lira or British pound.

"No," he replied. ". . . I do not believe any market participant can, other than for a short time, successfully influence currency markets for major currencies contrary to market fundamentals. . . . hedge funds are relatively small players given the size of the global currency markets. The lack of liquidity in markets for smaller currencies also acts to prevent any investor from successfully influencing prices for a minor currency. Any investor trying to influence prices by acquiring a large position in that currency will, because of the lack of liquidity, face disastrous results when the position is sold."

Soros sought to distance himself as much as possible from derivatives, those financial contracts derived from stocks, debt, or commodities. The committee had been intensely curious about these financial instruments. Soros sounded as if even he, the consummate investor, had a hard time trying to figure out what to make of them. Moreover, he pointed out that hedge funds "do not act as issuers or writers of derivative instruments. They are more likely to be customers. Therefore, they constitute less of a risk to the system than the dynamic hedgers at the derivatives desks of financial intermediaries. Please do not confuse dynamic hedging with hedge funds. They have nothing in common except the word

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