Markets climb, markets dive, and it all seems to involve fast talk and sleight of hand, as well as computers and high-level math. Indeed, a lot of smart people think it’s not wise or even possible to try to beat the market—the long-popular “random walk” theory concludes that over time you just can’t win.
But the guys who manage hedge funds believe you can.
The lords of these investment companies take on a small number of big-time investors, and use a variety of aggressive and often mysterious strategies to make often astounding amounts of money for their clients, and for themselves. But they’ve also lost billions.
While there’s no single definition of a hedge fund, financial journalist Sebastian Mallaby pinpoints four characteristics in his new book More Money Than God. The funds’ managers avoid publicity and regulation so they have flexibility to shift strategies. They embrace short selling—that is, trades that bet the price of a security or commodity will go down—so that they can make money when other investors are losing. They rely on a lot of borrowed money, called leverage, to magnify their bets. And they are paid on performance, as well as a percentage of assets—usually a stunning 20 percent of the profit they make for customers.
Mallaby, a fellow at the Council on Foreign Relations and a columnist for the Washington Post, takes a personality-driven approach to showing how hedge fund managers move and shake in a world of stock, bond and currency speculation that is nearly impossible to explain to the uninitiated. Mallaby keeps his topic human by focusing on the individual masterminds. Greed and risk are always with us, he writes. Still, he concludes, hedge fund managers are, on balance, the good guys.
Mallaby recently spoke with the AARP Bulletin about hedge funds and the people who run them.
Q. The thing that drives people absolutely nuts about hedge fund managers is in the title of your book: They have more money than God. How can these compensation structures possibly be fair?
A. In some ways they are a lot fairer than the smaller fees charged by mutual fund managers. That sounds preposterous, so let me explain. When you pay an actively managed mutual fund that’s trying to beat the market average, every study that’s been done by academics shows that, on average, mutual funds don’t beat the market average. With hedge funds, the best academic studies show that they do provide positive value. Now if as a society we think that what’s left over for the hedge fund managers is socially unacceptable, the answer is to tax them more. I don’t think that their clients are being ripped off, unlike with many financial products.
Q. You point out that about 5,000 hedge funds failed between 2000 and 2009. Are those investors being ripped off?
A. There are hedge funds that go wrong and lose money. It’s important, though, to remember that the risk actually is not bigger than lots of things that people do in finance every day.
Q. How does that work?
A. Take a famous blowup, which was a fund called Amaranth, where there was a 42-year-old natural gas trader who used to drive his Ferrari to work every day, except when it was too snowy, and then he had to take the Bentley. In 2006, the fund blew up and lost an amazing $6 billion of his investors’ money. What had been $9 billion of equity in Amaranth became $3 billion. There were some pension funds, with the money of ordinary hard-working people, and they were down by two-thirds. But the truth is that no pension fund puts more than a fraction of its assets into a particular hedge fund. And so the losses to the retirement plans were smaller than you might get on an average day’s volatility on the S&P 500 index.
Q. What are successful hedge fund managers like?
A. Their key characteristic is a sort of obsessive desire to win, almost an addiction. To do well over a long period, you have to have this manic quality, this juice that just drives you to focus on everything that could go wrong. To keep up that level of intensity over a really long period is extraordinarily draining. The ones that really make it, who have sustained success over 10 years or more, they have to have some sort of special kind of almost crazy focus.
Q. For example?
A. Because hedge funds attract larger-than-life egos, you get a lot of high-voltage energy. One example is Michael Steinhardt, who flourished in the 1970s and 1980s, and who had a ferocious temper. He would lose his temper at people working for him and yell at them horribly. In one instance his employee says, after being yelled at, “All I want to do is kill myself.” Steinhardt responded, “Can I watch?”
(Read about more hedge fund managers in an excerpt from More Money Than God.)
Q. Many of these fund managers are almost the opposite of traditional suited, gray-haired bankers. They’re 30-some years old and they play with superhero figures.
A. The hedge fund effect is somewhat like the entrepreneurs that spin off and start their own little boutiques. They’re often quite smart, but they’re not into hierarchy or wearing ties, and it is that kind of culture that you find in hedge funds.
Q. Like dot-com companies?
A. Yes. But there is an interesting double standard in our culture, which is one of the things that attracted me to write this book. If you had a handful of smart people with quantitative skills set up a boutique company on the West Coast, everybody loved it because it was doing software. If you had a handful of smart quantitative people set up a boutique company on the East Coast, everybody hated you because you were a hedge fund. In the end I don’t think that’s justified, because hedge funds do contribute to the economy and to society in a way that isn’t recognized.
Q. Let’s talk about those contributions.
A. One is that they earn profits for their clients. Depending on who those clients are, we may or may not think that’s a nice contribution. To the extent that they are managing money for people who are already extremely rich, it probably isn’t terribly important to make them even richer. But about half of the money in hedge funds comes not from individuals but institutions, which could be retirement plans or university endowments. It is a useful social function to make money for universities.
Q. And beyond profit?
A. They can drive markets toward a more stable level when they go toward excess. Hedge funds are set up to be contrarian, and therefore when something overshoots, they come in to drive the price more toward where logic would suggest that it would be. For instance, when a currency price jumps for no good reason, they can sell it short.
Q. What else?
A. And the third thing, which is very, very important, is that we had a financial crisis that demonstrated that too-big-to-fail financial institutions are a huge problem for society because when they do fail the government bails them out. So what we need to do is drive financial risk out of too-big-to-fail institutions into small-enough-to-fail institutions. And hedge funds are small enough to fail, and that’s why when 5,000 went down in the last decade, they didn’t cost taxpayers one cent.
Q. You conclude that governments must encourage hedge funds. How?
A. One way is not to impose symbolic regulations that don’t do much to make anything safer but do increase costs for hedge funds to operate. For example, requiring hedge funds to register with the Securities and Exchange Commission—it sounds good, who could object? And so it’s sort of politically popular to advocate that.
Q. So what’s wrong with doing so?
A. The fact is the SEC doesn’t know what to do with the data. Bernie Madoff was registered with the SEC, and the SEC was warned that Bernie Madoff was cheating, and that didn’t have any effect at all on catching Bernie Madoff. The other thing to do is to be burdensome toward the very big risk-taking investment banks, which I think have proven themselves to be a terrible menace.
Q. How does the new financial regulation legislation affect hedge funds?
A. That’s being debated in conference still. One part of the debate is whether to restrict risk-taking within big banks via the so-called Volcker Rule, which would try to stop banks from doing bets with their own capital, so-called proprietary trading. That is very hard to implement, but I totally support the sentiment because it does drive risk out of big institutions.
Q. If these are such great investments, how can the average investor get a piece of them?
A. The only way that the little guy can get access to hedge fund returns is through pension or retirement funds investing on your behalf, because the securities rules say that you have to be a qualified investor. And that means, legally, you have to have $5 million minimum in investable assets.
Q. Do you have any money invested in hedge funds?
A. I certainly don’t have $5 million in investable assets!
Maryann Haggerty is a freelance writer from Washington, D.C.