A Billion Here, a Billion There

Fun with hedge funds: "JWM Partners LLC, the investment firm run by ex-Long-Term Capital Management LP chief John Meriwether, lost 24 percent in its $1 billion fixed-income hedge fund this year through March 14, according to two people with knowledge of the matter."

This reminds me of a parable I'm stealing from someone else but I don't recall who that is. Imagine I find a kind of gambling machine somewhere that works kinda sorta like an enormous roulette wheel. It has 100,000 possible outcomes, and on 99,999 of those outcomes it pays off at a 1:1 ratio. But on the 100,000th outcome, you lose at a 1:300,000 ratio. Obviously, placing a bet on that machine would be foolish. But suppose instead I set myself up as a financial assets manager. People invest money with me, I "invest" it for them by betting on the machine, and then I take 15 percent as my management fee. Well, the odds are that for a while I'll be earning a good return for my investors. I'll get a reputation as a genius. The volume of assets under my control will skyrocket, and with it my management fees. And then one day we hit the whammy and everyone loses everything. Except me -- I've already pocketed all the management fees I need.

I mean, if I did that once, nobody would be crazy enough to help me start up a second hedge fund, right?

UPDATE: I should say that, naturally, to make this work in practice you'd have to come up with something a bit more complicated so that your clients don't understand the risks involved. You need to convince them that there are all these really impressive mathematical models that they don't quite understand but don't really want to admit they don't understand lying underneath the whole thing.

Comments

The best exposition of that idea was Andrew Lo's paper where he talked about "Capital Decimation Partners".

But really, that analogy applied much better to the stuff that happened with Long Term Capital Management and some similar examples over the past few years. Due diligence by hedge fund investors is supposed to prevent it, but can't always.

In contrast, I think what's happening now was pretty well understood in advance. Real estate couldn't go up forever. But if you could offload your rotten mortgages in some fancy security you'd have pocketed the bonus before it all went south.

Posted by mq | March 19, 2008 5:26 PM

I love the Meriwhether schadenfreude here. "When Genius Failed" is a great book tracing the rise and fall of LTCM. In the epilogue, it talks about Meriwether shopping around a prospectus for his new hedge fund. Everyone had lost everything, and Meriwether was going around trying to find new investors for his next venture.

The funny thing is that JWM was doing the exact same thing that LTCM did-- looking for spreads in related bonds and making leveraged arbitrage bets that those spreads would converge. This works until it doesn't (ie, the roullette wheel lands in the wrong place), and then it implodes.

I suppose it worked out for the investors who managed to make sufficient gains over the years to cover the recent losses, but still-- the investors had to know that this system would break eventually, in the same way that these systems always break. I just hope they can get their money out before it's all gone.

Posted by Tyro | March 19, 2008 5:29 PM

I believe that the issue here is that it's difficult to determine the exact ratios.

Consider the reverse: 299,999 times it pays 1:1, and 1 in 300,000 times it lose at a 1:100,000 ratio. In this case playing the wheel is rational over the long term-- you lose a lot of money when you lose, but overall you win.

Anything resembling insurance exhibits this behavior-- and both LTCM and JWM use strategies known as "short vol", or essentially selling insurance against financial crises. Insurers lose a ton of money when disasters hit (take a look at the losses suffered after Katrina or Andrew); the trick is to collect enough in premiums in the good times to make up for the downturns. LTCM effectively made the mistake of not having the cash on hand to pay its creditors when the "storm" (the Asian financial crisis) came, to complete the analogy.

JWM Partners is in more-or-less the same business, but it's run at lower leverage (they keep more cash). From what I understand of JWM Partners' performance, their initial investors are still well more than whole for their investments. So from the investors' perspective, while there will be concern, I doubt they're particularly surprised.

Posted by David | March 19, 2008 5:36 PM

to summarize tyro's point and steal a phrase from someone else: JWM was picking up dimes in front of a steamroller.

This is his third major blowup (salomon, LTCM, and now JWM). I wonder if he can double his assets next time. He is a one-man value destroyer.

Posted by mike c | March 19, 2008 5:39 PM

"I mean, if I did that once, nobody would be crazy enough to help me start up a second hedge fund, right?"

On the contrary, many hedge fund managers have failed spectacularly in the past and have been given new funds to run. In fact, in your own post you mention John Meriwether as an example, and there are plenty more if you look.

Posted by minderbender | March 19, 2008 5:51 PM

Matt,

What you are trying to articulate was better explained by Martin Wolf in today's Financial Times: "Why today’s hedge fund industry may not survive". One bone to pick: he gives Taleb too much credit. The concepts of skewness and kurtosis have been used to describe different investment return patterns for at least the last few years.

