Sebastian Mallaby has done his homework. This has allowed him to write a brilliant history of hedge funds, managing to give it the life of a novel while at the same time maintaining the accuracy of an academic paper. Some of this ground is well known – for example, how Soros brought down the pound or LTCM blew up – but even here there are extra details that give a fresh insight. I suspect for most readers, including myself, many of the characters & funds are unfamiliar, at best names from the papers, and bringing such a diverse group together in a comprehendible narrative is a considerable feat.
While the book covers both successes & failures, it is the latter that somehow draw the readers attention more. Perhaps this is human nature – as one manager says “fear is a stronger emotion than greed” – and there is a small feeling of satisfaction that those who profits by the markets can also die by them. Inevitably the reader’s mind turns to what lessons are there to learn, partially stimulated by the author’s final chapter which suggests hedge funds are the ideal free market investment vehicle.
Perhaps unfortunately these lessons are not simple. Some of the risks are obvious to the casual observer – such as leverage exaggerates both gains and losses. Others, such as unstable correlations, are perhaps better known now than they were a few years ago. And indeed what usually starts the problems of a fund are either large unhedged positions going wrong or a series of smaller positions starting to correlate in ways they didn’t previously. But what is the killer each time is liquidity. In particular, the common issue is that trades become ‘crowded’, with lots of investors following the same strategy which means they are all rushing to the exits at the same time, leading to a failure in the the markets. Other factors can exaggerate this, such as visibility of a fund’s positions and their liquidation leading to other market players positioning against you (the author points out the paradox of this in the current rush to transparency.)
But this isn’t quite the whole story. The author, inevitably, focusses on the biggest funds, which generally have been among the most successful at some time. He also points out that 5000 hedge funds have failed in the last 10 years. Now many of these will be startups which raised money in times when it was plentiful, but many will be others. Did they fail for the same reasons? If you are running a $100m fund rather than a $10bn one your risk issues might be a little different. On the other hand, if you are playing the same strategies as the larger funds then the crowded trade issue still applies to some extent – but for the same proportionate exposure the absolute amount is smaller and hence more liquid.
Perhaps the single biggest factor is hubris. To borrow Tom Wolfe’s phrase, these are the Masters of the Universe. I know from experience the fawning that you get as the fund manager of a small and pretty insignificant investment company. When you have made billions and brought down whole countries it must be pretty hard to keep your ego in check. And on the other hand you have the pressure to continue your success. But not all is foreseeable. Far from it, and the reason for most failures is that the managers forgot that. Humility in the land of big egos may be the biggest asset of all.
In the final chapter the author makes the case for hedge funds as the ideal capitalist investment vehicle. Some of his points – that none of the 5000 hedge fund failures required government support and those managers truly paid the cost of failure – are very to the point. I also like his observation that investment banks compensation ratios of 50% compare poorly with the 20% performance fee of most hedge funds, even if he’s not quite comparing like with like (in reality a 2%+20% fee on a return of 10% gives a 36% figure for comparison, though perhaps the bank figure needs other cost adjustments too.) Its difficult to argue with his opposition to SEC registration as pointless for investors, though it may still be of use to the regulator.
He is also right to point out that the ways in which hedge funds occasionally upset markets are not exclusively to them – other investors can make a mess of markets, as asset-backed securities have shown recently. But there is a fine line. After his Thai Baht success in 1997, George Soros started to have misgivings. The effects of his actions had strayed out of the financial domain and had huge real world effects. Subsequently he lost money trying to prevent similar events happening in Indonesia, Korea & Russia. Which actions were more ‘moral’? Its true than in most cases the government was following poor financial polices and significant imbalances had built up. And the history of financial markets in such situations is not good – it seems a dislocation was bound to occur at some time. Soft landings in these circumstances are rare, but it could be asked if hedge funds make these events more abrupt or dramatic than they might otherwise be. They do seem to create an urgency which makes sensible policy response harder. The current slow-mo crisis in Europe may not be good, but its timescale at least gives a chance for policymakers to come up with the right response – even if noone seems sure what that might actually be!
It may well be that hedge funds recognise this to some degree – too much currency smashing would lead to regulations that they wouldn’t appreciate – and recent years have seen different problems. Asset bubbles are the flavour of the day just now. After property came oil. And gold. Food gets the current headlines but most commodities are at or near long-term highs. Basically loose monetary policy leads to money looking for a home and at the moment that’s commodities. With money plentiful hedge funds can borrow to whatever level their investors will tolerate and there seems to be no shortage of investment opportunities just now. How long this will continue is far from certain, but two things are. One is hedge funds are here to stay. Second is that the story is going to stay interesting!