Luff Peter

Peter Luff

Luff, Peter

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'Edging Your Bets: Markets and the Management of Risk

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Reitaku University Academic Repository / 麗澤大学学術リポジトリ

【Book Review】ʻEdging Your Bets: Markets andthe Management of RiskPeter LuffSebastian Mallaby. 2010. More Money Than God: Hedge Funds and the Making of a New Elite.New York, The Penguin Press. Pp. 482. ISBN 978 1 59420 255 1 (hardback).Anyone seeking a comprehensive account of the hedge fund industry from its inceptiondown to the present will derive profit, but only limited profit, from Sebastian Mallabyʼs latestbook. The same holds true for those in search of a discussion of the economic significance ofhedge funds completely uncontaminated by polemic. For More Money Than God, as thehyperbole of its title indicates, is a work of high-quality financial journalism, one that has theweaknesses as well as the strengths of a quasi-insiderʼs view. Mallabyʼs extensive experience asa reporter for The Economist and The Washington Post, and his current position at a leadingWashington think-tank, the Council on Foreign Relations, mean that he has had a ringside seatfrom which to observe the key economic events of the past two decades. At the same time,intimate involvement with his subject makes detached and systematic reflection difficult;Mallaby genuinely tries to remain objective, but he is a self-acknowledged hedge fund partisanand it is difficult to avoid concluding that his affection for them is rooted not least in theentertainment value they provide. The rather breathless tone of the book suggests anovermastering urgency at work; there is a compelling story to tell, one that Mallaby has nowish to see cut short by regulatory interference. A defense of hedge funds must be mounted,and time is pressing.The story-telling first. The structure of the book is broadly chronological, with each of thefirst six chapters devoted to describing one of the formative hedge funds, its creator(s) andoffspring. Thereafter the approach becomes more episodic, a journey through the crises inwhich hedge funds have figured prominently during the past twenty years. Mallaby breaks offto describe some of the companies which led the hedge fund renaissance of the newmillennium, before returning to bring his narrative to a close with an account of the lead-up tothe Great Recession of 2008 and the cataclysm itself.What shape is there, if any, to this story? There are the obvious themes of the vast― 101 ―Reitaku InternationalJournal of Economic StudiesVol.19, No.2, September 2011expansion in the size and influence of hedge funds, and the increasingly diverse nature of theiractivities. But this immediately provokes the reader to ask whether their nature has notchanged so radically over time as to render the term ʻhedge fundʼ itself virtually meaningless.Mallaby rightly attempts to deal with the problem of defining his central concept at the outset,but his success is partial at best. He argues that the vehicle created by Alfred Winslow Jones,the founding father of the industry, had four essential features that nearly all its successorswere to replicate: a (very large) performance fee; the avoidance of official regulation insofar asthat was possible; a balance between being ʻlongʼ in some stocks and ʻshortʼ in others; and theʻleveragingʼ of bets on the performance of stocks with borrowed money (p. 2). It is only the thirdof these features, of course, which seems indispensible to the management of risk and so wouldmake a hedge fund seem appealing to even the most cautious of investors. Yet it was ʻcasuallydiscardedʼ by George Soros, the most famous/notorious hedge fund manager of them all (p. 91)― nor was he by any means single in this.The ʻhedgingʼ element appears to be largely fictional in any case. Its essential premise andpromise, that whether the market rises or falls the fund will return a profit, is far too grandiosea claim to be widely credible; it implies that risk can, in fact, be eliminated. If this seems toogood to be true, the facts adduced here prove that this is indeed the case, even accepting thatthe information Mallaby provides is incomplete because too great a focus on failure mightdisenchant the reader. Clearly, from the very outset, hedge funds have never provedthemselves immune to downturns in the market; as an economic life-form, they seem by theirnature prone to periodic mass extinctions. Mallabyʼs allusions