Hedge funds get rich on the back of the world's financial blunders
In the old days, technical books were read for one's education, but they were so boring that you would fall asleep. You read novels instead for their drama, romance and excitement. In this fast-moving world, where daily events are more thrilling than fiction, books like More Money than God by Sebastian Mallaby are real page-turners.
Written by a former journalist, who today works for the US Council on Foreign Relations, the book combines blood-and-guts story-telling with careful analysis of the hedge fund industry. The narrative is so thrilling that when the author described the scene where the hedge funds took down Thailand in 1997, my hair stood on end.
If you want to know how hedge funds sniff out opportunities by talking to honest and naive central bankers, then go on to make more money than God, read this book. It is both a clinical analysis of how hedge funds emerged from nowhere to become the market movers of today, and a morality story that raises more questions than it is able to answer. It may not be illegal (at least under existing law) to do a trade that tips a nation into abject poverty because there were tragic policy mistakes, but is it morally right to take home billions by accelerating the process of 'creative destruction'?
The central insight of the hedge fund industry is brilliant - it is that the academic theory about finance is all wrong. Modern finance theory begins with the assumption that the market is efficient and knows best. The efficient-market hypothesis is based on the view that it is not easy to beat the market. However, the hedge fund industry makes most money from the inefficiencies of the market. If you are not convinced, look at how, between May 1980 and August 1998, the Tiger Fund - a hedge fund founded by Julian Robertson - earned an average of 31.7per cent per year after fees, beating the 12.7per cent return on the S&P 500 index. The offshoots of the fund generated returns of 11.9per cent per year between 2000 and 2009, compared with the average of 5.3per cent per year for the S&P index.
Mallaby takes the story from the 1949 creation of the first hedge fund by Alfred Winslow Jones to the emergence of a sophisticated and complex US$2trillion industry. He weaves a wondrous tale of how tribal and interconnected the industry became as it emerged.
Nobel laureate Paul Samuelson, famous for arguing that randomly chosen stock selection would beat professionally managed mutual funds, was a founder investor of the Commodities Corporation, and one of the first quants, using computer analysis to trade commodities. The Commodities Corporation was the nursery for three future hedge fund giants, Bruce Kovner (Caxton), Paul Tudor Jones (Tudor Investments) and Louis Bacon of Moore Capital. Bacon had connections with two of the 'Big Three' in the early 1990s, being related by marriage to Robertson and having worked briefly with Michael Steinhardt. The last of the Big Three was George Soros (Quantum Fund), who became famous as the man who made GBP1 billion (HK$12.1 billion) speculating in sterling, and is now also known for his philanthropy.
Many of these funds were involved during the speculative raids on Asian currencies during the 1997-98 Asian crisis and it is likely that many of them are having a feast in Europe right now.
The book argues that hedge funds should not be regulated. '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 institutions.' In Mallaby's view, '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'. Yes, but when their prime brokers blew up with them, it cost taxpayers trillions.
Herein lies the contradiction of their existence. Hedge funds are symbiotically tied to their prime brokers, the investment banks and large global banks that provide the leverage for their activities. The latter group is too big to fail and its proprietary trading, combined with those of the hedge funds, are large enough to move markets. The argument that the prime brokers would safeguard systemic stability by indirectly regulating the hedge funds (many of whom are former staff of the prime brokers) failed when Lehman Brothers collapsed.
Hedge funds thrive because of regulatory and information arbitrage. The more the regular banking system is regulated, the more business drifts to the under-regulated shadow banking institutions. Mallaby argues that it remains unproven whether heavier regulation will succeed. The regulators were scared to regulate because of moral hazard, that is, the government would bear responsibility for industry taking higher risks. Unfortunately, in any financial crisis, the government would be blamed and would have to pay, irrespective of heavy or light regulation.
While hedge funds are not of public concern if they remain small, their herd-like effect becomes a real problem. Europe today is a live experiment of gigantic proportions. If someone makes tens of billions through speculation from the failure of some European countries and millions become unemployed, it is no longer a regulatory issue; this is a political crisis.
More Money than God should be read by anyone who wants to understand how hedge funds dissect the European crisis, seeing an opportunity.
Andrew Sheng is president of the Fung Global Institute and author of From Asian to Global Financial Crisis