Are Hedge Funds a Giant Scam?

My instincts are torn on this issue. On the one hand, my instinct is to say that based on my admittedly somewhat thin understanding of what hedge funds do, they seem like a giant scam. On the other hand, my awareness that my understanding is somewhat thin makes me skeptical that this could really be the case. Under the circumstances, the impressive establishment credentials of this piece -- a "think tank town" item in The Washington Post by Dean P. Foster of the Wharton School and H. Peyton Young of Oxford and the Brookings Institution -- carries a lot of weight with me.

These guys aren't smart-ass twentysomething bloggers and they say that while it's not necessarily the case that all hedge funds are huge scams, a lot of hedge funds are huge scams exploiting the fact that if you make a few bets with small odds of enormous downside, the probability favors you putting together a few years' worth of incredibly impressive returns and getting in a position to make a lot of cash. Nassim Taleb's The Black Swan discusses many related issues.

Photo of hedges in the New York Botanical Garden by Flickr user MoToMo used under a Creative Commons license

Comments

Well, for the last couple of years I thought it would make sense to start the Red-and-Black Fund...

You collect lots of money and keep it in the bank, earning maybe 3%. Then, once a year, you fly down to Las Vegas and bet it all on one fair roll of the big Roulette Wheel, having covered all but one or two of the numbers. Unless you're really unlucky during the first couple of years, this should net you a total return of something 6-9% annually (including your bank interest).

Notice that these returns are very, very stable. Basically, you earn 6% or whatever, each and every year.

Since your returns are so extremely stable, you must have a very safe (secret) investment strategy, and everyone is impressed.

But 6% isn't high enough, even for a very safe strategy. So you go down to the big money-center banks, and "leverage up" your stable strategy, by borrowing five times your invested capital. Suddenly, your returns are just as stable, but have been now "leveraged up" to an annual 30% or whatever!

Even netting out your hedge-fund fees of 2% of equity plus 20% of profits leaves an outstanding return for all your fudn investors, especially since it's so remarkably stable, year after year. Best yet, your "investment strategy" is one of the very few that can be scaled up in size without limit or degradation in performance.

So many, many, many more investors give you their money as well.

I've sometimes wondered whether the recent growth in hedge-funds had some connection to the recent growth in Las Vegas revenues...

Posted by RKU | December 29, 2007 4:49 PM

Anyone honest who has spent any time on Wall Street will admit that a lot of money is made in new "products" that ultimately turn out to be profitable only to insiders.

Does this constitute a scam? For most of us, the answer is clearly yes. After all, the very name of "hedge funds" has become a misnomer, as Wikipedia says:

"The term "hedge fund" has come in modern parlance to be overused and inappropriately applied to any absolute-return fund – many of these so-called "hedge funds" do not actually hedge their investments."

The irony of this question is that the very wealthy folks most able to profit from so-called hedge funds are the same people least likely to need the money -- and the people most able to call on political connections to be bailed out in case of financial disaster.

Posted by Kit Stolz | December 29, 2007 4:55 PM

Taleb's black swan is Malkiel's efficient market theory plus 3,000 words.

Posted by Garuda | December 29, 2007 4:55 PM

This seems pretty obvious to me. 2 and 20 deals as typical of such funds offer pretty staggering incentives to run very high risks in order to achieve moderately above market returns in the short run. It's simply impossible to manage any fund in a style that achieves long term results that can justify a 2 and 20 deal unless you regularly trade illegally on inside information; given historical rates of return on stock funds it would require a hedge fund to produce long run returns of 40% or more--the amount more depending on levels of risk aversion among the fund's shareholders--above market average, and no one's ever managed to do even close to that.

Posted by R Johnston | December 29, 2007 4:57 PM

There's another financial institution out there with leverage ratio of about 90 percent that borrows from people who aren't entirely sure what is going to happen with the money and the institution gets to keep whatever it makes over what it promised the lenders whereas any losses get dumped onto someone else.

Your average commercial bank.

Posted by P O'Neill | December 29, 2007 5:03 PM

Hedge funds might be called a scam but there are better pejorative terms for them. Calling them a scam involves an argument about semantics and there are plenty of negative things about them that don't entail semantics.

Their name is a scam. Most 'hedge' funds take huge leveraged speculative bets which are mostly not hedged at all and if they are then hedged lightly.

