More Money Than God: Hedge Funds and the Making of a New Elite

by Sebastian Mallaby

Hedge funds are the vehicles for loners and contrarians, for individualists whose ambitions are too big to fit into established financial institutions.

But from the mid 1960s to the mid 1980s, the prevailing view was that the market is efficient, prices follow a random walk, and hedge funds succeed mainly by being lucky. There is a powerful logic to this account. If it were possible to know with any confidence that the price of a particular bond or equity is likely to move up, smart investors would have pounced and it would have moved up already. Pouncing investors ensure that all relevant information is already in prices, though the next move of a stock will be determined by something unexpected. It follows that professional money managers who try to foresee price moves will generally fail in their mission.

And on average they do fail. This is why index funds are generally superior to mutual funds.

“Out of all the research that we’ve done with top players, we haven’t found a single player who is consistent in knowing and explaining exactly what he does,” the legendary tennis coach Vic Braden once complained. “They give different answers at different times, or they have answers that simply are not meaningful.”

July 2007, a credit hedge fund called Sowood blew up, and the following month a dozen or so quantitative hedge funds tried to cut their positions all at once, triggering wild swings in the equity market and billions of dollars of losses.

If the Fed had curbed leverage and raised interest rates in the mid 2000s, there would have been less craziness up and down the chain. American households would not have increased their borrowing from 66 percent of GDP in 1997 to 100 percent a decade later. Housing finance companies would not have sold so many mortgages regardless of borrowers’ ability to repay. Fannie Mae and Freddie Mac, the two government-chartered home lenders, would almost certainly not have collapsed into the arms of the government. Banks like Citigroup and broker-dealers like Merrill Lynch would not have gorged so greedily on mortgage-backed securities that ultimately went bad, squandering their capital. The Fed allowed this binge of borrowing because it was focused resolutely on consumer-price inflation, and because it believed it could ignore bubbles safely.

Maybe, maybe not. I don't think what happened in the mortgage market was quite that simple. This is the first notable example in this book where the author begins to defend investment groups (hedge funds, banks, insurance companies, etc) as being largely blameless in their impact to the overall economy and pointing the finger at the government for making dumb rules that allowed them to do the damage they've done.

Perhaps it is no surprise that the typical hedge fund is far more cautious in its use of leverage than the typical bank. The average hedge fund borrows only one or two times its investors’ capital, and even those that are considered highly leveraged generally borrow less than ten times. Meanwhile investment banks such as Goldman Sachs or Lehman Brothers were leveraged thirty to one before the crisis, and commercial banks like Citi were even higher by some measures.

So-called hedge funds that are the subsidiaries of large banks lack the paranoia and focus that give true hedge funds their special character.

As I finished writing this book, in early 2010, regulators seemed poised to clamp down on the financial industry.

In hindsight, they didn't clamp down much and what little added regulation they did add is under active assault by Republicans.

Capitalism works only when institutions are forced to absorb the consequences of the risks that they take on.

But Jones had other ideas about his life. Having inherited the wanderlust of his father, he signed on as a purser on a tramp steamer and spent a year touring the world. He took a job as an export buyer and another as a statistician for an investment counselor. And then, after drifting aimlessly some more, he took the foreign-service exam and joined the State Department.

This actually seems like a great real world education in business.

Having dismissed fundamental analysis, Jones turned his attention to what he believed was a more profitable premise: the notion that stock prices were driven by predictable patterns in investor psychology. Money might be an abstraction, a series of numerical symbols, but it was also a medium through which greed and fear and jealousy expressed themselves; it was a barometer of crowd psychology.

It's amazing that behavioral economics was ignored or dismissed for so long. Meanwhile those that bought it made a killing off of it.

Jones believed that investor emotions created trends in stock prices. A rise in the stock market generates investor optimism, which in turn generates a further rise in the market, which generates further optimism, and so on; and this feedback loop drives stock prices up, creating a trend that can be followed profitably. The trick is to bail out at the moment when the psychology turns around—when the feedback loop has driven prices to an unsustainable level, and greed turns to fear, and there is a reversal of the pendulum.

Both believed that successful market forecasters could not sustain their performance. The very act of forecasting a trend was likely to destroy it.

There are a number of examples later in the book of this. A hedge fund, usually a large one that has made a name for itself, predicts something will happen, acts on it, then everyone else follows their lead which destroys any advantage they have.

The art of investment is not merely to maximize return but to maximize risk-adjusted return, and the amount of risk that an investor takes depends not just on the stocks he owns but on the correlations among them.

Tobin’s insight was to see why this was wrong: An investor’s choice of stocks could be separated from the amount of risk he wanted. If an investor was risk averse, he should buy the best stocks available but commit only part of his savings. If an investor was risk hungry, he should buy exactly the same stocks but borrow money to buy more of them.