Re When Genius Failed: one point the book was clear on was that when LTCM was about to collapse, the geniuses were fairly sanguine about it. Even though they would lose their assets, they knew they had 7-figure gigs in their future, in the worst case.

Posted by Fred | March 19, 2008 5:55 PM

It has 100,000 possible outcomes, and on 99,999 of those outcomes it pays off at a 1:1 ratio. But on the 100,000th outcome, you lose at a 1:300,000 ratio. Obviously, placing a bet on that machine would be foolish.

Seriously? Placing a single bet on that machine would be foolish? Damn, you are one incredibly risk averse fool.

Do you ever fly in an airplane? Ride in a car? I suspect those activities pose at least a 1 in 100,000 risk of death or serious injury, whereas your hypothetical gambling machine only costs you some big bucks, but doesn't take your life. The remainder of times, it makes you some cash money.

Fool.

Posted by WTF?? | March 19, 2008 6:19 PM

I should also use this opportunity to note that as far as books about LTCM go, "Inventing Money" is better than "When Genius Failed." Though part of this opinion of mine is based in the fact that when I say "better" what I mean is "more math and rigorous explanations."

Which, I should also note, is why "Linked" is better than "The Tipping Point."

Posted by Tyro | March 19, 2008 6:20 PM

Saw a reference to a George Ure comment about his lawyer telling him that Bear Stearns handed out BILLIONS in bonuses in January. And now that they're been bought out, instead of going bankrupt, they won't have to pay those back.

So the guys who engineered the collapse walk away with a "golden parachute" paid for by the US taxpayer.

Not only that, they'll get MORE when the money from the bail out package is distributed.

Bank robbery was never this good, I can tell you. And none of these assholes will ever see the inside of a Fed cell.

Posted by Richard Steven Hack | March 19, 2008 6:21 PM

People invest money with me, I "invest" it for them by betting on the machine, and then I take 15 percent as my management fee. Well, the odds are that for a while I'll be earning a good return for my investors.

Got to love Matthew - always looking out for the rich investors!

Meanwhile, actual hedge fund investors do NOT just look for a "good return" - they look for a good risk-adjusted return. The risk-adjusted return Matthew is offering is obviously very bad, not good.

But I don't think Matthew understands what a risk-adjusted return is. Certainly not, if his posts are any indication of his understanding.

Posted by Al | March 19, 2008 6:26 PM

This reminds me of a parable I'm stealing from someone else but I don't recall who that is.

I know! I know!

The Red-and-Black Fund

That's what I get for making fun of Matt's Harvard philosophy degree...

Posted by RKU | March 19, 2008 6:29 PM

Also have a look at John Kay's column which Martin Wolf references:

Mr Buffett’s fortune has come not through growing an investment management business, but from his own share in the value of the funds he manages. Suppose he had adopted a more conventional investment management structure, charging the 2 per cent management fee and 20 per cent of performance common in private equity and hedge funds. How much of that $62bn wealth would have been the property of Buffett the manager – Buffett Investment Management – and Buffett the investor – the Buffett Foundation?

The answer is astonishing. At “2 and 20”, the split is $57bn for Buffett Investment Management and $5bn to the Buffett Foundation. The effect of compounding at 14 per cent, rather than at 20 per cent, is to reduce the accumulated pot by over 90 per cent. Of course, it is unlikely that Buffett Investment Management would have reinvested in its own funds sufficiently to have grown $57bn of assets. There would have been bonuses to pay. And the birthday parties! Eat your heart out Steven Schwarzman: Omaha would never have seen anything like it.

Posted by Lance Knobel | March 19, 2008 6:40 PM

http://en.wikipedia.org/wiki/Parable
http://en.wikipedia.org/wiki/Analogy#Rhetoric

and yeah, i'm not gonna run the math on this, but i'm pretty sure the upper limit for the number of spins to make this a bad bet is pretty high, if it even exists at all.

Posted by ...grumble... | March 19, 2008 6:51 PM

Inventing Money is much much better than When Genius Failed. One of the great short nonfiction books -- sort of the anti Taleb.

Posted by david | March 19, 2008 6:54 PM

Al,

"But I don't think Matthew understands what a risk-adjusted return is."

I don't know whether Matt understands that either, but I'm not sure how relevant it is here: the standard measures of risk-adjusted returns (e.g., the Sharpe ratio) are all based on past returns. This is a case where the math, and Modern Portfolio Theory, can both obscure more than they illuminate. You could have run a highly-leveraged hedge fund that produced equity-like returns for several years (e.g., 12%, 9%, 15%, etc.), and it's risk-adjusted returns would have looked great according to the usual metrics. An analyst crunching the numbers on its returns would have told you that. A better sense of risk would have come from a critical examination of its strategy.

