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Saturday, November 26, 2011

The audacity of hedge funds and their lack of righteousness

Lehman Brothers Rockefeller centre


IN the old days, technical books were read for one's education, but they are so boring that you would fall asleep. You read novels instead for their drama, romance and excitement. In this fast moving world where daily events are more thrilling than fiction, books like More Money than God by Sebastian Mallaby make you want to turn the next page.

Written by a former journalist, who today works for the US Council for Foreign Relations, the book has combined blood and guts story-telling of the hedge fund industry with careful analysis, tracing meticulously how the industry works like Sherlock Holmes. The narrative is so thrilling that when the author described the scene where the hedge funds took down Thailand in 1997, my hair stood on end. I was a ringside witness but I had not known who was doing what and how they did it.

If you want to know how hedge funds sniff out opportunities by talking to honest and nave central bankers who admit that they made policy mistakes and then make more money than God, read this book. It is both a clinical analysis of how hedge funds emerged from nowhere to become the market movers of today, as well as a morality story that raises more questions than it is able to answer. It may not be illegal (at least under existing law) to do a trade that tips a nation into abject poverty because there were tragic policy mistakes, but is it morally right to take home billions by accelerating the process of “creative destruction”?

The central insight of the hedge fund industry is brilliant it is that the academic finance theory is all wrong and we are all naive to believe otherwise. Modern finance theory begins with the assumption that the market is efficient and knows best. The efficient market hypothesis is based on the view that it is not easy to beat the market.

However, the hedge fund industry makes most money from the inefficiencies of the market. If you are not convinced, how between May 1980 and August 1998, the Tiger Fund earned an average of 31.7% per year after fees, beating the 12.7% return on the S&P500 index. The offshoots of the Tiger Fund, created by people who left the Fund to set up on their own, generated returns of 11.9% per year between 2000 and 2009, compared with the average of 5.3% per year for the S&P index.

Mallaby takes the story from the 1949 creation of the first hedged fund by Alfred Winslow Jones to the emergence of a sophisticated and complex US$2 trillion industry. He weaves a wondrous tale of how tribal and interconnected the industry became as it emerged.

Nobel Laureate Paul Samuelson, famous for arguing that randomly chosen stock selection would beat professionally managed mutual funds, was a founder investor of the Commodities Corporation, one of the first “quants” to use computer analysis to trade commodities. The Commodities Corporation was the nursery for three future hedge fund giants, Bruce Kovner (Caxton), Paul Tudor Jones (Tudor Investments) and Louis Bacon of Moore Capital.

Louis Bacon had connections with two of the Big Three in the early 1990s, being related by marriage to Julian Robertson (Tiger Funds) and worked briefly with Michael Steinhardt. The last of the Big Three is George Soros (Quantum Fund), who became famous as the man who made 1bil speculating in sterling and has become a philosopher/philanthropist. Many of these funds were involved during the speculative raids on Asian currencies during the 1997/98 Asian crisis and it is likely that many of them are having a food fest in Europe right now.

The last chapter of the book is a defense of why hedge funds should not be regulated. “The case for believing in the industry is not that it is populated with saints but that its incentives and culture are ultimately less flawed than those of other financial institutions.”

In Mallaby's view, “whereas large parts of the financial system have proved too big to fail, hedge funds are generally small enough to fail. When they blow up, they cost taxpayers nothing.” Yes, but when their prime brokers blew up with them, it cost taxpayers trillions.

Here lies the contradiction of their existence. Hedge funds are symbiotically tied to their prime brokers, the investment banks and large global banks that provide the leverage for their activities. No leverage means no ability to hedge or speculate. The latter group is too big to fail and its proprietary trading, combined with those of the hedge funds, are large enough to move markets.

The earlier argument that the prime brokers would safeguard systemic stability by indirectly regulating hedge funds (many of whom are former staff of the prime brokers) failed when Lehmans collapsed.

Hedge funds thrive because of regulatory and information arbitrage. The more the regular banking system is regulated, the more business drifts to the under-regulated shadow banking institutions.

Mallaby argues that it remains unproven whether heavier regulation will succeed. The regulators were scared to regulate, because of moral hazard, that is, the industry would take higher risks and the government would pay. Unfortunately, whenever there is a financial crisis, the government would be blamed and have to pay, irrespective of heavy or light regulation.

While hedge funds are not of public concern if they remain small, their herd like effect becomes a real problem when the momentum play can drive even mid-sized nations over the brink. Europe today is a live experiment of gigantic proportions. If someone makes tens of billions through speculation from the failure of some European countries and millions become unemployed, it is no longer a regulatory issue. Rightly or wrongly, this is a political crisis of the first order.

More Money than God should be the first book for everyone to read if they are to understand how the hedge funds dissect the European crisis as an opportunity.

Andrew Sheng is President of Fung Global Institute and author of From Asian to Global Financial Crisis.

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