Hedge Funds Ate Lunch!
“Take a speculative cocktail shaker. Add four parts public ignorance and 33 parts greed. Toss in a little perceived genius. If you don’t have any freshly ground perceived genius to hand, a little dried genius status will do. Season generously with mystique. Add apparent publicity shyness to taste. Serve in opaque tumbler of awes, ill informed media coverage”. Martin Baker” A Fool and His Money”
Hedge funds are fashionable. Hedge fund managers are the new Masters of the Universe – the new financial celebrities. Today, there are probably over 8,000 hedge funds with over $1,500 billion in asset under management (“AUM”).
Hedge funds have been around for 50 years but they are not well understood. In a recent interview, a minor Master of the Universe stated that he threw light on “fragmented information” and “opaque” track records. The statement is reminiscent of another in a company prospectus during the South Sea bubble: “a company for carrying on an undertaking of great advantage, but nobody to know what it is”.
In reality, the key things about hedge funds are: ? They are unregulated. ? They can engage in certain strategies denied to traditional investors, primarily short selling and leverage. ? They focus on generating absolute returns rather than trying to beat an index. Investment in hedge funds is being driven by a number of factors: ? Institutions – hedge funds are the latest attempts to beat markets and generate alpha (outperformance). ? Individuals – the potential ability to generate higher returns than those available from traditional assets.
There are a number of issues with hedge funds: ? Returns – average hedge fund returns when properly adjusted for risk and survivorship bias (many hedge funds don’t survive) are not above those for traditional assets over longer periods. A few hedge funds outperform but many of these do not accept new money. ? Risks – hedge funds increasingly take “new” risks – correlation, liquidity, complexity and event risk – that are not well understood and captured by systems understating the real risk and overstating returns. ? Transparency – over 50% of hedge funds have been in existence for less than 2 years and are small in terms of size (less than 20 people). This increases operational risks and combined with the lack of transparency significantly increases risk.
Banks are the real cheerleaders of hedge funds. A large part of their revenue now comes from helping hedge funds raise capital, trading with them and settling their trades and (most lucrative of all) funding them. Banks increasingly invest – “seed” – hedge funds to ensure flow of business. Internally, banks often replicate hedge fund strategies or market them to other traders. This profit comes with risk. In a severe market correction, large losses by hedge funds may lead to large losses by banks funding and trading with them. This is precisely what happened when LTCM collapsed in 1998.
The fundamental business logic of hedge funds is flawed. There is too much money chasing too few opportunities. Louis Bacon (of Moore Capital) when returning capital to investors commented: “Size matters. It is the bane of the successful money manager”. Clever people can make money if there are a few clever people and lots of opportunities. In 2004, one academic argued that the maximum size of the hedge fund industry was 6% of institutional (and high net worth) assets. History may show that hedge fund returns, other than a few exceptional cases, reflect the confluence of market conditions and good luck that prevailed in the 1980s and 1990s.
The large amount of capital commanded by hedge funds creates systemic risks. Increasingly, trading is centered on “big” stories – China, India, corporate actions (LBOs/ Mergers/ bankruptcies). Traders take positions in a wide variety of instruments all focused on the same event. The tremendous volatility created by relatively minor events points to the explosive build-up of risk concentration. Central bankers are belatedly focusing on these extreme money games.
As one commentator has warned: “…the risk to the stability of the world’s financial system posed by the existence of these massive vehicles has not gone away. We have chosen, in the main, not to think about it – in the same way that wives sometimes choose not to think about whether their husbands are really working late at the office. The implications of thinking about it are just too scary”.
In the attached paper I have set out a critical analysis of hedge funds and their influence on modern financial markets.
Satyajit Das works in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management. His works include Swaps/ Financial Derivatives Library – Third Edition (2005, John Wiley & Sons) (a 4 volume 4,200 page reference work for practitioners on derivatives) and Credit Derivatives, CDOs and Structured Credit Products –Third Edition (2005, John Wiley & Sons). He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall), an insider's account of derivatives trading and the financial products business filled with black humour and satire. The book has been described by the Financial Times, London as " fascinating reading … explaining not only the high-minded theory behind the business and its various products but the sometimes sordid reality of the industry". He is also the author (with Jade Novakovic) of In Search of the Pangolin: The Accidental Eco-Tourist (2006, New Holland), an unique travel narrative offering passionate and often poignant insights into the natural world and the culture of eco-travel.