to the culls of 1968-74 (pp. 40-41),1994 (pp. 182, 191) and 2000 (pp. 262-264), and his rather more detailed account of some of thecasualties of the turmoil of 2008, point to the irresistible conclusion that hedge funds in generalhave failed to foresee and ride out crises−even though, as late as 2009, investors continued tobelieve that they should and would (p. 371). Yet if they have not in fact abolished risk, or evenmanaged it with consistent success, what have they been doing with their time and energy?The answer is, in some cases at least, making vast sums of money in astonishingly shortorder. A. W. Jones christened his brainchild a ʻhedged fundʼ and vehemently but unavailinglyobjected to the removal of the final ʻdʼ when the term was popularized; Mallaby acknowledgesthat he himself has gone one step further by dropping the initial ʻhʼ as well (p. 5). What trulyfascinate him are ʻedgeʼ funds, the ones that have seemed able, for a while at least, to beat themarket in spectacular fashion. The relatively few individuals who have acquired sudden anddizzying wealth thereby dominate swathes of the book (they constitute the ʻnew eliteʼ of itssubtitle). Mallaby is not, in fact, particularly concerned with the generality of hedge funds−which is perhaps the severest limitation of his study. In pursuit of good ʻcopyʼ, his spotlight fallsrepeatedly on men who have seemed able to generate immense profits year after year, and hecannot refrain from the inevitable question, ʻhow did they do it?ʼ (pp. 109-111). Is there someformula for success that has characterized these ʻhigh performance clustersʼ?Reitaku International Journal of Economic Studies― 102 ―Mallaby wisely refrains from trying to provide a single, simple answer to this question.None of the ʻtitansʼ of the industry was blessed with exact foreknowledge of events; at best theywere all, in their own different ways, much quicker to acquire information or sense opportunitythan their peers. Furthermore, limited as their individual talents may have been, these werewell adapted to their times and circumstances−up to a point. Some, like Julian Robertson ofTiger Management, were adept and ultra-confident stock-pickers, or in the case of A. W. Joneshimself, managers of stock pickers. They were able, for a time anyway, to incentivize and infusetheir subordinates with an esprit de corps that made them seem invincible. Others, like MichaelSteinhardt and Paul Tudor Jones II, were successful students of market psychology, takingadvantage of their insights to identify market ʻwavesʼ and adopt strategies to exploit them,based either on contrarianism or on a feeling for how other market players would react in agiven situation. Being first in the field also gave some hedge funds a temporary institutionalʻ edge ʼ−part of Steinhardt ʼ s profits, for example, came from block trading, i. e. providingliquidity where others had not yet seen the opportunity. Sometimes this shaded into illegality;A. W. Jones flirted with insider dealing on occasion, while Steinhardt almost certainly engagedin substantial collusive trading - claims of a type that continue to be made against hedge fundstoday (e. g. Lattman and Ahmed, 2011). Luck, too, played its part (e. g. pp. 38, 47-48, 92, 120), butMallaby is right to insist that it cannot provide anything like a complete explanation. Moreimportant, he argues, was the ability to spot and exploit market inefficiencies that allowed forthe laying of huge asymmetrical bets, most notoriously on currencies. These were especiallylucrative since the counterparties were central banks and governments whose understandingof the market was often woeful; the victory of Soros and Druckenmiller over the Bank ofEngland and Norman Lamont on 16 September, 1992, ʻBlack Wednesdayʼ, remains the perfectspecimen of the type.Mallaby has much less time for the generality of hedge fund managers. But these meremortals can take comfort from the fact that none of the ʻtitansʼ proved able to master themarket or the art of risk-taking completely or indefinitely, and a large part of the interest ofstudying elite hedge funds lies in seeking to understand their limitations. Mallabyʼs book is ofconsiderable help in cataloging these. It is clear from his case studies that all hedge fund gurus,each in their own different way, have fallen victim to their own success; this is partly a matterof hubris that betrays them into folly, partly the simple loss of ʻedgeʼ as their protégés defect(taking with them the proprietary