The History of Hedge Fundsa review of More Money than God by Philip Greenspun; March 2011
More Money Than God: Hedge Funds and the Making of a New Elite is a history of the hedge fund industry by Sebastian Mallaby, an Economist and Washington Post journalist.
Much of the attention directed at hedge funds has come in the form of pure envy. The managers can earn, literally, billions of dollars in a single year. A fund rakes off 2 percent of the total fund size every year as a basic management fee, e.g., $200 million if the fund were at $10 billion in assets. The fund next collects 20 percent of any gains, e.g., $2 billion if the fund were to double in value over a year.
These fees certainly sound rather high compared to the fees at Vanguard, which charges 0.07 percent for investments in its S&P 500 Index fund or 0.23 percent for its actively-managed Wellington Fund.
Mallaby, who is a bit of a hedge fund fan, points out that on average mutual funds don't beat a dartboard portfolio or market index. Therefore, whatever you're paying in mutual fund management fees is a bad value. Mallaby also points out that the employees of investment banks help themselves to roughly 50 percent of revenue every year. Thus the investors in Goldman or J.P. Morgan are giving up 50 percent of any returns to their capital, which makes the 20 percent fees of the most rapacious hedge fund seem low. Finally, Mallaby cites a study by Ibbotson, Chen, and Zhu that found, after attempting to compensate for reporting and survivorship bias, that hedge funds returned an average of 7.7 percent annually between 1995 and 2009, net of fees. This included "3 percentage points of alpha" (returns better than you'd expect from the class of investments and risk/leverage). So the hedge fund is a better value than investing in an I-bank or a mutual fund.
If hedge funds are, on average, up, someone else must be down. Google can get rich while making the economy more efficient, improving peoples' access to information. Google's gain is not necessarily someone else's loss. Hedge funds, however, primarily trade. If, over the decades, they are making hundreds of billions of dollars, the money is coming out of some consistent loser's hide.
Who are the big losers that correspond to the hedge fund winners? Mallaby identifies the following losing counterparties:
Governments and politicians are consistent sources of wealth for hedge fund managers. A politician may do something financially irrational to get reelected, even if it costs taxpayers billions. A government agency may have a goal that is not purely financial. Hedge fund managers who figure this out are able to make a fortune. In 1992, for example, George Soros and managers of a bunch of smaller hedge funds concluded that the British pound would need to be devalued if Britain were to avoid a rise in interest rates that would cripple its economy. As long as a currency peg existed, the Bank of England, i.e., the British taxpayer, was obligated to buy sterling at DM 2.778. So Soros and company sold the Bank of England so many billions of pounds that eventually the Bank basically ran out of money. For personal and political gain, officials did not want to act without sharing the blame around. Meanwhile the British taxpayer handed over $3.8 billion in profits to George Soros's Quantum and similar hedge funds.
Mallaby chronicles the money flow during the mortgage-backed securities collapse of 2008:
"If hedge funds mostly recognized subprime assets for the garbage that they were, who did lead the buying? The answer, to a large extent, was banks and investment banks--firms such as Citibank, UBS, and Merrill Lynch. ... whereas the failure of hedge funds such as Peloton and Sailfish cost taxpayers nothing, the failure of Citi and its peers imposed enormous burdens on government budgets and the world economy.
"Why this stark contrast with hedge funds? There are four principal reasons and they begin with regulation. Banks that take deposits, such as Citi and UBS, are required by regulators to hold a minimum amount of capital in order to shore up their solvency. This should have made the banks more resilient than hedge funds when the mortgage bubble imploded. ... Bonds backed by toxic mortgages were given the top (AAA) rating, partly because the rating agencies were paid by the bond issuers ... Once the AAA seal of approval was affixed to subprime assets, banks were happy to hold them ... Regulation and ratings agencies thus became a substitute for analysis of the real risks in mortgage bonds. Because hedge funds are in the habit of making their own risk decisions, undistracted by regulation and ratings, they frequently fared better.