Posted by Fred | March 19, 2008 7:01 PM

but I'm not sure how relevant it is here: the standard measures of risk-adjusted returns (e.g., the Sharpe ratio) are all based on past returns.

But here, in this post, Matthew is talking about a roulette wheel. We don't need past returns to calculate the expected risk-adjusted returns of a roulette wheel, all we need is simple math. And using simple math, we know that the risk-adjusted returns Matthew is offering are negative.

Posted by Al | March 19, 2008 7:16 PM

Doesn't anyone remember that John Meriwether was in the middle of the Salomon Brothers blow up in the late 80's/early 90's?

Posted by Joe Klein's conscience | March 19, 2008 7:18 PM

As regards the roulette example: Gamblers do actually do such things (risk ruin for little gain). There's a popular gambling technique (I forgot its name) wherein, if you lose the first time, you keep doubling your bet until you pull even. And then start all over again. In theory you can't lose with that technique: if you play 10 cents and win (for example you bet on heads and heads it is), you win a dime. If you lose, you play two dimes, then four, then eight, until finally you win and wipe out all your losses. But that's presuming that you have unlimited capital. I wonder how many people have used this technique to win a few dollars, and instead lost all they had.

Posted by Hans B | March 19, 2008 7:26 PM

"Also have a look at John Kay's column which Martin Wolf references"

Prior to Berkshire Hathaway, Buffett's predecessor investment vehicle was the Buffett Partnerships. His fee structure was this: 0% on any annual returns below 6%, and 25% on returns above that.

In his book The Dhando Investor, in which he distilled the wisdom gained from his 8-year second career in investment management, thirty-something Buffett-wannabe Mohnish Pabrai mentioned how he copied this fee structure. "Heads I win, tails I don't lose too much," was the motto behind Pabrai's "low risk, high uncertainty" investing strategy. Presumably following this strategy, he bought mortgage lender Delta Financial Corporation at $9 per share, then doubled-down at around $5 per share last August, after the sub prime crap had hit the fan and the securitization market for mortgages (that stand-alone lenders like DFC depend on) had seized up. "DFC" used to be Delta Financial's stock symbol, btw. Now it has a few more letters: DFCLQ.PK

Posted by Fred | March 19, 2008 7:32 PM

Al:

But here, in this post, Matthew is talking about a roulette wheel. We don't need past returns to calculate the expected risk-adjusted returns of a roulette wheel, all we need is simple math.

Well, obviously!

So you just spend an extra few million buying a whole lot of fancy computers and also some Harvard MBAs to talk a blue streak about gammas, upsilons, and neutrinos---and maybe a few Harvard Philosophy majors as well!

Basically, if you actual honest-to-goodness historical returns are good enough and consistent enough, and your "market strategy" sounds complex and confusing enough, do you think many investors will be scared away?

Superduper-complexifying your fundamentally very simple "investment" strategy is the easiest piece of the business...

(And I'm pretty sure Meriwether was head of the Salomon division that blew up in the 1990s Treasury-squeeze scandal and basically took the whole firm down with it, and was one of the first people fired).

Posted by RKU | March 19, 2008 7:35 PM

"We don't need past returns to calculate the expected risk-adjusted returns of a roulette wheel". True, not since probability was invented. I was referring to the case of actual hedge funds.

"And I'm pretty sure Meriwether was head of the Salomon division that blew up in the 1990s"

Yes, Meriwether was at Saloman during the Treasury scandal. And Buffett (who was an investor in Saloman) was brought in to clean up the mess. See Carol Loomis's Fortune article on this, reproduced here.

Posted by Fred | March 19, 2008 7:49 PM

Hans,

That is why Casino's have table limits, the system doesn't work then. Take BlackJack at a $5 table with a $100 table limit. Lose once double to $10, lose again double to $20, lose again double to $40, lose again double to $80, lose that one and you are hosed. 5 losses in a row isn't at all unrealistic.

Posted by Eric k | March 19, 2008 8:02 PM

I lived on John Street (lower Manhattan) during the early 80's when the go-go times met with new entertainment development on Fulton. On weekends it was not uncommon to see fistfights (embarrassing ones) between young, suited, and drunken new traders. The times in the financial markets were very heady. Young graduates were making serious money and huge bonuses.
Now, zoom forward 25 years and those kids, now with gray temples, are the leaders of vaunted trading, banking and bonding companies. This is their time. They finally hold the keys to the place.
Oh, a book was written about those go go times.
It was called Bonfire of the Vanities.

Posted by carsick | March 19, 2008 8:49 PM

Smart investment strategies will lose money sometimes. This doesn't necessarily make them super-crazy, manipulative, and high-risk.

For example, the crazy hedge-fund wizard strategy known as "buy and hold Microsoft shares" has paid off pretty well over most time frames. But in 2000, it would have seen roughly a 50% decline in value.