It was Valentine who realized that if managers took a share of a hedge fund’s investment profits rather than a flat management fee, they could be taxed at the capital-gains rate: Given the personal tax rates of the times, that could mean handing 25 percent to Uncle Sam rather than 91 percent.

A loophole that unfortunately doesn't look to be closed anytime soon

All new markets are inefficient at first, and the inefficiency means profits for early adapters.

See cryptocurrency

In some eras, markets appear destabilizing while governments are heroes, but in the stagflationary 1970s the libertarian view that big government screws up was frequently vindicated.

the truth is that innovation frequently depends less on grand academic breakthroughs than on humble trial and error—on a willingness to go with what works, and never mind the theory that may underlie it.

Because of this feedback loop, certainty was doubly elusive: To begin with, people are incapable of perceiving reality clearly; but on top of that, reality itself is affected by these unclear perceptions, which themselves shift constantly.

Soros replaced the signals from his aching back with a more cerebral process. Starting in August 1985, he kept a diary of his investment thinking, hoping that the discipline of recording his thoughts would sharpen his judgments. The resulting “real-time experiment” is dense, repetitive, and filled with complex ruminations about scenarios that never in the end materialize.

Soros saw no point in knowing everything about a few stocks in the hope of anticipating small moves; the game was to know a little about a lot of things, so that you could spot the places where the big wave might be coming.

The truth is that markets are at least somewhat efficient, so most information is already in the price; the art of speculation is to develop one insight that others have overlooked and then trade big on that small advantage.

The larger the funds grew, the harder it became to jump in and out of markets without disrupting prices and damaging themselves in the process.

Markets can move away from fundamental value because speculators lack the muscle to challenge the consensus; a trend can keep going far beyond the point at which it ceases to be rational.

Asleep in his New York apartment, Robert Johnson was beeped by Quantum’s head trader; he slipped out of bed and quietly returned the call, anxious not to alert his wife to the conversation since she was an official at the New York Fed.

This had to be the least trusting relationship ever.

Another call went out to Robert Johnson’s apartment, this time from the New York Fed; Johnson’s wife spent the remainder of the night monitoring the crisis, unaware that her husband had helped cause it.

This, this is the stuff they should make reality shows on.

At the height of the sterling crisis, John Major effectively bought sterling from Stan Druckenmiller at a price both knew to be absurd. Major did this for a reason that appears nowhere in financial texts: He wanted to force political rivals to share responsibility for devaluation.

The fact that John Major had transferred $1 billion plus of taxpayers’ money to the Soros funds was not entirely Druckenmiller’s fault. If somebody had fleeced the country blind, it was the prime minister, not the speculator.

Steinhardt had flirted with the idea of retirement for years: “I don’t feel what I do is profoundly virtuous,” he had told Institutional Investor as far back as 1987. “The idea of making wealthy people wealthier is not something that strikes to the inner parts of my soul.”

And yet people keep doing it selling their souls to capitalism. I can't help but speculate how far scientific research has been impeded by drawing in so many highly educated people to a pursuit of questionable value.

The roots of the crisis stretched back to 1995 and 1996, when the Thais had refused to devalue their exchange rate gradually in the face of China’s rise; speculators had merely forced an adjustment that was ultimately inevitable. Besides, although Soros and Tiger were part of the trigger for the crisis, they were not quite the villains that critics imagined. In particular, Druckenmiller had refused to leverage to the max, rightly fearing a political backlash. As the endgame played out in June, he had actually reduced his position.

I'm not sure I buy the defense. Exploiting a weakness in a countries monetary policy that left millions in poverty helped them? Bull.

The Russians wanted two contracts for the metal sale: an official one that made no mention of the commission and a private one that laid down how it should be paid into a bank in Cyprus. Russia’s parliament and people would only see the official version, so no questions would be asked about who kept the commission.

To galvanize the Treasury team, Soros urged Senator Mitch McConnell, an influential Republican, to call Rubin and offer his party’s support for a last-ditch attempt to save Russia.

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.

Ten years later, when the credit bubble imploded in 2007–2009, value-at-risk calculations fell out of favor. Warren Buffett admonished fellow financiers to “beware of geeks bearing formulas.

Most fundamentally, the traditional leverage ratio compared capital to assets, whereas value at-risk compared capital to potential losses. There was no doubt that LTCM had chosen the more relevant yardstick: The whole point of capital was to serve as a cushion against losses, so it was the size of potential losses that determined whether a fund’s capital was adequate.

In years to come, critics ridiculed value-at-risk calculations for ignoring the worst day in a hundred, likening them to car air bags that are designed to work all the time except during a collision. But because of the corrective power of arbitrage, ignoring the worst day in a hundred was less reckless than it appeared to be. A bad day for Long-Term would be followed by a better one. The market always tended to spring back.