The incentives for those running hedge funds are screwed up. Most hedge fund runners have no skin in the fund. The incentive is to take huge bets to make big money in a calender year so you get paid big. If the fund happens to blow up oh well, scrape the name off the door paint a new one on and start over.

It is not coincidence that the $3 trillion or so that has flowed into hedge funds is about equal to the tax savings Bush bestowed of the top decile. Those tax savings went into speculation and conspicuous consumption, the hallmarks of our age.

The pace of failure has been slow but look for it to pick up in the new year.

http://hf-implode.com/

Posted by rapier | December 29, 2007 5:05 PM

The book "Innumeracy" explained how to get into financial management many years ago. You buy a mailing list of 100,000 investors and send half of them a letter saying the Dow will go up this week, guaranteed, and half of them a letter saying it will go down this week, without a doubt. If it goes down, you mail half of the latter group a letter saying the Dow will go up this week and half a letter saying it will go down. Keep it up for six weeks, and you have about 1500 people left for whom you have called every turn of the Dow six times in a row! Then sell them a newletter at $10,000 per year. If 10% of the 1500 bite, that's $1.5 million per year. Of course, offering to manage their funds for them at 2 and 20 is even better.

Posted by Steve Sailer | December 29, 2007 5:13 PM

On the other hand, the endowment managers at Yale and Harvard have been raking in huge returns on big pools of money for a long time now. I've never seen a good explanation of how they beat the market consistently.

Posted by Steve Sailer | December 29, 2007 5:15 PM

Style note, Matt: Illustrating the headline "Are Hedge Funds a Giant Scam?" with a picture of a hedge, and then explaining the connection ("Photo of hedges in the New York Botanical Garden by...") is what is known in the advertising trade as a "see-say," and is generally avoided--the assumption being that the reader is smart enough to make the connection on his own.

Posted by James Gary | December 29, 2007 5:24 PM

Well, if you think hedge funds are a big scam, when you have that extra $100 million that Foster and Young are talking about, don't invest in one!

Meanwhile, I await someone to explain to me why I should pay my hard earned tax dollars for the government to regulate hedge funds to protect people from losing their extra $100 million from crazy long shot events.

Maybe the money that Foster and Young think should be spent protecting $100 millionaires from bad bets should instead be spent giving poor children health care.

Posted by Al | December 29, 2007 5:29 PM

Steve,

Those endowments can invest with very long time horizons, can provide large amounts of liquidity on short notice so that the best opportunities come to them (it takes less effort raising funds if you go to just a handful of big sophisticated players, this is why the best funds are closed to new investors), have the expertise to invest in exotic assets (like forests), can make investments that would kill non-non-profit investors with tax consequences, get good private equity/venture capital deals (illiquid markets where investors are creating real value and changing the operations of companies) from their alumni, etc.

Posted by Carl Shulman | December 29, 2007 5:31 PM

On the other hand, the endowment managers at Yale and Harvard have been raking in huge returns on big pools of money for a long time now. I've never seen a good explanation of how they beat the market consistently.

Well, don't they just place their Harvard money into various other investment funds run by other people. And don't those other people have children who are going to be applying to Harvard one of these days...

I've long suspected that that the "Harvard secret" is a little like how Hillary managed to earn $100K on a $1000 commodities "investment" in a 24-hour period or whatever while her husband was Governor. If I'm wrong, then maybe Bill should have made Hillary Chief Investment Officer of the U.S. Treasury....

Posted by RKU | December 29, 2007 5:33 PM

BTW, the stupidest thing about the Foster and Young article to which Matthew links is that it says nothing about these $100 millionaires who are investing in this hedge fund. The investors that I know would be inquiring into the risk-adjusted returns of the fund: what's the beta, what is the expected alpha? Anybody can make up an example showing that hedge funds are all a scam if they ignore the principle idea of a hedge fund: that you are not just looking at the rate of return, but rather you look at the alpha: the rate of return in excess of the beta (or riskiness) of the fund.

Please get Foster and Young to write an article that tells us what the alpha of the Oz fund is, then I'll pay attention.

Posted by Al | December 29, 2007 5:38 PM

Why would honest wealth concentration be any more legitimate than dishonest? The former is if anything even more deserving of destruction.

Posted by rda | December 29, 2007 5:54 PM

The original sin, if you will, of modern "Hedge" funds is that they were given the name "Hedge" at birth - Thus, falsely suggesting a conservative hedge against future market volatility.