"... the second problem hinged on incentives. [hedge fund managers] generally have their own wealth in their funds, which gives them a strong reason to control risks effectively. By contrast, bank proprietary traders do not risk their personal savings in the pools of money that they manage.
"[reason number three was] distracted executives. ... Merrill Lynch is said to have sold $70 billion worth of subprime collateralized debt obligations, or CDOs, earning a fee of 1.25 percent each time, or $875 million. Merrill's bosses obsessed about their standing in the mortgage league tables. The chief executive, Stan O'Neal, was prepared to finance home lenders at no profit in order to be first in line to buy their mortgages. ... when demand for CDOs collapsed in early 2007, the banks were stuck with billions of unsold inventory... The banks therefore became major investors in mortgages as an unintended by-product of their mortgage-packaging business.
"the final explanation for the banks' fate hinges on their culture. Hedge funds are paranoid outfits, constantly in fear that margin calls from brokers or redemptions from clients could put them out of business. ... Banks are complacent by comparison. ... Deposit-taking banks have sticky capital that enjoys a government guarantee. ... They sold John Paulson billions of dollars of mortgage insurance via the new ABX index, but they did not stop to ask themselves what Paulson's buying might tell them."
In other words, bank employees such as Stan O'Neal were able to make hundreds of millions dollars personally by imposing tens of billions of losses on the shareholders of Merrill and the U.S. taxpayer.
How about special access to an inefficient or illiquid market? Mallaby describes consistent profits made by Steinhardt, Fine, Berkowitz in the 1970s. They were able to get big blocks of stock at a discount to the market price and conduct the trade outside the normal exchange so that ordinary investors were not aware that the stock had sold for less than the quoted price. The biggest funds and the brokers developed a cozy information-sharing arrangement that ensured good profits for both at the expense of small investors: "A broker might call to say that a big institution was about to unload 500,000 shares of such and such, so perhaps Steinhardt should get short ahead of time, before the selling hit the market."
Government regulation can lead to extraordinary profits. Mallaby describes Michael Marcus of Commodities Corporation trading plywood: "At the start of the [1970s], Nixon imposed price controls that turned out to be the functional equivalent of the misguided currency controls of later years... By fixing plywood, for example, at $110 per thousand square feet, the Nixon administration was putting up traffic cones in the path of an invading tank: The United States was in the midst of a construction boom, and demand for plywood was booming; builders were willing to buy planks for much more than the price mandated by the government. Pretty soon, plywood warehouses were shipping supplies to Canada and back again to get around Nixon's controls, or they were performing "added-value services" such as shaving a sliver off their planks and then charging $150 per thousand square feet. .... Marcus bought plywood futures by the truckload. Their value virtually doubled. When Nixon's price controls were abandoned at the start of 1973, Marcus made even more money ... incompetent government was debasing the currency by inflating the money supply, so a trader was likely to get rich simply by leveraging himself up and holding huge positions in grains and beans and metals. In 1974 alone, the coffee price went up by a quarter, rice went up by two thirds, and white sugar doubled; anyone who bought these commodities on margin was multiplying his money. ... When the Carter administration tried to stimulate the economy, the boost to inflation caused the dollar to drop by a third against the yen and the deutsche mark, and the big moves gave surfers on the new currency-futures markets ample opportunity." (In these cases, it seems that the money flows into hedge funds from people who have faith in the competence of government and/or lack the time and resources to think about the likely impact of government actions.)
Mallaby does not explore what to me seems a likely source of hedge fund wealth: the tendency of retail investors to sell after crashes and buy right before peaks. Compared to buy and hold, which should produce a return very similar to the published index, retail investors lose about 1.3 percent per year (this paper surveys some of the literature). That means a huge amount should be available to a more cool-headed professional investor such as a hedge fund manager. I'm not sure how to test my theory and there is some evidence against it, e.g., hedge funds are highly leveraged and may be forced to sell when the market crashes. Also, hedge fund investors may try to redeem during crashes, forcing selling by managers, if only because the institution that invested in the hedge fund needs cash due to a collapse of other assets.