The totally roulette-wheel risky play called "buy and hold GE" would have lost about 30% of its value from August 2000 to August 2001.

Merriwether's fund lost 24% of its value in the past few months. "Buy and hold a set of blue chip stocks mirroring the Dow", which is about as conservative a play as you can get, would have seen a similar decline in a similar time frame from March 5 to Oct 4 2002.

This is the deal. You get equity-like returns only if you're willing to accept short-term losses like these from time to time. If that's too risky for you, buy T-bills. But don't call the people who get you those return fraudsters. They may be, but usually they're not.

Posted by Andrew Edwards | March 19, 2008 9:02 PM

----- I should say that, naturally, to make this work in practice you'd have to come up with something a bit more complicated so that your clients don't understand the risks involved. You need to convince them that there are all these really impressive mathematical models that they don't quite understand but don't really want to admit they don't understand lying underneath the whole thing. -----

Someone should spraypaint this on the ceiling above Kevin Drum's bed.

Cranky

Posted by Cranky Observer | March 19, 2008 9:11 PM

EDIT:

JWM's hedge fund Jan 1 to March 12 2008: -24%
NASDAQ Jan 1 to March 12 2008: -18%

Posted by Andrew Edwards | March 19, 2008 9:14 PM

Matt--
This is a really stupid metaphor.

Posted by Rice | March 19, 2008 9:54 PM

Bravo Andrew Edwards

It's easy to be smug and glib when someone who is ordinarily sucessful loses lots of money

People keep investing with Merriwether and similar managers because over the long haul they make much more than they lose - much more

So fool mentioned the "Salomon Brothers blowup" previously. There was no loss of money, there was a "scandal" - tempest in a teapot is a more apt description - that had to be one of the most hyped nonevents in the past 30 years. A trader bid more than his allotment of Treasury bills (snooze) and the management did not report fast enough to please the Giuliani/Spitzer types that are on the prowl in lower Manhattan. What a joke.

There is a cherished belief among leftists that nobody ever makes money by being smart or good at something (well, Oliver Stone maybe) so when things like this happen it only confirms lunatics' prior perceptions. Read "How We Know What Isn't So" (a psych prof from Cornell wrote it) for an exegesis on how people selectively choose observations to reinforce their illusions. Merriwether or Soros could make astronomical returns over decades but small minded people will look at the bumps in the road and say. "yep, he's no better at that than me, he was just lucky"

Posted by Jozef | March 19, 2008 10:00 PM

I like you guys. Really. Rarely do I have a chance to listen in around the water cooler.
What I don't understand about all of this is why anyone would agree to loan anyone else 99 times their assets. Say I come to you with a dollar, and ask for 99 to place a bet. Why would you say yes?

Posted by jay Dwight | March 19, 2008 10:31 PM

I'm glad to see that our friend "Jozef" is keeping his spirits up considering that his employer Bear, Stearns just disappeared, and his accumulated life savings' in Bear stock lost about 99% of its value. Since he'll now have much more time on his hands, we'll probably see his comments much more frequently!

And don't fret Jozef, you'll still have your Social Security checks to keep you in nutritious dog-food once when you get a little older.

Meanwhile, here's a simple arithmetic problem to keep your mental skills sharp. Which of the following investments produces a higher total after five years:

3% x 3% x 3% x 3% x 3% (stupid bank CD)

30% x 30% x 30% x 30% x -97% (genius-level super hedge-fund)

Posted by RKU | March 19, 2008 10:48 PM

I should say that, naturally, to make this work in practice you'd have to come up with something a bit more complicated so that your clients don't understand the risks involved. You need to convince them that there are all these really impressive mathematical models that they don't quite understand but don't really want to admit they don't understand lying underneath the whole thing.

Gee, you mean if you commit fraud, you might be able to bilk people out of their money?

Genius, Matthew! Pure genius! I'm sure nobody ever thought of that before!

Meanwhile, actual, legitimate hedge funds are required to disclose their risks to their investors.

Posted by Al | March 19, 2008 11:20 PM

I have to agree with you on this one, Al.

This analogy to hedge funds doesn't work, thus the update. What's the point? He could have just said "Dumb people shouldn't buy hedge funds" and left it there.

Posted by AKBY | March 19, 2008 11:46 PM

Al will be living under a bridge next week, if he really believes what he just posted.

Posted by Richard Steven Hack | March 19, 2008 11:46 PM

RKU,

The problem with your example (and with Matt's for that matter) is twofold.

The most basic is that it doesn't come close to describing how managed investments operate. (Expected annual returns are always greater than 0)

The more fundamental is that when Murphy's Law bites a trader in the ass, this doesn't mean that his actions were fraudulent. It doesn't even mean that his fund was a bad investment from a probabilistic perspective.