The name is deceptive, but the world wants to be deceived - 'mundus vult decipi.' As they say.

Posted by Comment | December 29, 2007 6:05 PM

After posting my comment above, scanned up and noticed that many other commenters saids the same thing. Oh well - glad the world notices. Names are important.

Posted by Comment | December 29, 2007 6:09 PM

Steve - If Harvard and Yale consistantly beat the market - then there is a probability that that they will eventually have a bad year that more than makes up for the good years - Say if the markey goes down 10, they may go down 25.

So maybe you should open up the Sailor Schadenfreud Opportunity fund and capitalize on that possibility -

Posted by Comment | December 29, 2007 6:23 PM

The most important thing to know about hedge funds is that they 'invest' in nothing which is productive. They speculate in financial instruments which are totally divorced from real investment in plant, equipment or people in order to garner real cash flow profit.

"From Minsky (1993): “The main financial houses became highly-leveraged dealers in securities, beholden to banks for continued refinancing. A peculiar regime emerged in which the main business in the financial markets became far removed from the financing of the capital development of the country.” In today’s stage of “Financial Arbitrage Capitalism” the U.S. financial sector has accumulated unprecedented leverage, beholden to the vagaries of the repo and money market for continued refinancing. It is the assurances and direct market interventions by the Fed and GSEs that have largely been the impetus for the explosion of speculation and leveraged holdings. A peculiar regime – operating in a most perverted marketplace - has risen to absolute dominance in which the main business of the financial markets has become the over-financing of existing (real and financial) assets and consumption-related receivables, with non-productive debt virtually supplanting the financing of capital development. The Credit system has regressed to the point of being virtually decoupled from productive investment as well as overall economic performance, with the key inflationary manifestations arising in the asset markets and through intractable trade imbalances."

Credit Bubble Bulletin 12/27/01
Financial Arbitrage Capitalism
http://www.prudentbear.com/index.php/archive_menu?art_id=3002

Posted by rapier | December 29, 2007 6:40 PM

So many thoughts...

1. Regulating "hedge funds" is silly. There is no specific definition for them except that they are funds that manage to operate outside any regulations (because, like commenters here, the government feels $100 millionaires can watch out for their own damn money). If you regulated any specifically circumscribed investment firms, then those would go away, and whatever else wasn't regulated would become the new "hedge funds".

2. People with $100 million really can watch out for themselves, and generally pay someone to do due diligence on their investments, making sure the investments aren't completely dumb. A $100,000 private accountant is nothing if you're investing $20 million. It's average families getting conned by penny-stock callers, like Matt linked to a few days ago, that are the real scam. And the deals that go on there are much worse than the neutral expected value scenarios today's article describes. That's where our real anger should be.

3. 90% of the sins attributed to hedge funds are really about Private Equity Managers, who have existed for decades. They are the dudes who do leveraged buyouts of companies, strip the assets, and move on. Bain Capital has existed for a long time, and they're probably the worst. Those are also the groups that tend to benefit the most from our absurdly low capital gains tax, and shady tax loopholes like the one Chuck Schumer protected a few months ago.

4. The risk-friendly problem the article alludes to is structural. The real problem is if many funds take dumb risks, some of them will in fact pay off (and they could even be negative expected value risks), but they'll look good in hindsight, when they were really just lucky. Being dumb and lucky with money is the easiest way to rise to the top and get attention. And the fact that our financial (and political) world is led by people who largely, were risky and lucky, is a really bad structural problem.

Posted by Tony V | December 29, 2007 6:55 PM

A lot of hedge funds that were run by poseurs relying on leverage to boost returns have gone out of business this year. But there is a subset of hedge fund managers who have long track records of posting market-beating returns, and some of them charge a lot more than 2-and-20. Steven A. Cohen of SAC Capital, for example.

"Steve - If Harvard and Yale consistantly beat the market - then there is a probability that that they will eventually have a bad year that more than makes up for the good years - Say if the markey goes down 10, they may go down 25."

I wouldn't hold your breath waiting for that to happen. Look how Harvard's and Yale's respective endowments performed in 2002, when the S&P 500 was down ~22%.

Posted by Fred | December 29, 2007 7:02 PM

Fred - you illustrate my point - Every year that goes by that shows Harvard and Yale beating probabilties, just means that you get closer to the year of reckoning.
The one year anecdote is meaningless substance - wise (unless you can explain what it was about their portfolio that was so wise and so rare). But as time passes - things correct.

