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More Money Than God: Hedge Funds and the Making of a New Elite (Council on Foreign Relations Books (Penguin Press)) Paperback – May 31, 2011
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I set out to write the history of hedge funds for two reasons. Explaining the most secretive subculture of our economy posed an irresistible investigative challenge; and the common view of hedge funds seemed ripe for correction. Hedge funds were generally regarded as the least stable part of the financial system. Yet they managed risk better than banks, investment banks, insurers, and so on—and they did so without a safety net from taxpayers.
Four years on, the book is done; and both my original motivations have been vindicated. Unearthing the story of hedge funds has been pure fun: From the left-wing anti-Nazi activist , A. W. Jones, to the irrepressible cryptographer, Jim Simons, the story of hedge funds is packed full of larger than life characters. Getting my hands on internal documents from George Soros’s Quantum Fund; visiting Paul Tudor Jones and reading the eureka emails he wrote in the middle of the night; poring over the entire set of monthly letters that the Julian Robertson wrote during the twenty year life of his Tiger fund; interviewing Stan Druckenmiller, Louis Bacon, and hundreds of other industry participants: my research has yielded a wealth of investment insights, as well as an understanding of why governments frequently collide markets. Meanwhile, the financial crisis of 2007-2009 vindicated my hypothesis that hedge funds are the good guys in finance. They came through the turmoil relatively unscathed, and never took a cent of taxpayers’ money.
Since the book has come out, many readers have posed the skeptical question: Do hedge funds really make money systematically? The answer is an emphatic yes; and without giving the whole book away, I can point to a couple of reasons why hedge funds do outsmart the supposedly efficient market.
First, hedge funds often trade against people who are buying or selling for some reason other than profit. In the currency markets, for example, hedge funders such as Bruce Kovner might trade against a central bank that is buying its own currency because it has a political mandate to prop it up. In the credit markets, likewise, a hedge fund such as Farallon might trade against pension funds whose rules require them to sell bonds of companies in bankruptcy. It’s not surprising that hedge funds beat the market when they trade against governments and buy bonds from forced sellers.
Second, the hedge-fund structure makes people compete harder. There is an incentive to manage the downside: hedge-fund managers have their own money in their funds, so they lose personally if they take losses. There is an incentive to seek out the upside: hedge-fund managers keep a fifth of their funds’ profits. This combination explains why hedge funds were up in 2007, when most other investors were losing their shirts; it explains why they were down in 2008 by only half as much as the S&P 500 index. People sometimes suggest that hedge funds survived the subprime bubble by fluke—perhaps their ranks include wacky misfits who are naturally contrarian. But there is more to it than that. John Paulson poured $2 million in the research that gave him the conviction to bet against the bubble. The hedge-fund structure created the incentive to make that investment.
Financial risk is not going away. Currencies and interest rates will rise and fall; there will be difficult decisions about how to allocated scarce capital in a sophisticated and specialized economy. The question is who will manage this risk without demanding a taxpayer backstop. The answer is hiding in plain sight: To a surprising and unrecognized degree, the future of finance lies in the history of hedge funds.--Sebastian Mallaby (Photo of Sebastian Mallaby © Julia Ewan)
From Publishers Weekly
Journalist Mallaby (The World's Banker) gives unusually lucid explanations of hedge funds and their balancing of long and short positions with complex derivatives, but what really entrances him is their freedom from regulation, high leverage, and outsized performance incentives. In his telling, they empower a heroic breed of fund managers whose inspired stock picking, currency trading, and futures contracting outsmart the efficient market. In engrossing accounts of epic trades like George Soros's 1993 shorting of the pound sterling and John Paulson's shorting of subprime mortgages, the author celebrates hedge titans' charisma, contrarianism, and market insights. Mallaby contends that hedge funds benefit the economy by correcting market anomalies; because they put managers' money on the line and are small enough to fail, they are more prudent and less disruptive than heavily regulated banks. Mallaby's enthusiasm for an old-school capitalism of unfettered risk taking isn't always persuasive, but he does offer a penetrating look into a shadowy corner of high finance. (June)
Copyright © Reed Business Information, a division of Reed Elsevier Inc. All rights reserved. --This text refers to an out of print or unavailable edition of this title.
