ECONOMICS AUGUST 23, 2010
by Sebastian Mallaby
Penguin Press, 496 pp., $29.95
Let’s stipulate that the hedge funds have had a pretty good financial crisis—if not in monetary terms, then certainly in the public consciousness. While the big banks were busy either creating gobs of suspect mortgages, slicing them up into even more suspect securities, imbibing on said securities, or all of the above, many of the people who populate hedge funds saw that the binge would end in tears.
For this they have been lionized in the media. David Einhorn, the baby-faced founder of a firm called Greenlight Capital, has been hailed as the man who exposed Lehman Brothers after he questioned its accounting back in May 2008. The financial pages have breathlessly retold how John Paulson, who looks more like someone from the state comptroller’s office than a breaker of nations, made billions wagering that certain mortgage securities were close to worthless. Michael Lewis wrote a captivating book tracking a collection of oddballs and misanthropes who placed similar bets.
Now comes Sebastian Mallaby, who claims that these triumphs were no coincidence. In his new book, Mallaby suggests there’s something in the DNA of hedge funds that confers such powers of foresight and cognition, or at least draws them out. So convinced is Mallaby of the social utility of hedge funds that he favors actively encouraging the industry’s growth as a way to avert future financial crises.
If nothing else (and there is much else), Mallaby performs the indispensable task of defining a hedge fund—still a maddeningly vague concept some sixty years after the industry’s founding. He identifies four criteria: the pay structure, in which managers are compensated with a share of profits; a propensity for operating mostly out of regulators’ reach; a tendency to combine “short” and “long” strategies—which is to say, betting on some assets to depreciate and some to appreciate; and the heavy use of leverage, or borrowed money. The upshot, in Mallaby’s telling, is a set-up that rewards crisp, contrarian thinking with outsize profits and punishes sloppiness with crippling losses, presumably encouraging the former over the latter.
History seems to support this account. Mallaby tells his story through a procession of ingenious moneymen, beginning with Alfred Winslow Jones, the former sociologist and Fortune writer who invented the industry in the late 1940s. Jones decided to try his hand at running money after penning a piece about how emotion rather than blunt economic logic drove stock prices, meaning there were inefficiencies to be exploited. By shorting the Dow while buying attractive stocks individually, Jones reckoned he could book big profits whether the market itself was up or down. He would be “hedged.”
After Jones, we meet such hedge fund demiurges as Michael Steinhardt, George Soros, Julian Robertson, and Jim Simons, whose biographies Mallaby has meticulously compiled, often to entertaining effect. Though their methods are as varied as their personalities—Soros is famous for his public pronouncements, Simons is fanatically secretive—they share a knack for trouncing conventional stock market indexes. Reading Mallaby’s book, you start to think of the S&P 500 as a little brother who’s constantly getting wailed on.
So there is no question that many hedge funds have done well for themselves. (Though many more would have imploded if not for the indirect benefits of the financial-sector bailout.) The bigger question is whether they’ve done well by the rest of us. It’s here that Mallaby flies into some turbulence.
Ironically, the hedge funds’ most valuable social function may be the one they feel most conflicted about. Mallaby describes how, after making billions breaking the British pound and the Thai baht, Soros lost his passion for shorting over-valued currencies. On an emotional level, one can understand the change of heart. Beating a currency into submission involves bleeding a central bank of billions in reserves, money that would be better invested in the hemorrhaging country. Collapsed currencies can also leave behind economic devastation: if a country’s debts are denominated in dollars, and its currency buys fewer dollars, borrowers will suddenly owe more.
Still, the reason shorting a currency tends to work is that the country’s currency policy is unsustainable. Soros and company are a symptom, not a cause. And even if the short-selling provokes a more abrupt and painful devaluation than might otherwise occur, the existence of such speculators should have a disciplining effect, discouraging countries from letting their currency over-appreciate in the first place. In general, any financial transaction that tamps down irrationality should be looked on favorably. And hedge funds do more than their share of tamping.
Unfortunately, this is not the only thing hedge funds do. One whole class of managers specializes in momentum-investing, which means buying into bubbles and selling into panics—that is,exacerbating irrationality. The trend followers, Mallaby concedes, “make no claim to understand the fundamental value of anything they trade. … They are not interested in forcing prices toward some sort of equilibrium.” Before the recent real estate bubble, the most lucrative trend to surf was the dot-com boom. Back in 1999, Soros’s hand-chosen successor, Stanley Druckenmiller, kept the fund in the black by loading up on tech stocks he felt were spectacularly overpriced. (Druckenmiller wisely sold his positions in early 2000, but made the mistake of reacquiring them just before the crash.)
One of the most successful trend-surfers of all time is a man named Paul Tudor Jones. Much of what has made Jones a billionaire is relatively benign. But as Jones has gained prominence, some of his successes have become more troubling. By virtue of his fund’s size and reputation, the mere act of Jones buying or selling can trigger a corresponding buying spree or selloff, moving prices in the direction of his bet. “I can go into any market at just the right moment, by giving it a little gas on the upside, I can create the illusion of a bull market,” Jones tells Mallaby. Then he adds: “But, unless the market is really sound, the second I stop buying, the price is going to come right down.” Mallaby interprets this admission reassuringly—evidence that even the mighty Paul Tudor Jones can’t “cause snow to fall uphill.” But it’s actually pretty alarming—evidence that Jones can create his own market dynamics just long enough to profit from them, even if they defy the laws of gravity. Social work this is not.
