More Money Than God
Posted: Sun Feb 17, 2013 2:13 am
More Money Than God
by Sebastian Mallaby, 2010
This book is a history of hedge funds written by Mallaby with assistance from his colleagues at the Council of Foreign Relations. It is a much longer book than "The Quants" or "The Big Short", two other books about finance I've read recently. This book shifts away from infotainment and, therefore, is a bit of a bear at times. The bulk of the book documents the lives of the first and second generation hedge funds from the mid-twentieth century through the eighties, with the greatest space given to Julian Robertson's Tiger fund, which was a value investing fund, and George Soros's quantum fund, the king of them all - a "macro" fund more powerful than a small country. Mallaby naturally holds market efficiency theory in his sites throughout the book; a hedge fund can only be justified if the market can be beaten.
Here are the official ratings:
Entertainment: 7.2
Quality of information: 9.8
Command of the Efficient Market Hypothesis: 9.0
What is a Hedge Fund? For those with a little investing knowledge, the term "hedge fund" implies an investment style of taking a long position and "hedging" the potential losses with a short position, or vice versa. Alfred Winslow Jones, who the author credits with creating the first hedge fund, called his fund a "hedged fund" for this reason, and is credited for inventing the hedging strategy. But as the hedge fund landscape expanded, "hedging" is clearly optional. Many pile on the risk as high as it will stack. Hedge funds are merely investment funds, like mutual funds, but with large minimum investment requirements, plenty of latitude for strategy, and little oversight. The basic idea is that rich people should be allowed to risk their money, so hedge funds operate with minimal government oversight and create incentives for good management by requiring the mangers to be invested in the fund.
From a 26,000 foot view, the ivory tower discussions over whether the market can be beaten seem of little importance as George Soros breaks apart Europe's currency pegs and profits in the billions. Mallaby's implicit case against market efficiency theory -- the smallness of it when compared to the operations of real world of finance -- was more convincing than his explicit case.
Examples of the Funds
Mallaby credits AW Jones (50s) and Michael Steinhardt(70s), two early hedge fund managers for beating the stock market in novel, but unintentional ways. Jones led a large staff of traders that competed with each other and he significantly rewarded the winners. The competition pushed his staff in the direction of getting information faster. Information didn't flow back then like it does today, per Mallaby, and Jones's top traders built networks of contacts on Wall Street, which allowed them to move in and out of positions faster than Jones's rivals. But this situation was not sustainable, eventually, Jones's traders cut out the middleman and went off on their own, and when they did, the fund lost its information advantage. Steinhardt and his crew were contrarians who sought to time the top and bottom of a market. Mallaby is unconvinced this strategy accounts for their success, and credits their success to finding themselves in a fortuitous position as the "go to" liquidity providers for large funds, such as pension funds, that needed to unload positions in large "blocks". There are a few ways Steinhardt beat the market at this game. One example is that if the fund needed to unload a large position for purely administrative reasons, dumping a large volume bid the price of the stock down, but Steinhardt reckoned the lower price to be temporary, so he'd hold until the price rebound and then sold.
The first "consciously competent" player introduced is George Soros (80s). Soros is by far the most interesting character in the book in my opinion. As a youth he escaped Hitler's siege on Hungary and clawed his way to England and the London School of economics. Unlike the predictable brilliant yet shallow Wall Street Investor, Soros is an intellectual -- particularly fascinated with Karl Popper -- with a desire for academic greatness. Unfortunately, he wasn't in the top of his class at school. His future was a career of odd jobs until finally, with much effort, he found a small investment job. His financial ambitions were small, he just wanted enough money to support his life as an independent philosopher and self-publish his own theories. But he began making so much money investing that he couldn't quit and his philosophy combined with his investing life to create theories about how world economies work, and how to beat them. His biggest plays were against central banks that tried to keep their currency over-valued. Interestingly, Mallaby fully credits Soros's eventual billions to his hack theories. Where Soros fails at times is due to his conflicted life as a misplaced intellectual. He wants to be admired as an intellectual, a statesman, and a humanitarian, and his actions became incompatible with his career as an investor. For instance, he gives loans to Russia as a one man IMF, rather than taking contrarian positions against it to profit. Soros was a "macro" investor, who traded in currency markets and markets of all kinds.
Julian Robertson (80s) and his "tigers" lived larger than life as part world-class jocks and part traditional value investors like Warren Buffet. They made billions. Mallaby insists that they "beat the market," meaning, their returns on investment are higher than the average stock market returns when adjusting for risk taken. In fact, he has a special appendix devoted to supplementing his arguments to this end. The Tiger fund, however, eventually went under during the tech bubble. While Robertson primarily traded US stocks, in later years he also traded world markets.