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Top Customer Reviews
Hedge funds are defined by four characteristics: they stay under the radar screen of regulatory authorities; they charge a performance fee; they are partially isolated from general market swings; and they use leverage to take short and long positions on markets. Most importantly, in a financial system riddled with conflicts of interests and skewed incentives, hedge funds get their incentives right. As a result, according to Mallaby, they do not wage any systemic threat to the financial system, and they may even provide part of the solution to our post-crisis predicament.
The first set of well-aligned incentives deals with the issue of ownership. Hedge fund managers mostly have their own money in their funds, so they are speculating with capital that is at least partly their own--a powerful incentive to avoid losses. By contrast, bank traders generally face fewer such restraints: they are simply risking other people's money.
Partly as a consequence, the typical hedge fund is far more cautious in its use of leverage than the typical bank. The average hedge fund borrows only one or two times its investors' capital, and even those that are considered highly leveraged borrow less than ten times. Meanwhile, investment banks such as Goldman Sachs or Lehman Brothers were leveraged thirty to one before the crisis, and commercial banks like Citi were even higher by some measures. As Mallaby notes, hedge funds are paranoid outfits, constantly in fear that margin calls from brokers or redemptions from clients could put them out of business. They live and die by their investment returns, so they focus on them obsessively.
The second set of incentives deals with how hedge funds operate. They are usually better managed than investment banks. Their management culture tends to encourage team spirit and collaborative work as much as individual performance. Alfred Winslow Jones, the originator of the first hedge fund and the "big daddy" of the whole industry, invented a set of management tools and compensation practices to get the most from his brokers and managers. These innovations quickly paid off: whereas investors usually waited for company filings to arrive in a bundle from the post office, Jones' employees were stationing at the SEC's offices to read the statements the moment they came out. At a time when trading was considered a dull, back-office task, not something that a brilliant analyst would get involved with, Michael Steinhardt, another pioneer of the industry, would sit on his own trading desk and initiate the trading of large blocks of stocks with the seniority to risk millions on his personal authority.
Other funds introduced a more scholarly approach to management. At the Commodities Corporation, which combined econometric modeling and chart reading, anyone who blew half of his initial capital had to sell all his positions and take a month off. He was required to write a memo to the management explaining his miscalculations. At LTCM, John Meriwether recruited young PhDs and encourage them to stay in touch with cutting-edge research; they would visit finance faculties and go out on the academic conference circuit. At Renaissance Technologies, the holding company of the flagship fund Medallion, Jim Simons gathered a team of mathematicians, astronomers, code breakers and computer translation experts that were so well ahead of the curve that they gave up reading academic finance journals altogether. Their office spaces bore signs claiming that "the best research never gets published" and papers explaining "why most published research findings are wrong".
Hedge funds have a powerful incentive to improve upon existing knowledge, and market practitioners have often been ahead of academic theorists. They poked holes in the efficient-market theory long before the hypothesis came into disrepute among researchers. As Mallaby notes, innovation is often ascribed to big theories fomented in universities and research parks. But the truth is that innovation frequently depends less on grand academic breakthroughs than on humble trial and error--on a willingness to go with what works, and never mind the theory that may underlie it. A.W. Jones, the founder of the industry, had anticipated the rules of portfolio selection before Harry Markowitz formalized them in 1952. By the time William Sharpe proposed a simple rule for calculating the correlation between each stock and the market index in 1963, Jones had been implementing his advice for more than a decade.
The most important set of incentives is that hedge funds are not too big to fail, and therefore they do not cast systemic risk over the stability of the whole market. The great majority of hedge funds are too small to threaten the broader financial system. They are safe to fail, even if they are not fail-safe. There is no precedent that says that the government stands behind them. Even when LTCM collapsed in 1998, the Fed oversaw its burial but provided no taxpayer money to cover its losses. By contrast, the recent financial crisis has compounded the moral hazard at the heart of finance: Banks that have been rescued can be expected to be rescued all over again the next time they blow up; because of that expectation, they have weak incentives to avoid excessive risks, making blowup all too likely.
According to Mallaby, some of the perverse incentives that banks face come from regulation. Rather than running their books in a way that rigorous analysis suggests will be safe, banks sometimes run their books in a way that the capital requirements deem to be safe, even when it isn't. By contrast, hedge funds are in the habit of making their own risk decisions, undistracted by regulations and the false security provided by credit ratings. As a result, the hedge fund sector as a whole survived the subprime crisis extraordinarily well. By and large, it avoided buying toxic mortgage securities and often made money by shorting them.