An investment strategy functions essentially as a random walk. And for any random walk, no matter how skewed the probabilities are, and any value you specify, there is always a non-zero probability that the walk will fall below that value. This is called "gamblers' ruin", but it applies to any business that makes money off of the odds.

Return to Matt's example again, but this time have let's go with something a bit more realistic:

For every dollar of your own you put in, you can borrow a matching dollar to invest.

Now, in a given year, you will earn 30% on your investment 9 times out of 10, or you may lose half 1 time out of 10. If you can keep the account afloat, your long term annual return is 18%. Which is pretty good.

However, if you are unlucky, and have bad years too close together, then you may end up with an account worth less than your outstanding debt. At this point, there's a good chance your bank will demand it's money back, leaving you flat broke, even though your expected return was quite high.

This is essentially what happened to Bear Sterns. It's not that their investments were in the long term poorly chosen. Rather, when the mortgage crisis hit, they found that their assets couldn't cover their liabilities, and their banks stopped lending them money. So "poof", no more Bear Sterns.

This distinction, between a poor expected return and a margin call, is missing from both your example and from Matt's. It is also, apparently, missing from your understanding.

Posted by heedless | March 20, 2008 12:01 AM

Thank you Jozef. To be fair I'd like to think that this has little to do with "leftism" (Guiliani is hardly liberal), and much more to do with a general lack of familiarity with capital markets among the "chattering classes".

In my personal view, the alpha captured by hedge funds could be taken as (one small piece of) evidence pointing to the sorts of market inefficiencies that, in different contexts, can justify state intervention. The analogy I'd make is that if you believe that the capital markets are inefficient enough for Bain Capital to generate meaningful alpha, you might be willing to believe that the market for retail health care is also inefficient in a way that shifts benefits ("creates non-systematic returns") from consumers of health care to HMOs, and you might be willing to see the government work to re-allocate that benefit. Especially if you believe that health care has larger moral component than wealth generation.

Also, feel free to ignore RKU.

RE: jay Dwight's question. It's a bit more complicated than that - you may have heard of a
"repo" loan, which takes as collateral the underlying security. Think of it like buying a house with 1% down. It's risky, but it's not totally unbelievable that a bank would do it - after all they get to seize the house if you default.

Posted by Andrew Edwards | March 20, 2008 12:01 AM

"An investment strategy functions essentially as a random walk."

In Burton Malkiel's theory, perhaps, but in real life, 'gambler's ruin' seems to be a risk inherent primarily in highly-leveraged investment strategies, not all investment strategies. I wouldn't hold my breath waiting for a fund run by un-leveraged value investors such as Bruce Berkowitz or Seth Klarman to go to zero.

Posted by Fred | March 20, 2008 12:28 AM

Ah yes, the alpha--the alpha! Everything is perfectly clear now--us silly chatterers don't appreciate or understand the alpha captured by hedge funds, or capital markets, at all--and clearly we should just shut up and let the really smart people like Andrew decide what, in the long term, is best for us all. Thanks for setting us straight, Andrew.

Posted by James Gary | March 20, 2008 12:31 AM

Hans,

It is called the Martingale Betting Strategy.

Posted by Dogwood | March 20, 2008 12:44 AM

in real life, 'gambler's ruin' seems to be a risk inherent primarily in highly-leveraged investment strategies

Again, Merriwether's hedge fund lost 24%, the NASDAQ lost 18% in the same period. It should be true that high leverage increases the risk of ruin, but "primarily" might be somewhat strong.

James Gary:

Sorry, I was being technical. Sarcasm wasn't needed but point taken. That's what I get for talking about this stuff in my daily life only with people with similar training to me.

"Alpha" refers to a concept in the Capital Asset Pricing Model (CAPM). It means, in the simplest terms, the returns earned by being a smart investor, above those earned simply by taking on more risk. If markets are truly efficient, it shouldn't exist. But it seems to exist. Which, in my view, may have political implications. Assuming I've clarified the words I was using, I'd be interested to hear what you thought.

If you re-read my post, hopefully you'll see that nothing in there said that everyone should just do what I tell them. Nothing in there even says that I'm sure I'm right about this. I deliberately chose language like "in my personal view"; "if you believe"; and "might be willing to believe". Sorry you took it as a fiat statement, it certainly wasn't meant to be one.

Posted by Andrew Edwards | March 20, 2008 12:53 AM

Everyone who invests money for a living, or for their own retirement account, has to be concerned with risk of ruin, leveraged or not.

Value investors can still lose it all, but not with the speed and spectacular economy-rattling effects of a highly-leveraged hedge fund.

Also, a 24-percent draw down isn't that spectacular if the fund's trading strategy is able to recover quickly once volatility settles down.