The first hedge fund was started by Alfred Winslow Jones in 1949. He used leverage and trend-following to generate a 50X return between 1949 and 1968. Jones was a pioneer in the following areas: computing the volatility or "beta" of stocks; calculating performance attributable to market movements versus stock picking; compensating employees with capital gains to be taxed at 25 percent rather than ordinary income (personal income tax rates at the time could be as high as 91 percent!), escaping regulation, charging 20 percent of gains, and compensating individual portfolio managers with a share of his individual gains as well as additional money to manage if previous performance had been good. Jones's "reward the winners" system encouraged aggressive investing, which meant that the fund could not survive the bear market that arrived in 1969.
Mallaby describes how hedge funds can make money from the predictable behavior of central banks, including the U.S. Federal Reserve:
"In 1990 and 1991, the U.S. economy was in recession following the savings and loans crisis, and the Fed was trying to stimulate it by keeping short-term interest rates low. This created a situation in which Steinhardt could borrow short-term money exceedingly cheaply, then load up on longer-term bonds that yielded considerably more, pocketing the difference. ... Just as John Major has enriched Stan Drukenmiller because he wanted to neutralize political rivals, so the Fed rewarded Steinhardt because it was trying to assist the battered banking system. By increasing the gap between short- and long-term rates, the Fed was making it more lucrative for banks to engage in their normal business... The Fed wanted to help banks, so Steinhardt turned himself into a shadow bank. He borrowed short and lent long, as just like any bank would do. ... because he had none of the infrastructure of the banks, he could charge in and out of their business as the Fed's policies shifted. ... Real banks faced regulatory controls on how much they could lend. For every $100 worth of customer deposits that they turned into loans, they had to set aside about $10 in capital ... For every $100 that Steinhardt borrowed to buy U.S. government bonds, he could often get away with setting aside as little as $1 in capital."Photo at right: Some of the young Mexicans we will need to lure into the U.S. if we are ever to pay off all of our debts.
One thing that frightens laypeople about hedge funds is the possibility that hedge funds make markets more volatile. After all, what sense does it make for stocks to bounce up and down 30-100 percent within a year or two? The world's economic prospects are not changing that fast. Mallaby looks at the Crash of 1987 and reminds us that the then-new portfolio insurance instruments had accounted for only $6 billion of the $39 billion in stock sold on October 19, 1987: "Low-tech villains were just as important. Many investors had standing orders with brokers to sell if their positions fell, and these old-fashioned stop-loss policies may have accounted for at least as much selling as portfolio insurance."
Where does all of the market volatility come from then? Economists with their Efficient Market Hypothesis will tell you that trading pushes markets toward an equilibrium. Traders with their experience of actual markets will tell you that trading tends to result in momentum and wild swings: "If you aimed to survive as a floor trader, it was less important to understand the news than to foresee the pit's reaction to it. The story is told of a floor operator who made $10 million in a spasm of trading following the release of a government inflation report. When the pandemonium had subsided he walked out of the ring and asked, 'By the way, what was the number?'"
The leverage of hedge funds led to forced selling and therefore big price dips in many of Mallaby's anecdotes: "As hedge funds liquidated bond positions [due to margin calls], the selling pressure drove their remaining holdings down, triggering yet further margin calls from brokers. The scary pyramiding of debt, which had fueled the bond bubble in good times, now accelerated its implosion."