Posted by Comment | December 29, 2007 7:29 PM

Steve Cohen (SAC) may be the exception that proves the rule -

Posted by Comment | December 29, 2007 7:31 PM

It's the Federal Reserve, Stupid

Hedge funds use "transaction" and "bond" lawyers to game (up to and including looting) "commercial" and "investment" banks, but, also now, pension funds and public trusts, like university endowments or somewhat conspicuously, now, "money market funds" that "service" debt-ridden state and local governments.

These are all run by either politically adept or just sheltered members of the Anglo-American overclass, plus some "affirmative action" beneficiaries who provide racial cover for what are now, actually, Wasps, Irish or Italian Catholics, maybe a few Poles, and Jews.

They do not include politically idiosyncratic, not very well connected, or just indifferent but actual capitalists, like Buffett, Gates, or various Hunt and Bass brothers.

Osama bin Ladin, Soros, and Murdoch are interesting: They can game the gamers pretty well by being distant and cutthroat in politics and business.

Those individuals have to work every day either not getting killed, not losing money, or giving it away to pet causes, and have little time for our parasitical and dysfunctional Anglo-American political establishment.

Both the hedge funds and their "investors" are all "financial institutions" subject to being bailed-out by the Federal Reserve Bank, if and only if they are deemed "to big to fail" or just well connected, for instance, to the Bush family, other relatives of the British and Dutch Royal families, a medley of intelligence agencies, or either faction of the House of Saud.

Actually, while there are a few influential Jewish banking families here and there in all of that, in fact, the days of the Rothchilds' and so on ended in 1918.

So, under "Law & Economics" theory these are all an "industry" providing "financial services" in a "free market".

For the GOP, that is core doctrine for the economic liberal faction, and fits in somehow with core doctrines or fantasies of the Trotskyites, usually called "NeoCons", and Darbyites, claiming to speak for all Christians.

For the Democratic Party of Lawyers Mostly, "Law and Economics" is just utban (Chicago) myth and not very important compared to legal process and humbug that amount to procedurally complex, but also fee-based, political intermediation that has long since replaced "responsible, two-party government".

In any case, for the cornpone leadership of the Congressional Democratic Party all of the above are now contenders for "Hold Harmless" protection and whatever sort of legislation-for-hire the best grade of lobbyists and, now, "think tanks" are peddling with a "Jes' He'p Ever'body" pitch, you know, like how "Fannie", "Ginnie", and "Sallie" are helping poor, pitiful ... whatever, not simply enriching a politically-connected and now virtually entitled elite.

Jefferson or Hamilton would be aghast, for different reasons, but I do not see this pseudo-capitalist version of Soviet-style state capitalism -- now called "public/private partnerships" or "government-sponsored enterprise" -- ending until either the GOP or the Democratic Party purge their rotten, corrupt leadership -- bi-patisan concession-tenders.

I just wish it did not take nuclear terrorism or a global depression to force the Democratic Party, in particular, to rediscover republican and democratic principles, or as they are now dismissed by party leaders, "populis" rhetoric.

A "New Direction"? Humbug, it is all business-as-usual in Washington.

Posted by John Robert BEHRMAN | December 29, 2007 7:52 PM

It's the Federal Reserve, Stupid

Hedge funds use "transaction" and "bond" lawyers to game (up to and including looting) "commercial" and "investment" banks, but, also now, pension funds and public trusts, like university endowments or somewhat conspicuously, now, "money market funds" that "service" debt-ridden state and local governments.

These are all run by either politically adept or just sheltered members of the Anglo-American overclass, plus some "affirmative action" beneficiaries who provide racial cover for what are now, actually, Wasps, Irish or Italian Catholics, maybe a few Poles, and Jews.

They do not include politically idiosyncratic, not very well connected, or just indifferent but actual capitalists, like Buffett, Gates, or various Hunt and Bass brothers.

Osama bin Ladin, Soros, and Murdoch are interesting: They can game the gamers pretty well by being distant and cutthroat in politics and business.

Those individuals have to work every day either not getting killed, not losing money, or giving it away to pet causes, and have little time for our parasitical and dysfunctional Anglo-American political establishment.

