I’ve drafted a review of a More Money than God, a history of hedge funds. Comments and corrections would be appreciated. I’m particularly interested to hear what folks have to think about my theory that the tendency of retail investors to buy near peaks and sell after crashes (i.e., near troughs) is a consistent source of gains for hedge funds.
10 thoughts on “History of Hedge Funds”
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It’s worth mentioning that strict capital reserve requirements tend to make banks *less* solvent than not having such rules unless the requirements are extraordinarily carefully-designed. The problem is that a legally required reserve serves a different role than a voluntarily assumed reserve. A bank that freely chooses to hold X$ in reserve would be free to *draw on* this reserve whenever some crisis occurs that makes it necessary but a bank that is *required* to hold X$ in reserve at all times is *not* free to actually use that money *as a reserve*. So the bar that defines what makes a bank solvent goes from “able to pay off existing claims” to “able to pay off existing claims *and* maintain an unused and unusable “reserve”.
Some mandated capital requirements don’t reduce risk for current bank investors or customers but do slightly reduce the cost to regulators of shutting down the bank, so they make taxpayer-funded takeovers more likely. Which is the exact opposite of the claimed goal of such regulation.
Since banks are regulated by a variety of ham-fisted organizations, hedge funds should tend to gain over time at the expense of banks. (I can’t comment on the other theory)
Worth a look at Vic Neiderhoffer’s “The Education of a Speculator”, where he diagrams finance as a biosystem, retail investors below herbivores, Soros up there with big game predators.
My own view is little moves without incentives for sale trickling down the system, oiling the cogs, backsheesh, and opportunity cost inertia as ideas flow. Which can be fairly easily observed.
By the time that happens, usually the opportunity is arbed, and the big wave comes in to drive price momentum, which is happily scalped by the original arb observers, causing first margin money, then straight cash retail investors to be tapped out.
Tangentially, Sobel’s “The First Junk Bond” led me on a path of enlightenment when i first encountered it.
http://www.amazon.com/First-Junk-Bond-Story-Corporate/dp/1587981203
I’d recommend Mallaby’s interview with The Economist.
The first guy to discover a market inefficiency makes a killing. The second and third guys to “discover” it by watching their golfing buddy exploit it can earn a decent return. The fourth-through-Nth guys, who follow the new “trend” get eaten, and would be better off in an index fund.
It’s sort of like poker. If you can’t spot the fish at the table, try looking in the mirror.
Hedge funds aren’t a refutation of the ECMH…they’re just the legal and regulatory term we attach to one of the major forces that makes it work in the long run, by spotting the inefficiencies and exploiting them to death.
The takeaway lesson? “No free lunch…you will never, ever, ever earn a stable outsized return on your money unless you’re executing a strategy that nobody has ever thought of before. You probably aren’t smart enough or well-enough informed to even think of such a beast, and even if you are, it might still turn out to be a loser. Sure, some other guys made a killing at it. But then, somebody wins the lottery every few weeks, but you’re not likely to be that guy, either, and knowing how those guys did it back then is about as useful to you today as is knowing last night’s Powerball numbers.”
– “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.”
This one jumped out so much that it’s the only one I’ll comment on: This is not an example of why hedgefunds make money while Banks are held back by regulatory oversight. There are various measures of “capital” that banks need to hold (the $10 in the example). Generally it’s a sum of capital charges for various assets the bank holds: say 50% for residential mortgages (for $1b in mortgages, banks hold $500mm in capital), less if they are high-downpayment mortgages. Say 20% for higher quality non-financial corporate bonds, etc… and 0% for US Govt Bonds! No problem there
– So why don’t banks do what Steinhardt did? (sometimes they do) Remember, for that $100 in customer deposits banks have to pay interest to the depositors, which is usually higher than the short term T-Bills. Instead they usually give mortgages and loans backed by other collateral at higher rates: traditionally that’s been pretty safe, as long as bubbles aren’t being blown up by various off-balance sheet “innovations”
– The other question if that were an actual reason for hedgefund earnings, is why theinvestor wouldn’t just buy her own risk free Treasuries instead of paying a hedgefund like Steinhardt? She could, but to get a good return out of buy and hold treasuries you have to lock up your money for a while (ie buy longer dated notes). Steinhardt could trade in and out, and I suppose hedge, more skillfully than others (his Alpha), and you could also leverage via the repo, though quite a few hedgefunds eschew high leverage for risk management purposes. With a lot of investors you could also manage your redemptions (usually you can count on some lock up periods and that not every investor wants their money out at the same time so any-one investor can get some money out at any time).
@Matt
Totally agree that hedge funds is a major forces that makes ECMH work. But they also earned many “free” lunches in the process. I don’t think it’s correct to use ECMH to discourage anyone from pursuing these “free” lunches.
It’s not a coincidence that majority of successful hedge fund managers are extremely smart and well educated and have worked in the industry for many years. Their probability to earn outsized returns are many orders of magnitude greater than someone who simply plays the lottery. It’s more correct to compare hedge fund managers to someone who enters medical school in hopes of becoming a cardiologist. Some succeed, many fail, but odds are decent overall.
Hedge fund managers are usually those who have done very well working for the banks, but almost all people who succeed in finance are smart and well-educated, the banks quickly get rid of people who don’t make the grade. It could also be down to luck. If you take a thousand new graduates entering the finance industry, and assume that every year half of them lose money and get canned, after five years you will have 30 people who have made the right decisions every year, and are now very rich and successful. If they now leave the banks to set up hedge funds, and continue tossing the coin, half of them will blow up in the first year and the other half will make an absolute fortune. But it could still all be down to pure luck.
Just like anything in life, managers’ success can be attributed to luck. But also as many famous golfers will tell you, the more you practice, the luckier you get.
But golfers (it was Gary Player, not so?) exercise a physical skill that is amenable to practice, they don’t execute binary buy-sell decisions that you can model by flipping a coin. You can call the market correctly a hundred times in a row, and still get the 101st trial wrong.
I got back from Germany in the summer of 1999 and picked up an old paperback of the “Money Game”, written by a guy who calls himself “Adam Smith”. The “Money Game” was about the bubble of 1968, and it had a sequel “Supermoney” that talked about how the U.S. financial system almost collapsed in 1970.
The financial news at that time read just like that book, except the names were different. When I went to see the in-laws for Christmas, I saw all the ads on a football game were for stocks and bonds, not for beer, so I ran home, called my broker and sold 50% of my holdings.
I got a bad feeling in April 2000 and sold the other half. As it turns out, I neatly bracketed the top.
I got some good advice from my broker and managed to lock in some savings at a 7.5% interest rate, I’ve still got some I bonds that are paying that, plus the extra security that the rate will go up when inflation jumps. My only regret is that I didn’t buy more.
I’ve been mostly out of stocks since then, though I won on a few trades and lost on a few. The worst trade I made was buying into a short fund in 2005 because I thought the Iraq war was going to lead to a crisis like the 1973 crisis. I closed out that position with a loss in 2006, but there wasn’t a lot of money involved.
My various investments have gotten something in the 7% to flat range in the last decade which ranges from “beating the market” to “par for the course”. Market gyrations haven’t given me ulcers; like anybody standing on the sidelines, I feel a little envy looking at the recent uptick of the stock market, but I’m pretty sure that this uptick is really a result of QE2 and that we’re going to have some kind of global crisis in the next couple years that will erase it.