As computer technology advanced, a new kind of fund entered the scene, the so-called "quant funds". These funds do little more than high-tech trend watching. Trend watching, charting, or technical analysis, has long been in disrepute. At worst, it's a pseudosocience that rivals the credibility of astrology (correlation/causation), at best, price data is easy to obtain and valuable trends should be exploited quickly and defeat the trend. But what if computers can find subtle trends that human chartists never could? Suppose a hundred mathematicians and scientists with real-world breakthrough research under their belts, not merely promising grad students, were to start a hedge fund. Suppose they have math skills to run circles around the economists who study market efficiency. Further, suppose their wealth buys the best market data available, better than what any finance school in the country can get. Further, suppose these scientists have roots working in national security and expertise running super secret operations that thrive on open collaboration among staff members who keep quiet outside of the group. But don't stop there, suppose any scientist that takes a job with the fund has to agree that if he ever quits, he can never take another finance job for the rest of his life, and the few who break their vows are aggressively and successfully sued. Suppose that to prevent reverse engineering, they filter their trades in creative ways through several brokers. And finally, suppose the fund is closed to outside investors and primarily trades its own money. Such a contrived example answers every intuitive objection that the market can't be beaten I can think of from the market efficiency view. But it turns out, this is not a contrived example, it's a fund that actually exists called the Renaissance Medallion fund, and it has consistently destroyed the market over the long term and under every condition including the financial crisis. Gun to the head, if I had to put a fund on the table that beats the market, I'd put down Medallion. To add insult to injury, Medallion not only refuses to hire economists, it boasts that most of the trends it follows have no rational interpretation. Medallion trades US stocks only.
The Inefficiency Narrative
All in all, Mallaby makes a reasonable case that the history of hedge funds contains examples of successes that are hard to explain away by market efficiency. However, his narrative is inconsistent at times and ultimately, he misrepresents the position of market efficiency.
Mallaby seems to believe the "efficient" price of a stock is grounded in its fundamentals. When prices move to levels predicted by solid fundamentals, he sees arbitrage at work, and as arbitrage brings prices to the right level, the market becomes efficient and arbitrage opportunities dry up. But he rarely uses arbitrage language. As a trading strategy ceases to work because too many funds jump in to use the strategy, the market, in his terms, is simply "crowded." By saying the market is crowded, he reserves the right to distinguish crowding from arbitrage, the crowded strategies might not be profitable due to competition, but they might push prices away from their efficient levels. Efficient markets are rational, crowded markets can be either rational or irrational. However, from a market efficiency view, a "crowded" market is an efficient one; agents are using all available information the best they can. There is no way to escape agent subjectivity and proclaim the objective value of a firm.
Mallaby says that the market was not efficient during the tech bubble, that the stock prices of companies could not be justified by firm fundamentals. But that merely rejects fundamental analysis, and market efficiency rejects fundamental analysis. In Mallaby's narrative, hedge funds can be highly adaptive both during times of relative efficiency and during times of irrationality. value funds get wiped out in bubbles and trend-surfers suffer during times of relative stability. But some funds adapt and win in both rational and irrational markets. In fact, he ends up arguing for hedge funds as a stabilizing force to the economy for this reason. But it would seem that irrespective of whether the market is rational or irrational (in his terms), he'd have to admit that ultimately hedge funds will be competitive with respect to their advantages over one another, and what would such a situation be called if not efficiency, in an informational sense?
Hedge Funds during the Crisis
In the book "The Quants", the author tells the story of a widely accepted view that hedge funds played their part in the financial crisis. Using computer models that failed to approximate reality correctly during a time of crisis, they nearly "blew up" Wall Street as they all had to exit similar positions and this caused large price drops. Mallaby agrees with most of the details of the quant meltdown story of August 2007, but has a totally different interpretation. He points out that many quant funds were liquid enough to get out of their positions without failing and the ones that did fail, did so without requiring a bailout. Some even made a lot of money. In other words, compared to investment banks, hedge funds are a tremendous success. He also points out that few hedge funds got suckered into CDOs, and a few profited greatly betting against them. He claims the smaller size of hedge funds along with their profit-making incentives such as requiring traders to be heavily invested in the fund keeps them risk adverse. Their trades are, therefore, smarter, they use less leverage than investment banks, and remain liquid enough to survive in a crisis. He believes regulators should stay out of hedge funds and let hedge funds run the economy. He loves hedge funds.