Both the hedge funds and their "investors" are all "financial institutions" subject to being bailed-out by the Federal Reserve Bank, if and only if they are deemed "to big to fail" or just well connected, for instance, to the Bush family, other relatives of the British and Dutch Royal families, a medley of intelligence agencies, or either faction of the House of Saud.

Actually, while there are a few influential Jewish banking families here and there in all of that, in fact, the days of the Rothchilds' and so on ended in 1918.

So, under "Law & Economics" theory these are all an "industry" providing "financial services" in a "free market".

For the GOP, that is core doctrine for the economic liberal faction, and fits in somehow with core doctrines or fantasies of the Trotskyites, usually called "NeoCons", and Darbyites, claiming to speak for all Christians.

For the Democratic Party of Lawyers Mostly, "Law and Economics" is just utban (Chicago) myth and not very important compared to legal process and humbug that amount to procedurally complex, but also fee-based, political intermediation that has long since replaced "responsible, two-party government".

In any case, for the cornpone leadership of the Congressional Democratic Party all of the above are now contenders for "Hold Harmless" protection and whatever sort of legislation-for-hire the best grade of lobbyists and, now, "think tanks" are peddling with a "Jes' He'p Ever'body" pitch, you know, like how "Fannie", "Ginnie", and "Sallie" are helping poor, pitiful ... whatever, not simply enriching a politically-connected and now virtually entitled elite.

Jefferson or Hamilton would be aghast, for different reasons, but I do not see this pseudo-capitalist version of Soviet-style state capitalism -- now called "public/private partnerships" or "government-sponsored enterprise" -- ending until either the GOP or the Democratic Party purge their rotten, corrupt leadership -- bi-patisan concession-tenders.

I just wish it did not take nuclear terrorism or a global depression to force the Democratic Party, in particular, to rediscover republican and democratic principles, or as they are now dismissed by party leaders, "populis" rhetoric.

A "New Direction"? Humbug, it is all business-as-usual in Washington.

Posted by John Robert BEHRMAN | December 29, 2007 8:06 PM

damn, Mr. Behrman, that was the damnedest blog comment I think I've ever read.

Posted by Bill | December 29, 2007 8:07 PM

Let's look at the risk-reward on this asinine example a little closer, shall be? The investors are investing $100 million in a fund that has a 90% chance of making the investors an annual return of about 9% and a 10% chance of losing everything.

Foster and Young think the investors are "thrilled" at this??? You've got to be joking. Junk bonds have a 1% default rate, not a 10% rate. And you can easily find something paying higher than a 9% coupon.

Posted by Al | December 29, 2007 9:16 PM

It's worth bearing in mind that not all hedge fund have the same goals. Some take a lot of risk and try to knock the cover off the ball. Others just try to hit singles consistently without striking out. See, for example this investor presentation (PDF) by Fortress Investment Group, a publicly-traded alternative asset manager. Their hybrid hedge funds are "Targeting risk free rate [i.e., the rate on Treasuries] plus 5% to 10% net".

Posted by Fred | December 30, 2007 12:19 AM

This article is bullshit. I am a CAIA charterholder and a CFA charterholder. The CAIA is mostly risk management for hedge funds.

These guys are really misguided and while they correctly identify that many managers are overpaid, they don't use the correct supporting arguments, namely that most money managers don't do anything that is worth $100s of millions of dollars. They are conflating the risks that are going to break the system right now (counterparty and model risks) with strategy risk.

This is a CYA article. These guys should have been screaming from their perch 1 year ago that the CDS models used to value positions have fundamental flaws. Instead, they are writing about strategy risk and manager overpayment in the middle of the greatest financial crisis of the last 50 years.

Posted by mickslam | December 30, 2007 10:47 AM

If they had been screaming from their tiny perch at the nominally 'liberal' Brooking's a year ago they would have lost that perch. No, it would not have been published. Nobody except the nutjobs on the internets could question the emperors clothes. It simply wasn't done and for the most part still isn't.

