More Money Than God_Hedge Funds and the Making of a New Elite

by Sebastian Mallaby

  The acknowledgment of the limits to market efficiency had a profound effect on hedge funds. Before, the prevailing line from the academy had been that hedge funds would fail. After, lines of academics were queuing up to join them. If markets were inefficient, there was money to be made, and the finance professors saw no reason why they should not be the ones to profit. Cliff Asness was fairly typical of the new wave. At the University of Chicago’s Graduate School of Business, his thesis adviser was Eugene Fama, one of the fathers of the efficient-market hypothesis. But by 1988, when Asness arrived in Chicago, Fama was leading the revisionist charge: Along with a younger colleague, Kenneth French, Fama discovered non-random patterns in markets that could be lucrative for traders. After contributing to this literature, Asness headed off to Wall Street and soon opened his hedge fund. In similar fashion, the Nobel laureates Myron Scholes and Robert Merton, whose formula for pricing options grew out of the efficient-markets school, signed up with the hedge fund Long-Term Capital Management. Andrei Shleifer, the Harvard economist who had compared the efficient-market theory to a crashing stock, helped to create an investment company called LSV with two fellow finance professors. His coauthor, Lawrence Summers, made the most of a gap between stints as president of Harvard and economic adviser to President Obama to sign on with D. E. Shaw, a quantitative hedge fund.9

  Yet the biggest effect of the new inefficient-market consensus was not that academics flocked to hedge funds. It was that institutional investors acquired a license to entrust vast amounts of capital to them. Again, the years after the 1987 crash were an inflection point. Before, most money in hedge funds had come from rich individuals, who presumably had not heard academia’s message that it was impossible to beat the market. After, most money in hedge funds came from endowments, which had been told by their learned consultants that the market could be beaten—and which wanted in on the action. The new wave was led by David Swensen, the boss of the Yale endowment, who focused on two things. If there were systematic patterns in markets of the sort that Fama, French, and Asness had identified, then hedge funds could milk these in a systematic way: There were strategies that could be expected to do well, and they could be identified prospectively. Further, the profits from these strategies would be more than just good on their own terms. They would reduce an endowment’s overall risk through the magic of diversification. The funds that Swensen invested in were certainly diverse: In 2002, a swashbuckling West Coast fund named Farallon swooped into Indonesia and bought the country’s largest bank, undeterred by the fact that a currency collapse, a political revolution, and Islamist extremism had scared most westerners out of the country. Following Swensen’s example, endowments poured money into hedge funds from the 1990s on, seeking the uncorrelated returns that endowment gurus called “alpha.”

  The new inefficient-market view also imbued hedge funds with a social function. This was the last thing they had sought: They had gotten into the alpha game with one purpose above all, and that was to make money. But if alpha existed because markets were inefficient, it followed that savings were being allocated in an irrational manner. The research of Fama and French, for example, showed that unglamorous “value” stocks were underpriced relative to overhyped “growth” stocks. This meant that capital was being provided too expensively to solid, workhorse firms and too cheaply to their flashier rivals: Opportunities for growth were being squandered. Similarly, the discounts in block trading showed that prices could be capricious in small ways, raising risks to investors, who in turn raised the premium that they charged to users of their capital. It was the function of hedge funds to correct inefficiencies like these. By buying value stocks and shorting growth stocks, Cliff Asness was doing his part to reduce the unhealthy bias against solid, workhorse firms. By buying Ford’s stock when it dipped illogically after a large-block sale, Michael Steinhardt was ensuring that the grandma who owned a piece of Ford could always count on getting a fair price for it. By computerizing Steinhardt’s art, statistical arbitrageurs such as Jim Simons and David Shaw were taking his mission to the next level. The more markets could be rendered efficient, the more capital would flow to its most productive uses. The less prices got out of line, the less risk there would presumably be of financial bubbles—and so of sharp, destabilizing corrections. By flattening out the kinks in market behavior, hedge funds were contributing to what economists called the “Great Moderation.”

  But hedge funds also raised an unsettling question. If markets were prone to wild bubbles and crashes, might not the wildest players render the turbulence still crazier? In 1994, the Federal Reserve announced a tiny one-quarter-of-a-percentage-point rise in short-term interest rates, and the bond market went into a mad spin; leveraged hedge funds had been wrong-footed by the move, and they began dumping positions furiously. Foreshadowing future financial panics, the turmoil spread from the United States to Japan, Europe, and the emerging world; several hedge funds sank, and for a few hours it even looked as though the storied firm of Bankers Trust might be dragged down with them. As if this were not warning enough, the world was treated to another hedge-fund failure four years later, when Long-Term Capital Management and its crew of Nobel laureates went bust; terrified that a chaotic bankruptcy would topple Lehman Brothers and other dominoes besides, panicked regulators rushed in to oversee LTCM’s burial. Meanwhile, hedge funds wreaked havoc with exchange-rate policies in Europe and Asia. After the East Asian crisis, Malaysia’s prime minister, Mahathir Mohamad, lamented that “all these countries have spent 40 years trying to build up their economies and a moron like Soros comes along with a lot of money to speculate and ruins things.”10