by Sebastian Mallaby, 2010
This book is a history of hedge funds written by Mallaby with assistance from his colleagues at the Council of Foreign Relations. It is a much longer book than "The Quants" or "The Big Short", two other books about finance I've read recently. This book shifts away from infotainment and, therefore, is a bit of a bear at times. The bulk of the book documents the lives of the first and second generation hedge funds from the mid-twentieth century through the eighties, with the greatest space given to Julian Robertson's Tiger fund, which was a value investing fund, and George Soros's quantum fund, the king of them all - a "macro" fund more powerful than a small country. Mallaby naturally holds market efficiency theory in his sites throughout the book; a hedge fund can only be justified if the market can be beaten.
Here are the official ratings:
Entertainment: 7.2
Quality of information: 9.8
Command of the Efficient Market Hypothesis: 9.0
What is a Hedge Fund? For those with a little investing knowledge, the term "hedge fund" implies an investment style of taking a long position and "hedging" the potential losses with a short position, or vice versa. Alfred Winslow Jones, who the author credits with creating the first hedge fund, called his fund a "hedged fund" for this reason, and is credited for inventing the hedging strategy. But as the hedge fund landscape expanded, "hedging" is clearly optional. Many pile on the risk as high as it will stack. Hedge funds are merely investment funds, like mutual funds, but with large minimum investment requirements, plenty of latitude for strategy, and little oversight. The basic idea is that rich people should be allowed to risk their money, so hedge funds operate with minimal government oversight and create incentives for good management by requiring the mangers to be invested in the fund.
From a 26,000 foot view, the ivory tower discussions over whether the market can be beaten seem of little importance as George Soros breaks apart Europe's currency pegs and profits in the billions. Mallaby's implicit case against market efficiency theory -- the smallness of it when compared to the operations of real world of finance -- was more convincing than his explicit case.
Examples of the Funds
Mallaby credits AW Jones (50s) and Michael Steinhardt(70s), two early hedge fund managers for beating the stock market in novel, but unintentional ways. Jones led a large staff of traders that competed with each other and he significantly rewarded the winners. The competition pushed his staff in the direction of getting information faster. Information didn't flow back then like it does today, per Mallaby, and Jones's top traders built networks of contacts on Wall Street, which allowed them to move in and out of positions faster than Jones's rivals. But this situation was not sustainable, eventually, Jones's traders cut out the middleman and went off on their own, and when they did, the fund lost its information advantage. Steinhardt and his crew were contrarians who sought to time the top and bottom of a market. Mallaby is unconvinced this strategy accounts for their success, and credits their success to finding themselves in a fortuitous position as the "go to" liquidity providers for large funds, such as pension funds, that needed to unload positions in large "blocks". There are a few ways Steinhardt beat the market at this game. One example is that if the fund needed to unload a large position for purely administrative reasons, dumping a large volume bid the price of the stock down, but Steinhardt reckoned the lower price to be temporary, so he'd hold until the price rebound and then sold.
The first "consciously competent" player introduced is George Soros (80s). Soros is by far the most interesting character in the book in my opinion. As a youth he escaped Hitler's siege on Hungary and clawed his way to England and the London School of economics. Unlike the predictable brilliant yet shallow Wall Street Investor, Soros is an intellectual -- particularly fascinated with Karl Popper -- with a desire for academic greatness. Unfortunately, he wasn't in the top of his class at school. His future was a career of odd jobs until finally, with much effort, he found a small investment job. His financial ambitions were small, he just wanted enough money to support his life as an independent philosopher and self-publish his own theories. But he began making so much money investing that he couldn't quit and his philosophy combined with his investing life to create theories about how world economies work, and how to beat them. His biggest plays were against central banks that tried to keep their currency over-valued. Interestingly, Mallaby fully credits Soros's eventual billions to his hack theories. Where Soros fails at times is due to his conflicted life as a misplaced intellectual. He wants to be admired as an intellectual, a statesman, and a humanitarian, and his actions became incompatible with his career as an investor. For instance, he gives loans to Russia as a one man IMF, rather than taking contrarian positions against it to profit. Soros was a "macro" investor, who traded in currency markets and markets of all kinds.
Julian Robertson (80s) and his "tigers" lived larger than life as part world-class jocks and part traditional value investors like Warren Buffet. They made billions. Mallaby insists that they "beat the market," meaning, their returns on investment are higher than the average stock market returns when adjusting for risk taken. In fact, he has a special appendix devoted to supplementing his arguments to this end. The Tiger fund, however, eventually went under during the tech bubble. While Robertson primarily traded US stocks, in later years he also traded world markets.