What did we learn from the collapse of Long-Term Capital Management (LTCM) in 1998? This hedge fund, rescued by its brokers in a deal organized by the Federal Reserve Bank of New York (no taxpayer money was involved), was the first to make the public aware that a hedge fund collapse could imperil markets and counterparties. Conventional wisdom says that the LTCM debacle and the Collapse of 2008 taught us the following:
Mallaby explains that LTCM, back in the 1990s, actually did all of the things that supposedly are going to "reform" our financial system post-2011: "Most of the [LTCM] partners invested nearly all their earnings in the business, year after year ... nearly a third of the ... fund was their own savings. ... LTCM partners had every incentive to be prudent. ... LTCM was one of the first hedge funds to quantify its risk mathematically. ... Long-Term used a technique developed in the 1980s known as 'value at risk,' which was essentially a formalization of the macro traders' mental computations. LTCM worked out the volatility of each position, then translated that finding into a dollar amount that could be lost in normal circumstances. ... Meriwether and his partners performed value-at-risk calculations for every position in their fund, then combined each potential loss into a total for the whole portfolio. The trick was to estimate the correlations among the various trades. [LTCM] knew full well that the models forecast the biggest loss that could happen on ninety-nine out of a hundred days; by definition, some days would be worse than that. ... LTCM was confident that a period of unusual losses would be followed by compensating gains in the portfolio. If a normal price relationship broke down, hitting LTCM with a big loss, other arbitrageurs would see a profitable opportunity to invest; their buying would drive prices back into line, and LTCM's portfolio would bounce back again. ... An extreme event could force prices out of their habitual patterns... But LTCM's partners understood this Achilles' heel too. They sought to compensate for the imagination deficit in their models, brainstorming about potential surprises that could throw off their calculations. ... LTCM also took pains to consider a related risk that was much discussed in later years--the risk to the fund's liquidity rather than its solvency. The fund's trades often involved buying an illiquid instrument and hedging it with a more liquid one. ... In a panic, the liquidity premium would rise everywhere... .Meriwether and his partners took this liquidity risk seriously. ... rather that following the usual practice among hedge funds and borrowing short-term money from brokers, Meriwether made at least some effort to secure longer-term loans and special lines of credit that he could call on in a crisis. ... LTCM's risk management was more nuanced and sophisticated than critics imagined, and the lessons drawn from its failure included several prescriptions that LTCM itself had implemented."
A big reason that LTCM blew up, according to Mallaby, is that people knew it was going to blow up. So even if its positions were sensible, nobody else wanted to buy them because they knew that LTCM was going to blow up. Matters were made worse by the fact that it had "an army of imitators... By the spring of 1998, every bank or hedge fund that might buy LTCM's positions had already followed Meriwether's example and bought them; if a trade went wrong and Meriwether needed to retreat, there would be nobody to sell to. Moreover, the canny players on Wall Street could see what was going on. On the one hand, there was nobody left to buy LTCM's positions, so there was no way they were going up. On the other hand, a shock that forced the arbitrageurs to sell would cause LTCM's portfolio to collapse precipitously."
Most of a chapter is devoted to "what is perhaps the most successful hedge fund ever: Renaissance Technologies." A bunch of mathematically-inclined folks, almost none from Wall Street, sit in central Long Island and figure out where the inefficiencies are in markets. They proceed to make billions without, apparently, taking any risk. The eventually earn so much that they close their fund to outsiders and trade mostly the partners' money ($6 billion total). "In the crash of 2008, [Medallion, the Renaissance fund] was up 80 percent after fees--and almost 160 percent before them. By the times James Simons retired, in 2009, he had become a billionaire many times over. In 2006 alone, his personal earnings reportedly came to $1.5 billion, as much as the corporate profits generated by the 115,000 employees of Starbucks and the 118,000 employees of Costco put together."
Mallaby is a reporter and he knows how to tell a good story. The mortgage-backed securities collapse is introduced with the tale of Daniel Sadek, an immigrant from Lebanon who was working as a car salesman in California when he "discovered that he could get a license to sell home loans without taking classes... By 2005, Sadek's company, Quick Loan, had seven hundred employees." Sadek's success and his colorful ads, e.g., "Prior bankruptcy. Tax Liens. Foreclosures. Collections and Credit Problems. OK!", tipped off at least one hedge fund manager that this was a market in which to be short. [Sadek's company ultimately wrote about $4 billion in subprime mortgages, presumably all of which eventually landed in the laps of the U.S. taxpayer.]