  And so, by the start of the twenty-first century, there were two competing views of hedge funds. Sometimes the funds were celebrated as the stabilizing heroes who muscled inefficient prices into line. Sometimes they were vilified as the weak links whose own instability or wanton aggression threatened the global economy. The heart of the matter was the leverage embraced by A. W. Jones—or rather, a vastly expanded version of it. 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.11 After the bond-market meltdown of 1994 and the Long-Term Capital failure in 1998, the two competing views of hedge funds wrestled to a stalemate. In the United States and Britain, hedge funds’ stabilizing impact received the most emphasis; elsewhere, the risk of destabilizing panics got most of the attention. Funnily enough, the countries that liked hedge funds the best were also the ones that hosted them.

  Then came the crisis of 2007–2009, and every judgment about finance was thrown into question. Whereas the market disruptions of the 1990s could be viewed as a tolerable price to pay for the benefits of sophisticated and leveraged finance, the convulsion of 2007–2009 triggered the sharpest recession since the 1930s. Inevitably, hedge funds were caught up in the panic. In 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. The following year was more brutal by far. The collapse of Lehman Brothers left some hedge funds with money trapped inside the bankrupt shell, and the turmoil that followed inflicted losses on most others. Hedge funds needed access to leverage, but nobody lent to anyone in the weeks after the Lehman shock. Hedge funds built their strategies on short selling, but governments imposed clumsy restrictions on shorting amid the post-Lehman panic. Hedge funds were reliant upon the patience of their investors, who could yank their money out on short notice. But patience ended abruptly when markets went into a tailspin. Investors demanded their capital back, and some funds withheld it by imposing “gates.” Surely now it was obvious that the risks posed by hedge funds outweighed the benefits? Far f
rom bringing about the Great Moderation, they had helped to trigger the Great Cataclysm.

  This conclusion, though tempting, is almost certainly mistaken. The cataclysm has indeed shown that the financial system is broken, but it has not actually shown that hedge funds are the problem. It has demonstrated, to begin with, that central banks may have to steer economies in a new way: Rather than targeting consumer-price inflation and turning a blind eye to asset-price inflation, they must try to let the air out of bubbles—a lesson first suggested, incidentally, by the hedge-fund blowup of 1994. 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. The carnage of 2007–2009 demonstrated how wrong that was. Presented with an opportunity to borrow at near zero cost, people borrowed unsustainably.

  The crisis has also shown that financial firms are riddled with dysfunctional incentives. The clearest problem is “too big to fail”—Wall Street behemoths load up on risk because they expect taxpayers to bail them out, and other market players are happy to abet this recklessness because they also believe in the government backstop. But this too-big-to-fail problem exists primarily at institutions that the government has actually rescued: commercial banks such as Citigroup; former investment banks such as Goldman Sachs and Morgan Stanley; insurers such as AIG; the money-market funds that received an emergency government guarantee at the height of the crisis. By contrast, hedge funds made it through the mayhem without receiving any direct taxpayer assistance: There is no precedent that says that the government stands behind them. Even when Long-Term Capital collapsed in 1998, the Fed oversaw its burial but provided no money to cover its losses. At some point in the future, a supersized hedge fund may prove to be too big to fail, which is why the largest and most leveraged should be subject to regulation. But the great majority of hedge funds are too small to threaten the broader financial system. They are safe to fail, even if they are not fail-safe.12

  The other skewed incentive in finance involves traders’ pay packages. When traders take enormous risks, they earn fortunes if the bets pay off. But if the bets go wrong, they don’t endure symmetrical punishment—the performance fees and bonuses dry up, but they do not go negative. Again, this heads-I-win-tails-you-lose problem is sharper at banks than at hedge funds. Hedge funds tend to have “high-water marks”: If they lose money one year, they take reduced or even no performance fees until they earn back their losses. Hedge-fund bosses mostly have their own money in their funds, so they are speculating with capital that is at least partly their own—a powerful incentive to avoid losses. By contrast, bank traders generally face fewer such restraints; they are simply risking other people’s money. 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.13