Look at some of the draw downs from Commodity Trading Advisers, some exceed 40 to 50 percent, but over the long-term their absolute returns smoke anything and everything available for the average retail investor.

Posted by Dogwood | March 20, 2008 1:01 AM

Fred,

You're absolutely right that gambler's ruin is difficult to achieve in investments if you don't leverage. (Mathematicians make careers, and occasionally fortunes, on theories of investment, so I hope you'll forgive me for the simplification)

The theory behind Bear Sterns style of investment is that they can hedge against risk sufficiently to permit them to leverage, and that investing with borrowed money will more than compensate for the lower rate of return that comes with the hedge.

Berkowitz, by contrast, can make more volatile (but higher return) investments because he doesn't have to worry about margin calls. Of course, he does still have to worry that his investors will pull out if he has a bad year.

(Please note that I'm not trying to imply that you don't understand this. You almost certainly understand it better than me. I'm just trying to show that I understand this, and hopefully not merely proving my ignorance)

Posted by heedless | March 20, 2008 1:03 AM

Just checked, the Nasdaq is down 23 percent from its November high.

Big swings are normal.

The key is, can the fund manager weather the difficult times until his strategy starts working again?

LTCM couldn't because leverage was way too high, cash was too low, and the Asian crisis so severe.

In short, they had no respect or fear for the risk of ruin, and investors paid the price. Hopefully, he has learned something since then.

Posted by Dogwood | March 20, 2008 1:09 AM

"So fool mentioned the "Salomon Brothers blowup" previously. There was no loss of money, there was a "scandal" - tempest in a teapot is a more apt description - that had to be one of the most hyped nonevents in the past 30 years. A trader bid more than his allotment of Treasury bills (snooze) and the management did not report fast enough to please the Giuliani/Spitzer types that are on the prowl in lower Manhattan. What a joke."

That's one way to put it. Another is that idiots at Salomon essentially gave the finger to the president of the New York Fed, after breaking federal laws and then concealing their law-breaking for four months. News of that caused the rest of the Street to rush to dump Salomon's short-term debt back on the highly-levered firm, leading to a liquidity crisis similar to the one at Bear last week. And then Buffett had to come in and clean up the mess so Salomon didn't evaporate like Bear Stearns, or worse, go bankrupt, leading to who-knows-what systemic disaster.

Posted by Fred | March 20, 2008 1:13 AM

Andrew,

"Again, Merriwether's hedge fund lost 24%, the NASDAQ lost 18% in the same period. It should be true that high leverage increases the risk of ruin, but "primarily" might be somewhat strong."

I'll happily stand by "primarily". The Nasdaq (which is an index and not an investment strategy unless you are some sort of EMT zealot) has never dropped to zero; neither has Berkowitz's Fairholme Fund. Merriwether has managed to go to that with a highly-leveraged fund.

A crucial point here, and this relates to Heedless's recent comment as well, is the different meanings of "risk" when the word is used by Modern Portfolio Theorist types (the same sort who are fond of "alpha" and "beta") and when it is used by value investors such as Berkowitz, Buffett, Klarman, etc. The MPT adherents equate risk to volatility; the value investors define risk as the permanent loss of principal.

In practice, the use of high amounts of leverage can turn volatility into permanent loss of principal. For example, consider Buffett's purchase of USG at $48 per share. He's down 27% now. That sort of volatility could lead to a permanent loss of principal in a highly-levered hedge fund. Buffett doesn't lose any sleep over it. He's confident that USG is intrinsically worth more than what he paid for it, and that its market price will eventually reflect this. If that turns out to be the case -- and he says that has been the case with all of his investments in publicly-traded stocks (he's had a few bad investments in private companies, e.g., Berkshire Hathaway) -- then despite the volatility there will have been no permanent loss of principal on his investment in USG.

Posted by Fred | March 20, 2008 1:43 AM

Heedless,

"You're absolutely right that gambler's ruin is difficult to achieve in investments if you don't leverage."

It's not just the leverage: for gambler's ruin to apply, long-term stock movements would have to be random. If Berkowitz & Co. thought that were the case, they would be doing something else for a living.

I understand mathematicians' fondness for those sorts of theories.

Posted by Fred | March 20, 2008 2:14 AM

Fred,

I have one quibble with your description of value investing. While Berkshire does not borrow against its own investments, the companies it owns do borrow against their future revenue. So while a 27% decline in the stock value of USG won't make Buffet lose sleep, a similar decline in its revenue stream could send the whole company into bankruptcy, at which point Buffet would either need to bail it out or see his entire investment vanish.

There is obviously much less risk of a complete collapse of the Bershire holding company, but if, say, Geiko goes belly up, Buffet and his investors will be out a considerable chunk of change.