There are more stories like this. Mallaby describes how Michael Steinhardt, a pioneer of the profession, made money buying large blocks of shares from institutional investors at steep discounts. No shame in that. But as Steinhardt became a bigger player, brokers began plying him with privileged information—helping him determine, for example, if a block was being sold because the seller needed cash (in which case it was worth buying), or because the seller knew the stock was headed south (in which case Steinhardt would want to beg off). “I was being told things that other accounts were not being told,” Steinhardt confesses to Mallaby. “I got information I shouldn’t have.” (Disclosure: Steinhardt once paid my salary as part-owner of The New Republic.) In a similar, if more innocent, vein, Mallaby explains how the legendary stock picker Julian Robertson benefited from his relationships with various “captains of industry,” who often passed along lucrative tips.
The point isn’t that these advantages were illegal—though the SEC once thought Steinhardt’s were close enough to investigate.The point is that they belie Mallaby’s view of hedge funds as havens for “loners” and “individualists” who hunger to topple the establishment. After a certain point, Jones, Steinhardt, and Robertson weren’t taking on the establishment; they were the establishment.
That fact is a body blow to Mallaby’s argument, since the anti-establishment ethos is what makes hedge funds useful to the rest of us. Consider the example of Michael Burry, a true misanthrope and one of the heroes of Michael Lewis’s The Big Short. The stock-picking method employed by Burry, who suffers from Asperger’s syndrome, is to sit alone in a sparsely furnished room pouring over investment prospectuses. Applying this methodology to mortgage securities, Burry discerned as early as 2004 that the market was delusional. He began betting accordingly in 2005. Had enough money managers followed his lead, the real estate bubble might have deflated harmlessly. Suffice it to say they did not. Burry spent the next two years taking all kinds of abuse from his own financial backers. Many of them were highly sophisticated investors, including some more established hedge funds.
This brings us to a catch-22. Small, nimble funds such as Burry’s have all the advantages Mallaby touts, and one huge disadvantage: they are powerless to move the market. Burry nearly went broke betting against housing even though he was exactly right about the fundamentals. He was at the mercy of the conventional wisdom on Wall Street and would have lost his shirt had it shifted a few months later. Similarly, several of the fund managers Mallaby esteems lost billions betting against the dot-com bubble prematurely. As the old Keynesian maxim goes, “The market can stay irrational longer than you can stay solvent.”
In principle, an enormous hedge fund with real market power could drive prices back to where they belong. But—and here’s the catch—size poses its own complications. As hedge funds get bigger, their benefits (nimble, contrarian thinking) get muddled and their potential drawbacks get magnified (heaping piles of leverage and tiny shreds of regulation). Big, highly-leveraged hedge funds turn out to resemble big banks in at least one respect: their mistakes can threaten the financial system. (Long-Term Capital Management, the well-pedigreed fund whose demise Mallaby chronicles, is a case in point.)
To be fair, Mallaby recognizes this second problem, allowing that the government should regulate the largest, riskiest players. He seems to prefer a proliferation of smallish funds—“entrepreneurial boutiques” he calls them. But this, too, is not so desirable. As more people leave traditional banks to join hedge funds, they’re likely to bring the banks’ flabby groupthink with them. One of the villains of Lewis’s book is a Morgan Stanley executive named Howie Hubler. Hubler and his small team of traders lost a cool $9 billion on mortgage securities they had assumed were nearly riskless. The bank empowered Hubler to do this for fear he would leave … to start a hedge fund.
Now, it’s certainly true that a different set of incentives would have helped here. Hubler might have scrutinized those securities a little better had he been on the hook for some of the losses, as he would have been at a hedge fund. On the other hand, the hedge fund industry will never fulfill its promise if its rank-and-file has a Hubler-esque weakness for market fads. And yet Hubler's former colleagues are crowding into hedge funds at a record clip. The Financial Times reported earlier this month that “many star traders across Wall Street and the City of London are … decamping for hedge funds in their droves amid a crackdown that will sharply curtail banks’ riskier activities.” So some of the same folks who brought you the financial crisis will henceforth be working their magic with more leverage and less regulation. How reassuring.
What Mallaby has done here is confuse compensation structure with sociology. What we really want to celebrate isn’t the hedge fund, but the eccentric genius willing to bet everything on a conviction that the market has lost its mind—the man (or woman) who flees a bank because the thought of toiling another day in some fat, stodgy, glad-handing bureaucracy turns his stomach. These people may thrive at hedge funds. Their success may not be possible anywhere else. But they are not created by hedge funds. In the end, the problem isn’t too few hedge funds. It’s too few Michael Burrys.
Noam Scheiber is a senior editor at The New Republic.