Even here we hear that a 9% coupon is easy to find despite the fact that trillions of dollars have been 'invested' in CDO's of variouis and sundry types from mortgages for overpriced homes to under financed consumers and speculators. Receivables on guitars from slackers at Guitar Center and boob jobs for depressive aspiring starlets and no doc used car loans for sparsely employed alcoholics. All at a point and a half or so over Treasury paper, quite a bit south of 9%. A claim having little to do with hedge funds per say but everything to do with the conventional wisdom desperately being coined as smoke starts pouring out of the 700 story derivatives tower (Mark To Market)

Low risk 6% real returns have always been difficult to get. For the average schmuck under Greenspan they were lucky to get 1%. So the oligarchs with their new found tax savings turned to highly leveraged arbitrage strategies and dressed it up as 'investment' in 'hedge' funds. While Greenspan was essentially correct that those taking on the risk could afford it what he forgot to mention is there was a huge increase in systematic risk.

He still doesn't get it which is pretty funny because he doesn't have a pot to piss in. When he was made Fed Chairman he had a consultancy, with no clients. (A real Libertarian test case. A failure made king of money) Now he has to shill his book after all the easy money has been made and all the rest of us will pay the price.

Posted by rapier | December 30, 2007 11:48 AM

I've never seen a good explanation of how they beat the market consistently.

My take on it is this: the returns on "the market" are artificially depressed because of all the poor money managers out there. Thus, "beating the market" is simply a matter of doing better than most of the incompetents whose job is to sell mutual funds, not create market-beating returns.

The Harvard and Yale endowment managers are incredibly value-obsessed and simply pursue better investment strategies than most mutual fund managers and individual investors, who are too emotionally involved in their investments, or legally bound to illiquid investments through their 401(k) that put too much money in their own company's stock.

Predicting that the Harvard and Yale endowments are going to have a bad year much worse than everyone else is like predicting that a champion marathon runner is going to come in at last place sooner or later because "his day of reckoning is coming."

If you're curious what the endowment managers themselves think, you could just read Yale's Chief Investment Officer's book on the issue.

That said, I just didn't like the op-ed's straw man example. The problems with hedge funds are the following-- the incentive for making a risky bet and succeeding: getting millions of dollars in bonuses. The consequence for making a risky bet and failing: losing your job and being forced to find a new one from the thousands of new hedge funds out there. So there's not really a huge downside. What normally causes hedge funds to go bust is that the managers have a bad model of volatility that doesn't expect that certain benchmarks of the market (say the spread between different types of bonds) will be very wide. In a time of economic disturbance, such as now, those models go out the window, and all of the carefully-balanced hedging the hedge fund managers did ends up collapsing, and the fund goes bust.

Losing millions of dollars for the investors but just forcing the managers to write up a new prospectus to investors looking for someplace to park their money.

Posted by Tyro | December 30, 2007 12:10 PM

Well,

May I chime in here a little bit? Is the hedge fund a scam, or is the obscene payments to these managers the scam? I predict that the aftermath of this will be a return to more normal payment patterns, as many of these $100 million net asset value investors are going to be a bit more picky than they were. The fact is that many of these high net-worth investors were basing their analysis in part on the rating agencies, which completely misjudged the risk related to the debt related securities that hedge funds loved (due to the seemingly impossibly juxtaposition of low risk but high returns).

What is going to happen is that sanity will come to the hedge fund market, and the fees paid will both be lower due to both the fact that investors are going to question the wisdom of these maestros as well as the fact that most hedge fund manager currently do not have an angle from which to justify their huge fees.

One last interesting tidbit is where will hedge funds start to invest. Sadly, just as America is reeling from this asset devaluation, any investor in their right mind is going to invest not in America, but now overseas. This is the entire “economies are local” issue. Where is the investment in the US which will spur us out of this recession going to come from? What investor is going to invest in plants, factories or R&D centers here in the United States? Folks – China and India are sucking up the influx of capital which used to spur our economy out of recessions.

And if you really think of it, our entire economy since the 90’s has been propped up by little except speculative financing and leverage. We no longer invest in long-term productive assets which provide economic stimulus and are self-reinvesting long after the initial financiers have left the building.

Can someone tell me what is going to get us out of this recession/depression we are heading into?

Posted by Brad | December 30, 2007 12:15 PM

John Lanchester's piece in the LRB -- partly on the housing crunch, partly on Northern Rock's run, partly on risk instruments, partly on City culture -- is well worth reading.

Posted by pseudonymous in nc | December 30, 2007 12:52 PM

Errrr, Foster and Young's example is deeply incorrect -

1. their price for highly unlikely (deep out of the money) options is probably quite a bit too high. Remember, there are counterparties buying the option on the other side who don't want to overpay for the insurance.