This doesn't happen to Buffet very often (which is why he is so spectacularly rich), but then George Soros has yet to go bust either, and he does use highly leveraged investments.

Posted by heedless | March 20, 2008 2:22 AM

Fred, I think we almost completely agree with each other and are veering dangerously close to either a totally pointless semantic debate about "primarily" (my bad, I started it) or a wonderful but off-topic discussion of value investing.

Dogwood, I would note that JWM, though losing 24% of its value, does not seem to have blown up yet. If it continues to stay afloat, it will likely make some pretty awesome returns as spreads return to sanity over the next 12-24 months. In other words, risk grants reward.

Posted by Andrew Edwards | March 20, 2008 2:28 AM

Andrew,

"In my personal view, the alpha captured by hedge funds could be taken as (one small piece of) evidence pointing to the sorts of market inefficiencies that, in different contexts, can justify state intervention. The analogy I'd make is that if you believe that the capital markets are inefficient enough for Bain Capital to generate meaningful alpha, you might be willing to believe that the market for retail health care is also inefficient in a way that shifts benefits ("creates non-systematic returns") from consumers of health care to HMOs, and you might be willing to see the government work to re-allocate that benefit."

The alpha captured by hedge funds (or by mutual funds for that matter) relates specifically to inefficiencies in the market's pricing of securities; it has nothing to do with inefficiently-run enterprises, or the price distortions in health care that are largely the result of third-party payment systems and massive government involvement (e.g., Medicare funding and price controls on procedures).

Bain Capital is a private equity firm. It generates returns by (ostensibly) buying inefficient businesses, making them more efficient and more profitable, and then re-selling them (either via an IPO or to a larger company). Bain could make a hospital more efficient, presumably, but it would have no power to change the broader economics of the health care industry (e.g., third party payment, distortions due to Medicare policies, etc.).

Posted by Fred | March 20, 2008 2:31 AM

Quickly:

- BainCap's returns on public-to-private transactions with an IPO exit are germane to market efficiency and so to the point I was trying to make, but obviously didn't make all that well. BainCap was just the first firm that popped into my head when I fumbled around for "undisputed generator of alpha". Insert Citadel or Berkshire or whoever if that makes it easier.

- I just find it curious and inconsistent that a lot of the same people who swear up and down that you can get meaningful alpha in investing also swear up and down that super-efficient markets will cure all health care (or whatever) woes. I guess it's possible that capital markets are inefficient markets while retail ones are efficient, but I'd find that hard to believe. I always try to make this point and always seem to do it clumsily. It makes sense in my head, really it does.

Thanks for the great engagement.

Posted by Andrew Edwards | March 20, 2008 2:46 AM

Heedless,

"I have one quibble with your description of value investing. While Berkshire does not borrow against its own investments, the companies it owns do borrow against their future revenue."

A number do, that's true, and that's also true of some of Berkowitz's investments. I know they both have their own guidelines on what they consider excessive debt and stay within them.

"So while a 27% decline in the stock value of USG won't make Buffet lose sleep, a similar decline in its revenue stream could send the whole company into bankruptcy, at which point Buffet would either need to bail it out or see his entire investment vanish."

USG is nowhere near levered enough for a 27% revenue decline to send it into bankruptcy, but I get your point. And not being anywhere near as sophisticated an investor as Buffett or Berkowitz, when I invest in individual stocks I limit myself to those with no net debt. I figure that's one less thing to worry about, particularly when credit is hard to come buy. For example, the stock I mentioned on this blog on Tuesday, Perini Corp (PCR), has about half of its market cap in net cash.

GEICO is a different animal, as an insurance company: it gets its cash upfront and is able to invest the float; it doesn't need leverage.

It's worth quoting Seth Klarman's nuanced comments on the use of leverage here, from his speech last year at MIT:

When the herd is single-mindedly focused on return, prices are frequently bid up and returns driven down. This is particularly so when leverage is used. Leverage does not have to be dangerous. Non-recourse debt on an asset can serve to make a large purchase more affordable. Taking out a non-recourse loan on an already owned asset can actually reduce risk, since the borrowed funds become yours, while the risk of loss is transferred to the lender. But recourse debt is something else entirely. If you purchase some investments, and then borrow with recourse debt to buy more, you are now vulnerable to mark to market losses in what you own. Depending on the precise terms of the debt, a decline in the value of your holdings could force you either to put up more collateral—which you may not have—or to sell off some of the investments you purportedly like to meet margin calls. By borrowing, you have ceased to be the master of your own fate and allowed the lender—or actually the market—to be. How ironic to allow the market, which has dished up your current portfolio of opportunity, to dictate to you the need to sell your attractive holdings in order to survive.

