The Directed Life

Date read: 2/8/23

Notes from Sebastian Mallaby’s history of hedge funds

The edge in investing often comes from going against the efficient market fallacy and finding a previously unrecognized inefficiency in the market. (5)

There was a major shift from efficient market theory to pricing flaws following the 1987 crash.

There also ended up being a major shift from investment money coming from rich individuals forming a pool to money coming from endowments.

Hedge funds contributed to what economists called the “Great Moderation”, where the competitive seeking for inefficiencies with statistical algorithms was thought to be smoothing out the market and making bubbles less common. (9)

Leverage gave hedge funds the ammunition to trade in greater volume, and so to render prices more efficient and stable. But leverage also made hedge funds vulnerable to shocks: If their trades moved against them, they could burn through thin cushions of capital at lightning speed, obliging them to dump positions fast—destabilizing prices. (10)

Central banks need to be just as wary of asset-price inflation as they have been of consumer-price inflation in the past. (11)

Why government bank bailouts were a dangerous precedent to set:

Banks that have been rescued can expect to be rescued all over again the next time they blow up; because of that expectation, they have weak incentives to avoid excessive risks, making blowup all too likely. Capitalism works only when institutions are forced to absorb the consequences of the risks they take on. When banks can pocket the upside while spreading the cost of failures, failure is almost certain. (13)

If they are serious about learning from the 2007-2009 crisis, policy makers need to restrain financial supermarkets with confused and overlapping objectives, encouraging focused boutiques that live or die according to the soundness of their risk management. They need to shift capital out of institutions written by taxpayers and into ones that stand on their own feet. (14)

Hedge funds started based around the idea that even if the market was overvalued you could profit from stock selection. The combination of leverage and short selling allowed for the birth of hedging against potential risk while profiting past whatever existing capital a given fund had. (23-24)

Skill-driven stock picking = alpha, passive market exposure = beta. (27)

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 one the correlations among them. (28)

A.W. Jones’s profit share was modeled after Phoenician merchants, who always kept 20% of the profits from successful voyages and distributed the rest to the investors. (30)

The linking of compensation to results was the key to Jones’s formula. (33)

Jones’s system was unique in that it combined “Darwinist individualism and top-down risk control.” (34)

Between the close of 1968 and September 30, 1970, the 28 largest hedge funds lost two thirds of their capital. Their claim to be hedged turned out to be a bald-faced lie; they had racked up hot performance numbers by borrowing hard and riding the bull market. (40-41)

The only way to beat the market is to be the first mover and find an approach that others haven’t yet exploited—the innovators made the most profits. (50)

Everybody recognized that fast monetary growth predicted inflation and therefore would compel the Federal Reserve to force up interest rates; when that happened, investors would move their money into bank deposits or bonds, preferring to collect interest rather than incur the risk of staying in the stock market. (50)

Steinhardt and block-trading in the late 60’s and early 70’s:

They weren’t engaged in the overcrowded business of analyzing company data and picking the stocks that would do well; instead, they aimed to make money by supplying something that other investors needed—liquidity. (55)

Efficient market theory may hold truth in the long term, but in the short-term minute-to-minute prices are reflections of investor appetites. (56)

Weymar completed his PHD dissertation on how the price of cocoa could be predicted by crunching historical data to analyze what types of economic growth increased demand for chocolate and thus demand for cocoa. (63)

Commodities traders could make exponential amounts more once the Nixon price controls were abandoned. (75)

But 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. (77)

Soros’ early years and inspiration:

The LSE luminary who inspired Soros the most was Karl Popper, a philosopher who fled his native Austria to escape Nazism—and who, in an entirely unintended way, stamped his ideas on the young man who was to become the most famous of all hedge-fund managers. Popper’s central contention was that human beings cannot know the truth; the best they can do is to grope through trial and error … Popper’s masterwork, The Open Society and Its Enemies, created in Soros a lifelong desire to make his own contribution to philosophy. It pointed him toward a distinctive way of thinking about finance and inspired the name of the philanthropy he was to found, the Open Society Institute. (84)

