Long before Mark Twain stood on Wall Street and saw it was a “street with a river at one end and a graveyard at the other,” there has been financial manipulation and scams. During the Punic Wars against Carthage, businessmen offered to ship supplies to Rome’s army on condition the state insured their ships and cargoes against loss. With the insurance in place, the businessmen loaded non-seaworthy ships with rotten goods and scuttled them at sea.
Recent history has seen more than its share of abuses. During the 1980s, Salomon Brothers foisted overpriced mortgage-backed securities on savings & loans as a way for those institutions to “enhance yield.” We soon had the savings & loan crisis to clean up. In the early 1990s, we had the structured notes scam, which involved selling leftover “toxic waste” to unsuspecting Midwestern insurance companies. Even younger professionals remember the dot-com boom, when hundreds of worthless internet companies were hyped to the investing public.
Wall Street’s best scams are those that involve coordinated, overwhelming hype. We saw this in the dot-com bubble, and we are seeing it now, beautifully executed, with hedge funds. Anywhere you look—newspapers, magazines, television, websites, books, congressional hearings—you learn that hedge funds are run by superstar managers employing brilliant investment strategies to reap extraordinary profits for their sophisticated investors. Like the dot-com bubble before it, this is a crock of shiitake.
Most of the “sophisticated” investors jumping into hedge funds—including too many pension fund, foundation and endowment trustees—don’t hold graduate degrees in finance. They know little, if anything of the efficient market hypothesis. Based on extensive empirical studies over several decades, this concludes that active investment managers don’t add value for investors. Their portfolios routinely under-perform the market before fees and expenses. When fees and expenses are factored in, they under-perform by a wide margin. An investment manager who outperforms one year is no more likely to outperform the next year than is any other manager. Occasionally, there are managers like Peter Lynch who outperform reasonably consistently for several years, but these are rare—fewer than we would expect if performance each year were purely random. After all, if you get enough people together in a room flipping coins, several of them are going to flip ten heads in a row.
Anyone who has delved into the literature on efficient markets should smell a rat when thousands of hedge funds are being launched each year, all flamboyantly claiming they can earn returns massive enough to cover their typically 2% management fee, 0.4% “administrative fee” and 20% incentive fee, not to mention the enormous brokerage fees the funds rack up on their frenetic trading.
Now don’t tell me the proof is in the pudding, because there is no pudding when it comes to hedge funds. Mutual funds are required to report their net asset values daily. If the mutual funds are willing to buy or sell shares at those values, the numbers have to be reliable. Hedge funds, on the other hand, are not required to disclose daily valuations. If they do, these are just whatever numbers the hedge fund manager comes up with. Investors aren’t allowed to buy or sell shares at those values, so the numbers could be (and often have been) bogus.
There are various hedge fund indexes compiled by the hedge fund industry. These purport to track hedge fund performance. They boast exceptional returns, but there are numerous flaws in how the indexes are compiled. Those flaws bias returns upward by several percent while biasing volatility downward to an even higher degree.
I won’t delve into all the sources of bias in those indexes, but let’s look at two. One is survivor bias. Reporting is voluntary, and hedge funds can stop reporting their performance whenever they like. I don’t know what indexes Amaranth reported their performance to, but I can’t imagine them taking the time to communicate their staggering losses to the indexes as the fund imploded. Why should they bother? I doubt any of the other numerous funds that have failed over the years bothered to make sure the indexes had the ugly numbers describing their death spirals. The hedge fund indexes—run by the industry to promote the industry—sheepishly say there is nothing they can do about such survivor bias other than hope it doesn’t distort their indexes too much.
Another huge source of bias arises from hedge funds inflating the reported values of their portfolios. If you find this hard to believe, read the Wall Street Journal. We are in the midst of a market meltdown stemming from aggressive subprime mortgage lending. Those subprime mortgages were repackaged as collateralized debt obligations (CDOs), many of which landed in hedge fund portfolios. Industry participants acknowledge that, should the hedge funds try to sell, the CDO market will collapse.
Let’s make this clear. The hedge funds are holding illiquid securities and valuing them at prices they could not receive if they tried to sell them today. Stated another way, they are overvaluing their portfolios, and their brokers are lending credibility to it by serving up inflated indicative prices for the securities. Investors are burned, not only because their investments are worth far less than they are being told, but also because they are having to pay the hedge funds fees based on the inflated valuations. The hedge fund indexes dutifully record the inflated valuations, adding to the myth of hedge fund outperformance.
Why do the brokers stand by the hedge funds? Why shouldn’t they!? I don’t have reliable figures, but I estimate that brokers earn $30 billion a year in commissions from their hedge fund clients. That is a staggering sum, even by Wall Street standards. That pot of gold is the reason the hedge fund industry exists as it does today. Fifteen years ago, the things that are going on would have been illegal. In the 1990s, when we were distracted by Bill Clinton and a semen-stained dress, lobbyists for the brokerage industry quietly had one law changed and one regulation clarified. That opened the door. The hype started, and hedge funds proliferated. Then Long-Term Capital Management failed, but the hype kept coming. The hedge fund train had left the station, and nothing was going to stop it. Another Wall Street success story! Print the bonus checks.