As computer technology advanced, a new kind of fund entered the scene, the so-called "quant funds". These funds do little more than high-tech trend watching. Trend watching, charting, or technical analysis, has long been in disrepute. At worst, it's a pseudosocience that rivals the credibility of astrology (correlation/causation), at best, price data is easy to obtain and valuable trends should be exploited quickly and defeat the trend. But what if computers can find subtle trends that human chartists never could? Suppose a hundred mathematicians and scientists with real-world breakthrough research under their belts, not merely promising grad students, were to start a hedge fund. Suppose they have math skills to run circles around the economists who study market efficiency. Further, suppose their wealth buys the best market data available, better than what any finance school in the country can get. Further, suppose these scientists have roots working in national security and expertise running super secret operations that thrive on open collaboration among staff members who keep quiet outside of the group. But don't stop there, suppose any scientist that takes a job with the fund has to agree that if he ever quits, he can never take another finance job for the rest of his life, and the few who break their vows are aggressively and successfully sued. Suppose that to prevent reverse engineering, they filter their trades in creative ways through several brokers. And finally, suppose the fund is closed to outside investors and primarily trades its own money. Such a contrived example answers every intuitive objection that the market can't be beaten I can think of from the market efficiency view. But it turns out, this is not a contrived example, it's a fund that actually exists called the Renaissance Medallion fund, and it has consistently destroyed the market over the long term and under every condition including the financial crisis. Gun to the head, if I had to put a fund on the table that beats the market, I'd put down Medallion. To add insult to injury, Medallion not only refuses to hire economists, it boasts that most of the trends it follows have no rational interpretation. Medallion trades US stocks only.
The Inefficiency Narrative
All in all, Mallaby makes a reasonable case that the history of hedge funds contains examples of successes that are hard to explain away by market efficiency. However, his narrative is inconsistent at times and ultimately, he misrepresents the position of market efficiency.
Mallaby seems to believe the "efficient" price of a stock is grounded in its fundamentals. When prices move to levels predicted by solid fundamentals, he sees arbitrage at work, and as arbitrage brings prices to the right level, the market becomes efficient and arbitrage opportunities dry up. But he rarely uses arbitrage language. As a trading strategy ceases to work because too many funds jump in to use the strategy, the market, in his terms, is simply "crowded." By saying the market is crowded, he reserves the right to distinguish crowding from arbitrage, the crowded strategies might not be profitable due to competition, but they might push prices away from their efficient levels. Efficient markets are rational, crowded markets can be either rational or irrational. However, from a market efficiency view, a "crowded" market is an efficient one; agents are using all available information the best they can. There is no way to escape agent subjectivity and proclaim the objective value of a firm.
Mallaby says that the market was not efficient during the tech bubble, that the stock prices of companies could not be justified by firm fundamentals. But that merely rejects fundamental analysis, and market efficiency rejects fundamental analysis. In Mallaby's narrative, hedge funds can be highly adaptive both during times of relative efficiency and during times of irrationality. value funds get wiped out in bubbles and trend-surfers suffer during times of relative stability. But some funds adapt and win in both rational and irrational markets. In fact, he ends up arguing for hedge funds as a stabilizing force to the economy for this reason. But it would seem that irrespective of whether the market is rational or irrational (in his terms), he'd have to admit that ultimately hedge funds will be competitive with respect to their advantages over one another, and what would such a situation be called if not efficiency, in an informational sense?
Hedge Funds during the Crisis
In the book "The Quants", the author tells the story of a widely accepted view that hedge funds played their part in the financial crisis. Using computer models that failed to approximate reality correctly during a time of crisis, they nearly "blew up" Wall Street as they all had to exit similar positions and this caused large price drops. Mallaby agrees with most of the details of the quant meltdown story of August 2007, but has a totally different interpretation. He points out that many quant funds were liquid enough to get out of their positions without failing and the ones that did fail, did so without requiring a bailout. Some even made a lot of money. In other words, compared to investment banks, hedge funds are a tremendous success. He also points out that few hedge funds got suckered into CDOs, and a few profited greatly betting against them. He claims the smaller size of hedge funds along with their profit-making incentives such as requiring traders to be heavily invested in the fund keeps them risk adverse. Their trades are, therefore, smarter, they use less leverage than investment banks, and remain liquid enough to survive in a crisis. He believes regulators should stay out of hedge funds and let hedge funds run the economy. He loves hedge funds.