As Mallaby shows, hedge funds are a diverse lot. Following the fall of Askin Capital Management in 1994, George Soros declared to a Congress hearing that "there is as little in common between my type of hedge funds and the hedge fund that was recently liquidated as between the hedgehog and the people who cut the hedges in the summer." Nowadays hedge funds operate in merger arbitrage, long/short equity investing, credit arbitrage, statistical arbitrage, subprime assets, and all the other segments of market investment. And yet hedge funds have been equally vilified, mostly by people, institutions, and countries that stand at the other end of their investment strategies. Conversely, as Mallaby notes, "the countries that like hedge funds the best are also the ones that host them." One may also conjecture that countries that use hedge funds for their sovereign wealth investments will also develop a liking for them, as did universities endowments and other institutional investors looking for higher returns.
I read this book after a series of popular essays on financial markets and the recent subprime crisis. I have no direct knowledge of the hedge fund or banking sector, and no practical experience of portfolio management. The names and faces of the people presented in the picture portfolio were all unfamiliar to me, with the possible exception of George Soros. More Money Than God therefore provided a useful introduction to a set of financial institutions that often appear collectively in the news, but that are not commonly analyzed as distinct managing entities or put in a historical perspective. Sebastian Mallaby revisits key episodes of recent financial history, from the Black Monday market crash of October 19, 1987, to the breakup of the sterling peg in 1992, the attacks on the Thai baht during the Asian crisis of 1997, the LTCM collapse in 1998, and the less well-reported quant quake of August, 2007.
As of the debate whether hedge funds should be regulated or not, although I tend to err on the side of regulation in general terms, I must confess that Mallaby presents cogent arguments, and I am convinced that his voice will have to be reckoned with in future discussions on the matter.
The book is very current (as of May 2011) mentioning even Raj Rajaratnam in an example of insider trading. Mr Rajartnam was just convicted in the past few days.
The last chapter (conclusion), however, falls off of the cliff entirely. It is completely out of line of the rest of the book, as he is making a case for some (but not much) regulation of hedge funds. Any intelligent reader of the previous 16 chapters would find this unnecessary. (That is why this gets a 4 star, really)
The reader is introduced to various legends of the industry like George Soros and Stan Druckenmiller as well as to Julian Robertson (Tiger), Paul Tudor Jones, the Commodities Corporation, Citadel, Jim Simons and others, as well as also to some hedge-fund implosions of Long Term Capital Management, Amaranth, etc. and to the bankruptcy of Bear Stearns and Lehman Brothers. Also some short sellers like Jim Chanos and David Einhorn are mentioned. Of course, there are many top guys missing, and the words SAC (Cohen) and ESL (Lampert) or Blackstone are only in the text without any details, ... and there's no mention whatsoever of Cerberus, BlackRock, Icahn, Apollo, etc.
One thing I didn't like in the book, was that quite some time was spent on George Soros, probably due to the author's background, ... but at least Soros wasn't portrayed as the hero/savior he holds himself so often out to be, but instead the author also shows the reality of the very dark side of Soros and it makes you dislike the guy even more.
But the book is an essential book and an absolute "MUST" read for every trader and money manager, and for everyone working at a hedge fund. Not only is the book interesting for a general reference for an overview of the evolution of hedge funds, but also the various trading techniques, and also about the fact that each superstar hedge-fund manager/trader in his time is just human and has made major mistakes along the way costing them at least many hundreds of millions and even billions of dollars. Some traders will get additional confirmation that they're on the right track with their strategies, even though they'll have to fight the same "demons" like everyone else in the biz, ... and others will get a good thought here and there and most likely will be able to improve on their strategies, to fine tune them and to become even more successful in their approach.
The author has a good categorical and chronological approach as well a rare somewhat easy recap feature so that the reader understands the whole picture and understands the rich substance of the context rather easily. There's also extensive and helpful appendix and index. Although I've read thousands of books and have written a number of books myself, I haven't found many good books over the past few years, but I can say that I'm glad that I've come across this book and I think it will be very beneficial to every reader interested in the subject. You could say that the book is even inspiring to those who are interested in this field. I would have given it almost five stars, but because major players were left out I couldn't go for the five, and if there was the possibility of 4 1/2 stars this book would have well deserved it.