Sebastian Mallaby: Hedge funds and the future of finance
By David Bukey
Several years ago Jim Simons, founder of the $15 billion hedge fund Renaissance Technologies that pioneered split-second computerized trading in the 1990s, threw a dinner party for 500 guests. Instead of designing the seating plan himself, Simons and one of his employees wrote a computer program to do it. The program used probabilities to gauge how certain guests might get along.
Simon’s plan either worked a little too well, or failed completely. His program sat an investor next to a woman who had just sued that client for sexual harassment.
Sebastian Mallaby, author of
More Money Than God: Hedge Funds and the Making of a New Elite (Penguin, 2010), has a knack for weaving such anecdotes into his sweeping history of hedge funds, which, like the financial markets as a whole, have had their share of ups and downs.
According to Mallaby, the first hedge fund was founded in 1948 by Alfred Winslow Jones, a financial journalist with communist sympathies, a fearless sense of adventure, and no formal business training. Jones couldn’t forecast the markets and had no special stock-picking talent, but he hired talented analysts to pick stocks for his fund. More importantly, Mallaby writes, Jones devised four key rules for his fund that hundreds of managers have followed over the past 62 years.
First, Jones took one-fifth of all profits so he was focused on absolute (as opposed to relative) performance. He also sidestepped government regulation, boosting his flexibility. In addition, he reduced market exposure by purchasing some stocks while selling others short. Finally, he borrowed money to leverage his investments and magnify fund performance.
Jones focused solely on stocks, but this framework also thrived in other markets, including fixed income, futures, and options. “More than by luck than design, Jones had invented a platform for strategies more complex than he himself could dream of,” Mallaby writes.
Mallaby is a veteran journalist who now works as a senior fellow for international economics at the Council on Foreign Relations in Washington, D.C. He also directs the council’s Center for Geoeconomic Studies. After graduating from Oxford University in 1986 with a degree in modern history, Mallaby wrote for The Economist for 13 years. In 1999 he moved to the Washington Post for an eight-year stint as a columnist and member of the editorial board.
Mallaby has written two other books:
The World’s Banker (Penguin, 2004) and
After Apartheid (Faber and Faber, 1992), and twice was a finalist for the Pulitzer prize.
Anyone who has read Jack Schwager’s Market Wizards books will recognize some of the bigger stars of Mallaby’s narrative — Michael Steinhardt, Paul Tudor Jones, Stan Druckenmiller, David Shaw — but Mallaby digs deeper into their success than others have. Mallaby knows better than to accept traders’ own explanations of their talent. “The nature of hedge funds’ true edge is often obstructed by their bosses’ pronouncements,” Mallaby writes.
For example, Paul Tudor Jones claims he anticipated the 1987 stock market crash with the help of his partner Peter Borish, who compared the stock market’s trajectory in the late 1920s to its moves leading up to the October 1987 plunge. However, the timing was off, and Borish later admitted he tweaked the data anyway. The lesson, Mallaby concludes in his book, is that “genius does not always understand itself — a lesson, incidentally, that is not confined to finance.”
The real reason for Jones’s success is that “he is very attuned to asymmetrical risk,” Mallaby says. In other words, the most successful traders know to pounce when a trade’s upside potential is extraordinary and its risk is minimal.
Mallaby’s book stands out, in part, because he puts these stories into historical context. After the initial success of A.W. Jones and his partners in the 1950s and 1960s, hedge funds fell out of favor. Prior to the October 1987 stock market crash, many institutional investors shunned hedge funds, believing markets were efficient, all investors were rational, prices reflected all known information, and price changes adhered to a “normal,” bell-shaped probability curve. If true, this meant traders couldn’t consistently beat the market, so hedge fund managers were playing a fool’s game.
However, after the stock market fell more than 20 percent on Oct. 19, 1987, all bets were off. “Over the course of a week, the value of corporate America had bounced around like a pachinko ball; there was nothing efficient about this, nor was there any sign of equilibrium,” Mallaby writes.
Now that the market had been “proven” irrational, it was easier for large institutional investors such as pension funds and college endowments to place money with hedge funds. The industry took off as the number of hedge funds jumped from just 68 in 1984 to 3,000 within a decade. Today, the industry has ballooned to more than 9,000 worldwide (including fund of funds), despite the crippling effect of the 2007-09 credit crisis.
But this history is only part of the discussion. Mallaby uses the 2008 financial crisis to argue that hedge funds are superior to major investment banks and pose little systemic financial risk. Unlike AIG, Goldman Sachs, or Lehman Brothers, hedge funds weren’t bailed out by the U.S. government, had their own skin in the game, and were just small enough to fail. Indeed, hundreds of funds closed in the wake of the financial crisis without incident.
Mallaby believes hedge funds can help solve some of the thorny policy questions the financial crisis has raised, and he urges lawmakers to give them more leeway. “To a surprising and unrecognized degree, the future of finance lies in the history of hedge funds,” Mallaby argues.
For the complete article, see the October 2010 issue of Active Trader magazine. Click here to subscribe.
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