  The very structure of hedge funds promotes a paranoid discipline. Banks tend to be establishment institutions with comfortable bosses; hedge funds tend to be scrappy upstarts with bosses who think nothing of staying up all night to see a deal close. Banks collect savings from households with the help of government deposit insurance; hedge funds have to demonstrate that they can manage risk before they can raise money from clients. Banks know that if they face a liquidity crisis they have access to the central bank’s emergency lending, so they are willing to rely heavily on short-term loans; hedge funds have no such safety net, so they are increasingly reluctant to depend on short-term lending. Banks take the view that everything is going wonderfully so long as borrowers repay; hedge funds mark their portfolios to market, meaning that slight blips in the risk that borrowers will hit trouble in the future can affect the hedge funds’ bottom line immediately.14 Banks’ investment judgment is often warped by their pursuit of underwriting or advisory fees; hedge funds live and die by their investment performance, so they are less distracted and conflicted. For all these reasons, a proper definition of hedge funds should stress their independence. 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. To a large extent, their instincts were right: At their peak, financial companies hogged more human capital than they deserved, and they took risks that cost societies dearly. But Wall Street’s critics should pause before they sweep hedge funds into their net. Who, in the final analysis, will manage risk better? Commercial banks and investment banks, which either blew up or were bailed out by the government? Mutual-fund companies, which peddled money-market products that the government was forced to backstop? And which sort of future do the critics favor: one in which risk is concentrated inside giant banks for which taxpayers are on the hook, or one in which risk is dispersed across smaller hedge funds that expect no lifelines from the government? The crisis has compounded the moral hazard at the heart of finance: 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 that they take on. When banks can pocket the upside while spreading the cost of their failures, failure is almost certain.

  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 underwritten by taxpayers and into ones that stand on their own feet. They need to shrink institutions that are too big to fail and favor ones that are small enough to go under. The story of A. W. Jones and his successors shows that a partial alternative to banking supermarkets already exists. To a surprising and unrecognized degree, the future of finance lies in the history of hedge funds.

  1

  BIG DADDY

  At the dawn of America’s second gilded age, and on the eve of the twenty-first century’s first financial crash, the managers of a few dozen hedge funds emerged as the unofficial kings of capitalism. Globalization was generating unheralded prosperity; and the prosperity was generating deep pools of wealth; and the wealth was being parked in quiet funds, whose managers profited mightily. Just in the three years from 2003 to 2006, the volume of money in the top one hundred hedge funds doubled to $1 trillion1—enough to buy all shares listed on the Shanghai Stock Exchange or an entire year’s worth of output from the Canadian economy. Nobody doubted that this hedge-fund phenomenon was new, unprecedented, and symbolic of the era. “Running a few hundred million dollars for a hedge fund—and taking tens of millions for yourself—has become the going Wall Street dream,” one magazine writer declared.2 “Hedge funds are the ultimate in today’s stock market—the logical extension of the current gun-slinging, go-go cult of success,” according to another.3

  But hedge funds are not new, and not unprecedented; and whereas the first line
just quoted comes from a New York magazine article published in 2004, the second comes from a remarkably similar essay, also in New York magazine, published four decades earlier. The 2004 article gushed that hedge-fund managers are the type who can “call the direction of the market correctly 22 days in a row.” The 1968 version invoked “the hedge fund guy who made 20 percent on his money in a week, for seven weeks in a row.” The 2004 essay complained of hedge funds that “in addition to being arrogant and insular, they’re also clandestine.” The 1968 version said peevishly that “most people involved in hedge funds are reluctant to talk about their success.” If hedge-fund managers had emerged as the It Boys of the new century—if they had supplanted the leveraged-buyout barons of the 1980s and the dot-com wizards of the 1990s—it was worth remembering that they were also the hot stars of an earlier era. A hedge-fund manager “can be away from the market and still know where its rhythm and his are meshing,” according to a famous account of the 1960s boom. “If you really know what’s going on, you don’t even have to know what’s going on to know what’s going on… You can ignore the headlines, because you anticipated them months ago.”4

  The largest legend of the first hedge-fund era was Alfred Winslow Jones, the founding father whom we have encountered already. He was described in New York magazine’s 1968 essay as the “big daddy” of the industry, but he was an unlikely Wall Street patriarch; like many of the hedge-fund titans of a future age, he changed the nature of finance while standing somewhat aloof from it. In 1949, when Jones invented his “hedged fund,” the profession of money management was dominated by starchy, conservative types, known tellingly as “trustees”—their job was merely to conserve capital, not to seek to grow it. The leading money-management companies had names like Fidelity and Prudential, and they behaved that way too: A good trustee was, in the words of the writer John Brooks, “a model of unassailable probity and sobriety; his white hair neatly but not too neatly combed; his blue Yankee eyes untwinkling.”5 But Jones was cut from different cloth. By the time he turned his hand to finance, he had experimented restlessly with multiple careers. He kept the company of writers and artists, not all of them sober. And although he was to become the father of hypercapitalist hedge funds, he had spent a good portion of his youth flirting with Marxism.