Soros’ application of Popper’s ideas to financial markets (at odds with efficient market theory):

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. (85)

When funds grew too large it became difficult for them to jump in and out of markets without disrupting prices. (101)

Post-WW2 Keynes-based macro investing died out as a result of stable inflation and regulated interest rates. (102)

Prices changes are not normally distributed, which is what efficient market theory is based on. Mandelbrot predicted that tails were much fatter than people assumed in price changes which is why huge jumps and crashes were much more common than the majority of people thought them to be. (104-105)

Chaos theory: small pieces of information might generate large prices moves because of complex feedback loops. (106)

Prepare yourself mentally to take advantage of emotional extremes, like Jones on Black Monday having prepared for the moment of a crash and being able to cash in on the opportunity instead of being destroyed by it. (135)

Spotting situations where the odds are so good you need to take a bet, “even in the absence of predictive certainty.” (140)

When you start a new trend you profit first from it. Markets swing in trends and bubbles appear oftentimes because contrarians don’t have enough firepower behind their bets. Ammo + courage + being first + being right = massive profit. (142-143)

The devaluation of the lira was sobering because it was “the first time that a member of the exchange-rate mechanism had been so bloodied by the markets.” (158-159)

Soros’s gutsy play on the sterling crash resulted in a gain of over $1 billion. (166-167)

If free trade in goods and services was beneficial, surely free flows of capital were good for the same reason; just as trade allowed car manufacturing to be concentrated in the countries that did it best, so cross-border capital flows funneled scarce savings to places that would invest them most productively. Moreover, capital controls might be impractical as well as intellectually suspect. In the week after the sterling crisis, Spain and Ireland tried to dampen speculative attacks on their currencies by restricting banks’ freedom to trade them. The controls were quickly circumvented. (171)

Shadow banking: borrowing short and lending long, from the big banks themselves instead of everyday customers, with the flexibility to slip in and out of the business depending on Fed policies. (173)

America in the late 90’s:

The American system was pyramiding debt upon debt: The government was borrowing from hedge funds, which in turn borrowed from brokers, which is turn borrowed from some other indebted somebody. If one player in this chain collapsed, the rest could lose access to these borrowed funds. That could force them to dump assets fast. A bubble could burst instantly. (176)

Hedge funds’ extreme logic flipped the central banking game on its head. Because of the fearfulness of even the possibility of collapse due to uncertainty / risk on extremely leveraged positions, funds would sell holdings which would force interest rates up instead of down. (178)

Overreaction to geo-political and economic events becomes inevitable in an over-leveraged world because investors feel ripples from the economy in a much more magnified way. (186)

Jones’s “The Economics of Deflation: What Keynes Would Say to Thailand.” (205)

Long-Term Capital’s bond arbitrage:

A bond analyst could find you two securities that were almost indistinguishable: The issuer was the same, the principal would be repaid in the same year, the legal documents describing the investor’s rights were word-for-word identical. If one of these bonds was trading for less than the other, you could buy the cheap one and short its overpriced pair. This was arbitrage, not simple investing, and it promised almost certain profits. (223)

LTCM philosophy:

The common theme was that market anomalies occur when the behavior of investors is distorted—whether by tax rules, government regulation, or the idiosyncratic needs of large financial institutions.

By being the flexible player with the freedom to mirror the quirks of the inflexible ones, Long-Term provided liquidity to the markets. (225)

Lessons from LTCM on risk:

To stress-test your portfolio, you have to conceive of all the inconceivable shocks that could occur; to compute your fund’s value-at-risk and liquidity risk, you have to estimate the correlations among your various positions and guess how these could change in extreme circumstances. The real lesson of LTCM’s failure was not that its approach to risk was too simple. It was that all attempts to be precise about risk are unavoidable brittle. (231)

Leverage as a real issue in causing collapses of financial institutions because of the impossibility to calculate true risk when tiny changes can cause major positive and negative swings. (245)

Instead of learning from LTCM’s leverages collapse, there was an expansion of leverage that ended up leading to the 2008 crash. (247)