If Ibbotson's study and Mallaby's anecdotes are correct, hedge funds on average are doing something that can't be done, i.e., beat an efficient market. Mallaby addresses the question of to what extent the Efficient Market Hypothesis is reasonable in a number of places throughout the book. Generally speaking, Mallaby attributes the success of the hedge funds that he chronicles to an inefficient market and to the fact that the hedge fund managers who are rewarded with more capital are smarter than the herd of less-smart people who make up most of the market. Aside from lack of liquidity, which can sometimes lead to profit opportunities, the market includes the government, which does not act either predictably or in a way that seeks to protect taxpayers.
An alternative theory, presented by a friend who has worked in the hedge fund industry, is that hedge funds have not outperformed ordinary stock investments on a risk-adjusted basis. He doesn't believe the academic studies are sufficiently free of sample bias. He thinks a lot of funds of all types take huge risks, e.g., adding Russian bonds to what is supposed to be a conservative fund, that aren't properly accounted for. In a world where markets generally move up, driven by inflation if nothing else, a fund that used comparable leverage to buy the S&P 500 might do just as well as the actively managed hedge funds that are supposedly delivering alpha. (A similar argument has been made against Kohlberg Kravis Roberts (KKR), a legendarily successful private equity firm whose performance is actually very similar to an investment in the S&P 500 using the same amount of leverage that KKR employed for its private investments.)
Some evidence that markets may be efficient is provided by the fact that nearly all of the funds described by Mallaby eventually either crash or fizzle. Either whatever particular market inefficiency that enabled the fund to make supranormal profits dried up or the fund manager lost his edge or maybe the fund's luck simply ran out and the previous great profits were simply the result of luck.
Mallaby doesn't settle the argument over the Efficient Market Hypothesis and he gives short shrift to the academic arguments in favor, but it is probably asking too much for a journalist to settle this 100-year-old debate.
The book does not explain how to make money as a hedge fund manager. The strategies all seem simple in retrospect, but the trades that Mallaby describes have become "crowded" and it is no longer possible to make a lot of money doing what made money in the 1970s or 1980s. On the other hand, the book is a great guide to how to be a sucker and give a lot of your hard-earned money to hedge funds:
To Mallaby's methods, I would add one more: "panic and sell after a big collapse; get excited and buy after a big run up in asset prices."
Mallaby shouldn't need a conclusion. The book works well as an anecdotal history of an interesting phenomenon. Nonetheless he concludes with an argument against the regulation of hedge funds, pointing out that they haven't required taxpayer funds to bail out, unlike America's banks and automakers. Mallaby points out that government regulation wasn't effective during the Collapse of 2008: "American deposit-taking banks were overseen by the Federal Reserve, the FDIC, and two smaller bodies, and they were required to abide by the Basel I capital adequacy standards: They did miserably. American investment banks were overseen by the Securities and Exchange Commission [SEC] and required to abide by a different set of risk limits: Two failed, one sold itself to avoid failure, and two were rescued by the government. The government-chartered housing finance companies, Fannie Mae and Freddie Mac, had a special government department devoted to their oversight: They had to be nationalized. ... When so many regulators fail at once, it is hard to be confident that regulation will work if only some key agency is differently managed."
[A similar perspective is voiced by Will Ferrell in The Other Guys: "From everything I've heard, you [SEC] guys are the best at these types of investigations... Outside of Enron... and AIG; and Bernie Madoff; WorldCom, Bear Stearns, Lehman Brothers..."]
The book has almost no charts, figures, or graphs. The photos in the center mostly depict hedge fund managers who are... white guys in suits and ties. You won't be missing much by listening to this as a book on tape or reading on a Kindle.