One fly in the ointment is the troublesome fact that the hedge funds can’t really produce the returns that are claimed for them. This can be hidden from the media and general public, since the industry has no disclosure requirements, but it can’t be hidden from the investors in those actual funds—at least not over the long-term. Those investors won’t know how other hedge funds are doing, but they will know that their own hedge funds have disappointed. They will pull their money and the hedge funds will fold. Every year, thousands of hedge funds quietly shut down without any sort of public announcement or explanation. This means the brokerage industry needs to replace them or lose the $30 billion pot of gold. Other clients don’t have 1000% annual turnover rates the way hedge funds do, so they don’t generate nearly the same commissions. The brokers need new hedge funds to replace the ones closing down, and they actively help launch them. They pony up advice, office space, systems and client introductions. Today, if you have a pulse and a firm handshake, you can launch a hedge fund. Just call your broker. They will do the rest.
It is great for the brokers, and it is a sure thing for the newbie hedge fund managers. Imagine that your broker sets you up with a $250 million hedge fund. Even if your performance is atrocious, you will be earning $5 million a year in management fees. Hold on for two years, and you will be rich. You might even get lucky and have positive returns, so your 20% performance fee kicks in. You could walk away with $20 million after two years. It doesn’t matter. Win or lose, you are going to make a killing.
Your broker is also going to make a killing. There is no contractual obligation for you to trade frenetically, but you will. The broker will review your account periodically. If they are unsatisfied with the commission income from your hedge fund, they will increase your commission rate. Hedge fund managers know where they stand. They trade frenetically.
The brokers need the hedge funds, and the hedge funds need the brokers. They are getting rich together, and this being Wall Street, there are favors. A broker gets tired of having to constantly launch new hedge funds, so it tries to boost hedge fund returns. When a mutual fund or other institutional investor places a large order to buy or sell stocks, the broker let’s the hedge fund know in advance, so it can frontrun the trade. This is illegal, and the SEC wants to investigate, but it is difficult to prove. The tip-off doesn’t exactly come over the recorded line.
Now suppose the broker is underwriting a CDO backed by subprime mortgages. The CDO is broken into various tranches. Some have little credit risk, and they are easy to sell to investors. Others have more credit risk, and they are more difficult to sell. A few are “toxic waste,” and no one wants to touch them. The hedge fund does the broker a favor and buys the toxic waste. They don’t really want it, but as long as things don’t come unglued, they can carry it for years in their portfolio at inflated valuations. The broker will provide the necessary indicative quotes. Is it any surprise that Bear Stearns was active in the subprime CDO market, and two hedge funds they launched were sitting on subprime toxic waste? In that case, of course, things came a little unglued.
If I had my way, legislators around the world would shut down the entire hedge fund industry. That is not likely to happen. Joseph Stalin once ask rhetorically, “How many divisions has he got?” If the brokerage industry asked how many lobbyists I had, I would have to admit to having none.
Basically I agree with your comments on the hedge fund mafia. With respect to the efficient market hypothesis, I think that the markets are not always (at all points of time) efficient. Some funds could exploit these inefficiencies to make money, however, that will disappear quickly and cannot be a basis for a investment strategy. On the other hand, the hedge funds are one of the reasons for the market efficiency, as they very quickly fill up the inefficient gaps.
I’m not so sure. Thats definitely the standard finance efficient markets view. But are hedge funds really making the market more efficient? How about how LTCM was doing this at first, but then got soooo big that its influence on the market and losses and endangerment to the whole financial system caused the Fed to have to step in. And now with all these highly levered funds chasing a limited numbers of investments (and usually with a long bias), they seem to have caused overly tight credit spreads similar to the equity market overshooting in 2000. And the guy I know who started such a fund was interested in his income and not so much about improving the financial markets. The efficient market hypothesis seems like a lot of those ideas from economics in which in individual cases is wrong, but somehow in aggregate is correct. I’ve often been puzzled by those. Back to Glyn’s paper, I think another point is how the leverage in addition to principal/agent issues (see his earlier paper in the FAJ) may lead to increased volatility and financial issues beyond their benefits of eliminating inefficiencies.
I would agree with you in some degree, but if you really go back before hedge funds became prevalent, the financial markets almost came to a halt in the late 70’s when North Korea assassinated the South Korean premier. No one had any faith in the credit markets in Asia because only the big banks did any business and they weren’t willing to take a risk. Now we have the blowup of Amaranth and the financial markets don’t even give it a second thought.
To continue, today the Moody’s Vice Chairman said that we are again at risk for the system freezing up. His quote: “A possible consequence of the repricing of risk assets would be the failure and disorderly liquidation of a hedge fund or other institution of sufficient size as to disrupt markets, as LTCM threatened to do in 1998,” Mahoney said. So, I am looking at hedge funds being blamed every couple of years for bringing the system to crisis and really don’t see that whatever relative pricing inefficencies hedge funds narrowed in the efficient markets theoretical world is comparable to the damage done systemically by them.