2. Obviously, luck is very helpful. If you can consistently - whether through luck or skill - write derivatives that you never have to pay off on, you'll do extremely well. But it's fairly easy for investors to begin to understand whether it's luck or skill. As an investor (yes, I used to analyze investments in hedge funds), you start probing what the manager did in difficult situations. You start asking what the research and risk analysis programs are. You talk with their previous employers about how they dealt with historic bad situation X or Y or Z. Now, statistically, there must be a certain percentage of investment managers who suceed, even over extended periods, solely due to luck. That's why investors in hedge funds nearly always have a portfolio of ten or more funds (on top of holdings in other asset classes).

You never do know whether it's all luck or skill - but you start to develope your own opinion (just like with any other human endeavour).

3. Risk-adjusted returns. You don't even need to be able to calculate alpha any more - it's standard in the hedge fund databases.

Posted by burritoboy | December 30, 2007 2:03 PM

The returns on financial speculation are in total dependent upon the supply of money available to bid up the prices of that paper. It must be stipulated that huge quantities of debt paper had the quality of moneyness, that being it were highly liquid and their 'value' went unquestioned. In that sense the party is already over for the speculative mania in paper assets.

The Fed certainly cannot fill the breach. after 95 years the Fed has monetized about $800 billion. Currently there is several trillion dollars worth of impaired or worthless debt sitting on the books. Much of it that only months ago was considered as good as money and now is untradeable and unpriceable. .Some of that paper is sitting on the books of hedge funds marked to market at 100% of value when in actuality it worth 50% and some is worthless. Some of it is not worthless if the 'insurance' backing it is good, but it isn't. The great bond insurers are essentially bankrupt. Other hedge funds are counterparties to default swaps and the equity they have to back up their obligations is their investors money.

There is no mystery as to why Wall Street has been awash with riches while Main Street is just limping along throughout the entire post 2001 recession period. It is because their money supply, M3 money has exploded and the near money not counted in M3 has not just exploded in quantity but gone nuclear. All that 'money' was highly liquid debt paper and now it has stopped being liquid. When looked at in total there are obvious Ponzi elements to the whole thing. More debt is required to pay off old debt and an increasing quantity is need to mask the losses of past debt gone bad.

This is all over. Hedge funds were just a symptom of a systematic change that was and is objectionable on very traditional grounds of what is proper 'investment' and what is fiduciary responsibility. Tradition was thrown overboard so the few could gain stupendous wealth while the nation dis saved and most citizens pay stagnated.

Make no mistake, wealth redistribution, to the top, was a deliberate strategy that was realized with the assent of both political parties and the entire establishment. To a large degree the strategy is universal among all elites from here to Moscow to Peking. While American liquidity and really solvency is in question the flood of money worldwide is still huge and could mitigate the bad outcomes here. Only to the extent however of abandoning all pretense that American corporations, especially the Wall Street giants are 'american' in any sense but the geographical.

Posted by rapier | December 30, 2007 4:01 PM

Well, I admit I've never even taken a single class in economics or finance, but offhand Rapier's analysis of the situation seems extremely plausible to me.

Here's a related matter. Most of the biggest investment banks (Goldman being the leading exception) have already reported staggering losses on bad derivative paper, with apparently much more still to come. These publicly banks are subject to very strict reporting scrutiny.

Meanwhile, almost none of the biggest hedge funds have reported any similar losses. Where they *all* smarter than then smartest investment banks, even though you'd expect them to be taking even bigger risks? Or is it just that they're more easily able to manipulate "mark to market" accounting, so as to at least delay their horrific "day of reckoning"?

Posted by RKU | December 30, 2007 5:31 PM

rapier,

I agree they would have lost their jobs, but does that excuse them at all? Really at some point professors of statistics needed to be heard from, they weren't and now we are as a society, to put it mildly, fucked, as you put so well in your most recent comment. It's going to be a long 5 yearsof transition, but when we come out of this, the world is going to be a better place, and humans will experience unprecidented wealth.

"Where they *all* smarter than then smartest investment banks, even though you'd expect them to be taking even bigger risks? Or is it just that they're more easily able to manipulate "mark to market" accounting, so as to at least delay their horrific "day of reckoning"?"

oh hell yeah, this is going to happen and be very bad. For a while I thought it would be Bear to go under, but it is probably going to be Merrill.

Posted by mickslam | December 30, 2007 9:08 PM