formula for success and setting up for themselves), andpartly burnout. Thus Julian Hart Robinson was seduced into diversifying from U. S. equities,where he had considerable expertise and where his long-term approach had made him afortune in the 1980s, into macro-trading (of currencies in particular ) where this approachinvited disaster in the 1990s ( pp. 122-127, 248-252 ). Mallaby seems right to argue thatRobertson threw caution to the winds primarily out of the desire to best Soros, just as Soroshimself lost heavily in Indonesia and Russia in pursuit of an unrealizable ambition to berecognized as a ʻ statesman-philanthropist ʼ ( pp. 207-209, 212-219 ). Generational change isanother force that eats away at the foundations of a successful hedge fund. Young andʻEdging Your Bets: Markets and the Management of Risk― 103 ―ambitious juniors, becoming increasingly frustrated, decide to strike out on their own, and theirmentors are powerless to restrain them, as A. W. Jones discovered early on (pp. 35-36) - theonly partially successful strategy for circumventing this rule seems to be teamwork culture ofRenaissance Technologies (pp. 303-306). But often the founding father is not unhappy to see hisdisciples go, because running a hedge fund is ultimately debilitating; the landscape is litteredwith extinct volcanoes. Even the greatest eventually burn out and retire, often disenchanted,the life sucked out of them: the roster here includes A. W. Jones (p. 35), Steinhardt (pp. 190-191),Robertson (p. 262), and Druckenmiller (p. 264). Even Soros, the ultimate prizefighter, could notsustain the punishment indefinitely, and took extended periods of leave from the ring (pp. 87,149-50, 264).Stories of the excess and chastisement of the powerful are, of course, the stuff ofjournalism, but Mallaby, in his concluding chapter, seeks to shift the focus from individuals tothe making of policy. On the merits and demerits of hedge funds in general and on one of theburning issues of the moment, how and how far they should be regulated, his argument is that,the very largest of them aside, lightness of touch is the wisest policy. On balance, he claims,these funds do more economic good than harm. He absolves ʻgenuineʼ, i. e. independent, hedgefunds of most of the responsibility for the ongoing Great Recession. For him, it was the fundslocated inside banks (and especially the great merchant banks) who were the true villains of thepiece (together with AIG, which took ineptitude to an entirely new plane). These internal funds,he argues, bore the stamp of bank culture rather than hedge-fund culture; they lacked theindependence from regulatory and ratings agencies, the exclusive focus on their business, andthe paranoia about margin calls that, Mallaby believes, preserved real hedge funds from thesuicidal risk-taking that brought down Bear Stearns, Lehman Brothers and others.The latter do not, admittedly, constitute a very high bar, and Mallaby can seem at times toengage in special pleading in favor of the independent hedge fund. Yet his basic reading of thecrisis of 2007-2009 aligns with those of Andrew Ross Sorkin and Michael Lewis. They too seeits major institutional casualties as largely the authors of their own demise. Sorkin has littlesympathy with those like Dick Fuld, CEO of Lehman Brothers, who tried to portray theircompanies as hedge fund victims (Sorkin, pp. 96-105). Lewis is even more scathing in detailinghow, to take perhaps the most egregious example, Howie Hublerʼs adventure into the bravenew world of the CDS cost his employer, Morgan Stanley, an estimated $9 billion (Lewis, pp.200-215). It is worth noting in passing that Lewis adds a moral dimension to the tale of fundoperators like Steve Eisner and Michael Burry (neither of whom figures in Mallabyʼs book) whoworked to unmask the folly of Hubler and his employers. Lewis takes the defense of such fundsone step further by asserting that the behavior of Bear Stearns, Lehman, Morgan Stanley andothers of their ilk in the bond market was not merely incompetent but essentially corrupt, andthat in dragging this into the light of day (and, in the process, profiting very handsomely) fundslike Cornwall Capital were doing the work of justice (Lewis, pp. 233-234, 242-251). Mallaby alsohas little time for the view that the ʻshortsʼ need regulating because they somehow unfairlyReitaku International Journal of Economic Studies― 104 ―conspired to bring down Lehman and others; he, too, believes that their role as the shock