The availability and use of margin or recourse debt is especially pernicious. Had you purchased an investment without leverage that declined in price, you could have used any available cash to buy more. Alternatively, you could sell another investment that did not decline or declined less to afford more of the now better bargains. This, in fact, is a healthy discipline, forcing you to choose among investments to own the ones you like best, and necessitating that you carefully decide when to hold onto cash and when to put it to work. Recourse leverage changes this equation, as you can seemingly own all the investments you want simply by borrowing to buy them. There is no healthy portfolio discipline enforced by the desire to make new purchases or the anticipation that you may want to. There is also a bit of a slippery slope in that if a little leverage is good, why isn’t more leverage better? When do you stop?

Posted by Fred | March 20, 2008 3:10 AM

Andrew,

Not to get too off topic, but I wouldn't claim that free market forces are a panacea for the high cost of health care: when you have highly-skilled labor prescribing drugs and using equipment that require years of R&D to develop, that's going to be expensive. I do fear the consequences of going from a health care system that's about half market-based to one that's almost entirely government-funded. My fear is that we'll end up with less innovation and any cost savings will come from rationing.

I still don't see the connection between the (sometimes) inefficient market for publicly-traded securities and the point you are trying to make about health care, but perhaps when you have more time you will be able to explicate it.

I've enjoyed the conversation as well.

Posted by Fred | March 20, 2008 3:31 AM

heedless,
Bear Stern's investments were not simply bad over the short term (i.e the mortgage backed securities simply showed a short term dip in value), but were risky bets even for the intermediate term, so it rightfully went belly up. I would be very curious to know why you think their investments were good over the long term.

Incidentally, please correct me if I am wrong but isn't the CAPM based on a least square fitting of the observed value of a portfolio to average returns, with the weights determined so as to minimize the residual (error)? This implies that the CAPM assumes that market fluctuations in value are uncorrelated, which makes no sense given the incidence of bubbles like the present housing bubble. This seems to be essentially the same as Fred's point about the alpha captured by hedge funds being driven by market pricing of securities.

Posted by krsa | March 20, 2008 6:00 AM

Your parable is excellent--thanks.

Posted by Chris Dornan | March 20, 2008 8:04 AM

People have studied the performance of hedge funds, and it turns out that overall they do indeed produce poor returns on a risk-adjusted basis, in part because of the exorbitant fees.

So, while I think Matt's analogy is obviously exaggerated, the fundamental point he is making is correct.

Posted by DTM | March 20, 2008 10:26 AM

And it has to have a good name.

Posted by Thomas Allen | March 20, 2008 11:18 AM

Andrew Edwards, Jozef, Heedless, Al, AKBY & Company:

Gee, you mean I really should NOT set up a giant hedge fund which annually bets its entire capital on a single fair spin of a Las Vegas roulette wheel?! Who'd-a thunk it!

For those reading this thread who are in the unfortunate category of "dims"---otherwise known as "Epsilon Minuses"---this suggestion of mine (which Matt picked up on) is what is known technically as a "thought experiment", namely an example which helps to clarify the dynamics of a particular system, in this particular case the world of hedge-fundery. If you've never heard of "thought experiments", maybe you should look them up.

The crucial point is that the incentive structure of current hedge funds would seem to massively benefit those managers whose "investments" are entirely random in nature, so long as the randomness follows certain general principles. And it's pretty trivial to convert any coin-flip randomness to the sort of randomness you'd need for a successful hedge fund "investment".

Now, obviously, fund-managers who actually bet their capital on truly random results might have a hard time pretending otherwise, and would therefore get into trouble either with their investors or with the law. But this can be easily avoided by replacing the random process with a "pseudo-random process", namely one whose deepest-level ultimate behavior is non-random, but which is effectively random in results at the level of granularity or understanding that we have.

For example, if you follow the doctrine of efficient-market theory---in which current equities reasonably incorporate all existing knowledge---most stock prices would be a pseudo-random variable and would follow a random-walk down Wall Street.

Now, admittedly, it's pretty hard to hire MBAs who can blow enough smoke to pretend that a single roulette-wheel spin can be a "brilliant investment strategy", but I'd argue they'd be fully capable of producing the verbiage to turn a pseudo-random process into one which is allegedly "somewhat predictable" over long periods of time. And the verbiage is all you really need, since you get rich even if the actual investment process results are truly random.

Anyway, I'm not in finance myself, so maybe all the brilliant self-described financial services investers challenging me on on this thread can reasonably explain the problem with my very simple analysis of hedge fund dynamics.

If not, then I'd suggest all the non-finance people reading this thread should get VERY scared at the sort of dimwits or swindlers running our financial sector, and should instead invest in gold bars buried in their back yards...

Posted by RKU | March 20, 2008 12:15 PM

Don't invest in gold bars in your backyard - that's super risky.

Posted by Kyle | March 21, 2008 5:45 PM