Liquid markets: prices fairly efficient. Illiquid markets: plenty of bargains, but mistakes are extremely costly. (283-284)

Before Amazon, Bezos worked at Shaw’s boutique startup hedge fund. (292-293)

Citadel rescuing Amaranth was significant in showing a large hedge fund could operate the same way a major bank could, providing proof for Griffin’s vision of Citadel being as big as Goldman Sachs. (320-321)

The Amaranth collapse was also indicative of hedge funds entering bubble territory, where so many were being born and so many were growing too fast for their own good where a collapse was inevitable. (321)

Hedge-fund incentives are not perfect, but they are much more closely aligned with performance than bank incentives are. Commissions often distort investment choices at banks. (333-334)

Tudor Jones’s study of history allowed him to see cycles appear and reappear and predict when a crash might be coming. (356)

A leveraged financial system in a credit crisis is like a high-wire artist in a storm. The wire is going to wobble, and the artist may lose his balance and tumble a long way. But he is definitely not going to levitate upward. (357)

Important to think about policy vs. payout: what might the incentive be in the private sector from a policy decision? Example: if there’s little downside to shorting and unlimited upside, hedge funds will bet aggressively on a collapse to the point where collapse becomes inevitable. (359)

• Always ask: what is the payout in each instance for each party involved?

The value in liquidity is the ability to exit positions quickly—speed is the value. (361)

Lehman Brothers collapse marked the end of the modern investment-bank model. (362)

Citadel absorbing shock on their own without government intervention is the proper way devaluation should happen—the person who takes on the risk initially absorbs it instead of being bailed out for it:

The episode showed that leveraged trading firms with billions under management do not necessarily need government rescues when markets go berserk; careful liquidity management can substitute for the Fed’s safety net. The old-line investment banks had built castles of leverage on foundations of short-term loans; when the crisis came, the whole edifice toppled. But because he shared the paranoid culture of hedge funds, Griffin had leveraged himself a bit more cautiously and relied less on short-term loans; when the moment of truth came, Citadel survived it. And so it turned out that an upstart Goldman imitator could be better for the financial system than the real Goldman—not to mention incomparably better than Bear Stearns or Lehman Brothers. (370)

The case for hedge funds:

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 companies. (375)

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. (376)

But the unpleasant truth is that government insurance encourages financiers to take larger risks; and larger risks force governments to increase the insurance. It is a vicious cycle. (377)

When so many regulators fail at once, it is hard to be confident that regulation will work if only some key agency is differently managed, better staffed, or cleansed of alleged laissez-faire ideology. Rather, the record suggests that financial regulation is genuinely difficult, and success cannot always be expected. (379)

Government should encourage hedge funds because this would be a concentrated effort of driving financial risk into places that impose fewer costs on taxpayers compared to the huge financial institutions and banks. Hedge funds should be a more favored institution because of the stronger incentives for controlling risk. (380)

Average actively managed mutual fund is a rip off once you consider difference between alpha, skill of fund manager, and beta, returns driven by market exposure. (382)

The persuasive argument is that hedge funds are growing. The case in favor of hedge funds is a case for entrepreneurial boutiques; when hedge funds cease to be small enough to fail, regulation is warranted. Equally, when hedge funds become public companies, they give up the private-partnership structure that has proved so effective in controlling risk: Again, the case for regulation becomes stronger. (388)

Firms such as Goldman Sachs, Morgan Stanley, and Lehman Brothers began as private operations that deployed the partners’ capital in a flexible way, much like today’s hedge funds.

Today, hedge funds are the new merchant banks—the Goldmans and Morgans of half a century ago. Their focus on risk is equally ferocious, and they are equally lightly regulated. But the same logic that tempted the old merchant banks to go public will seduce some hedge funds too; already a handful have sold shares in themselves, and doubtless more will follow. When that happens, hedge funds will pose the threat to the financial system that they have wrongly been accused of posing in the past. The wheel of Wall street turns. Greed and risk are always with us. (391)