troopsof the free market considerably outweighs any shortcomings they might have. But his principalargument for leaving them alone is that far from being too big to fail, they are too small towarrant much regulation. The claim that they are simply not at present systemically importantplaces Mallaby firmly in alignment with other hedge fund apologists like Richard Baker,president of the Managed Funds Association, for example (Ahmed, 2011). The evidence of thepast, even of the collapse of the inappropriately-named Long Term Capital Management in1998, Mallaby argues, shows that hedge funds can be allowed to fail without the cost beingpassed on to the taxpayer. That being so, as the standard bearers and, on occasion, the saviorsof modern capitalism (pp. 317-322, 363-371), they are worth two cheers at least.All of which sounds reassuring. And yet, if we are to believe Nouriel Roubini and StephenMihm, it will still not prove sufficient next time; future disasters there will be, for ʻfar frombeing the exception, crises are the norm ʼ (Crisis Economics, 4 ). On this view regulators,charged with both creating a framework of rules and taking the lead in responding to crises,face a seemingly impossible task, and Mallabyʼs book offers one obvious reason why; the clearand simple fact that the future will not resemble the past, a fact this is more than usually true ofhedge funds. But, whatever limitations regulators may face, a full appreciation of the proteannature of hedge funds can only help those charged with supervising them. These funds havechanged, and their changing has been rapid and constant. That will continue. Which meansthat regulators need to ask themselves; what will such funds look like in five years time? Orten? Or twenty? This is effectively asking how one should try to regulate the unknown, it istrue, but it is still a very worthwhile question. For Mallaby shows beyond fear of contradictionthat hedge funds have metamorphosed with such alarming rapidity over the past sixty yearsthat regulators have always been playing catch-up, not least because of the culture of secrecythat seems to be part of the hedge fund DNA. Regulators, it seems, like generals fighting thelast war, have failed to equip themselves to meet the enemy effectively because they have onlythe haziest understanding of what they are facing. Symbolic of this ignorance is the figure ofEddie George, deputy governor of the Bank of England, assuring an interlocutor on themorning of ʻBlack Wednesdayʼ that “We have got it all under control” (p. 164) - this, at the verymoment when Soros and Druckenmiller were selling the life out of sterling.One can, of course, hope that not all regulators are as utterly complacent and blindlyconservative as ʻSteady Eddieʼ, and Mallabyʼs book will certainly help to educate any of themthat wish to learn from the errors of the past; he may even succeed in persuading them to leavehedge funds largely alone in the present. But his book will serve its most important purpose if itstimulates them anew to ask where they should look in the present for clues to the future. Wasthe ʻquant quakeʼ of August 2007 really a public policy non-event, as Mallaby tends to suggest(pp. 345-347)? In a financial era increasingly dominated by ʻfly-by-wireʼ technology, symbolizedby the magic algorithms of Renaissance Technologies, will the human pilots of the system haveeither the time or the skill to intervene to prevent the next crash? It is the central virtue ofʻEdging Your Bets: Markets and the Management of Risk― 105 ―Mallabyʼs study of the past that one is led to ask questions of this kind about the future.(Professor at Reitaku University)ReferencesAhmad, A. (2011, January 31. Is No Hedge Fund Too Big to Fail? The New York Times. Retrieved 3February, 2011, from http://dealbook.nytimes.com/2011/01/31/is-no-hedge-fund-too-big-to-fail.Lewis, M. (2011). The Big Short: Inside the Doomsday Machine. New York: Norton.Lattman, P. and Ahmed, A. (2011, May 31). Galleon Conviction Likely to Embolden Prosecutors. The NewYork Times. Retrieved 2 July, 2011, from http://dealbook.nytimes.com/2011/05/11/galleon-conviction-is-expected-to-embolden-prosecutors.Roubini, N. and Mihm, S. (2011). Crisis Economics. New York, Penguin.Sorkin, A. R. (2010). Too Big to Fail. New York: Penguin.( Received for publication, July 18, 2011Revision accepted for publication, September 14, 2011)Reitaku International Journal of Economic Studies― 106 ―

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