I basicly agree with you. However, I see the problem more in the fact that hedge funds get too big and operate too long on the same strategy which eventually dries up.
I think you are being a bit harsh on the Hedge Fund industry. Like most critics you hold them to an impossible standard. You over emphasize the failures and say just wait and see for the successful. Name one industry, sport, or association where everyone is honest and successful! The problem I do see with the Hedge Fund industry is accountability. Many hedge funds are started on a shoe string, or are created by wealthy families to give junior a job. These are the funds that are most likely to fall apart and many of the do, as you have stated. I have worked with many hedge funds around the county and would break them down this way. About 1/3 are highly organized and sophisticated and employ excellent VaR management software to monitor their risk. About 1/3 are run by very capable intelligent managers that are a bit more free handed in their management techniques. The last 1/3 of the hedge fund managers are flying by the seat of their pants. The top two groups can afford to purchase the market intelligence and software packages necessary to add value and sustain above average returns.
Hi Krassimir: I don’t think we are in agreement at all. Did you read the part where I said “Anyone who has delved into the literature on efficient markets should smell a rat when thousands of hedge funds are being launched each year, all flamboyantly claiming they can earn returns massive enough to cover their typically 2% management fee, 0.4% ‘administrative fee’ and 20% incentive fee, not to mention the enormous brokerage fees the funds rack up on their frenetic trading.” I’m not saying there is a problem with the funds getting too large and their brilliant strategies drying up. I am saying the brilliant strategies don’t exist. I really like what BD says: “The efficient market hypothesis seems like a lot of those ideas from economics in which in individual cases is wrong, but somehow in aggregate is correct.” There have been rare market inefficiencies that professional traders have exploited, including fixed income arbitrage and statistical arbitrage. What the literature on efficient markets documents is how exceedingly rare such opportunities are. Year in and year out, study after study documented the fact that active investment managers do not add value for their clients. Hedge funds don’t change anything. They are just more expensive and, being far removed from regulators, more prone to dishonest practices. People who are interested may want to read my http://www.riskglossary.com articles on market efficiency http://www.riskglossary.com/articles/efficient_market_hypothesis.htm and hedge funds http://www.riskglossary.com/articles/hedge_fund.htm
That’s close to what I say, market inefficiencies exist, but are rare and will disappear too quickly to be basis for a serious long-term investment strategy. On the other hand, a strategy with high leverage and aggresive trading is legitimate, and their existance ultimately makes markets more efficient. The problem comes when this essentailly unregulated and unaccountable funds get too big, making a problem for the system as a whole.
You can’t have it both ways. You can’t accept market efficiency as generally valid but then claim “high leverage and aggressive trading” can be used to outperform. No amount of leverage is going to transform a bad trade into a good one. Leverage can magnify alpha, but it cannot generate alpha. If you have zero alpha, you can magnify it with leverage, but zero alpha magnified is still zero alpha.
I think the world is not just black and white. Market inefficiencies do exist, but disappear quickly. Levereging at the right point of time could brings huge profits. This cannot be, of course, a consistent source of income, and an institutional investor should not go in such schemes.
Okay, I would say that slightly differently — that exploitable market inefficiencies have existed in the past. They are notable for how extraordinarily rare they are compared to the thousands of regulated and non-regulated investment funds out there. The next question is whether there are any hedge funds out there actually exploiting one of these extraordinarily rare market inefficiencies, or are they all just fooling investors (and perhaps themselves). As I pointed out in my blog, hedge fund fees are so excessive that the managers will make a killing irrespective of their actual performance. So what fraction of hedge funds are run by managers who (knowingly or unknowingly) have no ability whatsoever to generate alpha but are just cashing in? My answer would be 100%. No Virginia, there is no Santa Clause.
Yup, I mostly agree with that. Note, though, that one does not have to completely accept the EM hypothesis to criticize hedge funds. The position sizes creating economic crises is bad. The misperception of high returns by the public is bad for the industry and reminds me of earlier scandals in money management. One PM I used to work for had the advice for me: “Sell the sizzle and not the meat”. In other words, returns are nice but for that company we needed to emphasize marketing to get the money in the door to get our revenue from percent of funds under management. The efficient markets is another independent issue. I agree it is the best description of the market if you only had one paragraph to describe it. I do beleive in periodic and significant market inefficiencies (yes, they get arb’ed away) or I would not be working in this particular position right now.
I think that no one should certainly be surprised. I invite to read “Negatively Skewed Trading Strategies” by Glyn A. Holton (2003), Derivatives Week, 12 (42), 8–9. freely available from the following link: http://www.riskexpertise.com/papers/Skewed.PDF .
So when I lived in Los Angeles on an earthquake fault, I had a negatively skewed return with respect to geology. And since I moved before the next big quake, I have an historically high return to show for it. But not on a risk adjusted basis.