“Individuals who lend money to others have a very important interest in getting that money back,” Alan Greenspan reminded the House hearings, falling back on the idea that private creditors would check hedge fund excesses.54 It was not until 2009 that Greenspan conceded that risk monitoring by lenders was a flimsy defense against financial excesses. Even then, he presented the concession as though the crisis of 2007–2009 had come out of the blue—as though LTCM had never happened.

If banks were required to hold capital worth 40 percent of their assets, as they had done after the Civil War, there would be far fewer episodes of market turbulence, the Fed chairman conceded. But capital would be more costly and living standards would be lower. “We do not have the choice of accepting the benefits of the current system without its costs,” he concluded.

LTCM’s failure had exposed the fallacy that diversification could reduce risk to virtually zero; but over the next decade investors repeated this miscalculation by buying bundles of supposedly diversified mortgage securities. Most fundamental, LTCM’s failure had provided an object lesson in the dangers of leveraged finance. And yet the world’s response was not only to let leveraged trading continue. It was to tolerate a vast expansion.

The investing public was losing interest in old-fashioned value stocks. “We are going through a most unusual market where in many instances fundamentals are being ignored,” Robertson wrote to his investors in April.

At the start of 1999, Stan Druckenmiller, Quantum’s supremo, had shared Robertson’s conviction that tech stocks were too high; but he had acted differently. Undeterred by the market’s momentum, Druckenmiller had placed an unhedged, outright bet against the tech bubble, picking a dozen particularly overvalued start-ups and shorting $200 million worth of them. Immediately, all of them shot up with a violence that made it impossible to escape: “They’d close one day at a hundred and open at one forty,” Druckenmiller remembered with a shudder.17 Within a few weeks the position had cost Quantum $600 million. By May 1999, Druckenmiller found himself 18 percent down. For the first time in his long career, he faced the prospect of a year with significant negative performance.

The Simons team took their experience with code-breaking algorithms and used it to look for ghostly patterns in market data. Economists could not compete in the same league, because they lacked the specialized math needed to do so.

Staffers rolled out sleeping bags to stay over at night. “It is easier to focus if you don’t go home,” explained a young employee named Jeffrey Bezos, who went on to found the Internet retailing giant Amazon.11

I only once slept under my desk while working at Amazon. I was not as well prepared with a sleeping bag, and it got really cold. I would not recommend. Just go home. Life is too short to be committed to your work like this.

Hunter had no difficulty persuading Maounis to allow him to move his family and trading team to his native Calgary. He commuted to his Canadian office in a Ferrari, though sometimes snowy conditions forced him to use a Bentley.

What a tragedy, being forced to take his Bentley to work.

Because inflation had been vanquished, central banks felt free to stimulate economies with low interest rates, rendering money cheap and creating the conditions for an asset bubble. Because exchange rates were now stable, Wall Street was emboldened to take other sorts of risk, leveraging itself up and further adding to the bubble. Each new era brought a fresh kind of blunder, creating a fresh opportunity for traders too.

So how exactly is 2017 different from 2007? Credit is certainly cheaper now. I wonder if anyone has looked at the total amount consumers pay in interest per year relative to their incomes? Yes, and it surprised me that its actually down:https://fred.stlouisfed.org/series/TDSP. Meanwhile, total household debt is back at peak levels:https://www.newyorkfed.org/microeconomics/hhdc.html. Have incomes really moved enough to meaningfully drop the debt to income ratio? Can find median income here:https://fred.stlouisfed.org/series/MEHOINUSA672N

If you wanted a reason why John Paulson made billions from the mortgage bubble and his former employer went out of business, the non-hedge-fund character of Bear’s internal hedge funds came close to supplying it.

Hold on though. John Paulson and a few others (see The Big Short for an entertaining story on this subject) made a killing by shorting mortgages. But it was a zero sum wager, meaning whoever was on the other side of that bet had to pay him. In this case it was the big banks who took the other side. So if this bet had never been made in the first place would so many banks have gone under? Certainly they would have been hit by the mortgages unraveling but they wouldn't have owed billions.

Meanwhile, Paulson’s mortgage wager generated the biggest-ever killing in the history of hedge funds. By the end of 2007, his flagship mortgage fund was up a cumulative 700 percent, net of fees.18 His company generated an estimated $15 billion in profits, and Paulson himself pocketed between $3 billion and $4 billion—he was “the man who made too much,” according to one magazine profile.

In December 2009, President Barack Obama said plaintively that he “did not run for office to be helping out a bunch of fat cat bankers.”4 But help them out is what he did, and populist anger at his openhanded policies is hardly surprising. Even more worryingly, neither Obama nor any other leader knows how to prevent too-big-to-fail institutions from fleecing the public all over again. The worst thing about the crisis is that it is likely to be repeated.

Between 2000 and 2009, a total of about five thousand hedge funds went out of business, and not a single one required a taxpayer bailout.