Spero Consulting

Archive for October 8th, 2008

From Big Bets Come Back to Bite Fund Man­agers in today’s Heard on the Street sec­tion of The Wall Street Jour­nal:

“To wit, a bas­ket of stocks most pop­u­lar among hedge funds tum­bled 19% in Sep­tem­ber, more than the 9% drop for the Stan­dard & Poor’s 500, accord­ing to Gold­man Sachs.”

We doubt that early Octo­ber has been any kinder.

We don’t want to make too much out of a sin­gle month’s or sin­gle year’s results or a sin­gle fund’s mis­for­tunes, but we are won­der­ing: were gains in past years due to sheer genius or were they due to the (equity) funds being invested in a highly-​leveraged man­ner, in a rel­a­tively sta­ble (low volatil­ity) envi­ron­ment, dur­ing a period of gen­er­ally increas­ing stock prices cou­pled with a period of very low bor­row­ing costs? (Whether such posi­tions were con­structed directly in stocks or options or other deriv­a­tives is irrelevant.)

We don’t fol­low hedge fund mar­ket­ing very closely, but we doubt that any fund claimed such a strat­egy, i.e., “we’re going to take your money, lever­age it as much as we can, take a bet, and hope for the best.” In which case, it would seem that “hedge” is defined as “speculation.” 

We’re also won­der­ing how many wealthy, “sophis­ti­cated” investors would have invested were such schemes explained in such an explicit, straight-​forward man­ner rather than via the var­i­ous sell­ing pitches used to appeal to the pseudo sophisticated.

Nei­ther the (1) frequency of trades, (2) exclu­siv­ity of the pro­pri­etary algo­rithms, (3) level of automa­tion, (4) speed of exe­cu­tion, nor (5) even the vol­ume of ‘tude exuded seems to have mat­tered. At the end of the trad­ing day, it is dif­fi­cult to not to be either long or short or lev­ered or not, and recent returns pro­vide evi­dence that despite all the machi­na­tions and claims to the con­trary, the de facto fund posi­tion was long and (highly) levered.

As the chair­man asks, aren’t the funds, their man­agers, and their infra­struc­tures still in place today? Why don’t we see out-​sized (pos­i­tive) returns now?

By the way, regard­less of the strat­egy, we’re not talk­ing about how inter­nal mod­els or investor reports show flat­ness to the mar­ket, etc., we’re talk­ing about real life, which is much more dif­fi­cult to accu­rately quan­tify. (Please see our dis­cus­sions of nedges and sledges for more on this topic. We’re also in the midst of writ­ing Hedg­ing the Pen­ny­wise and Pound-​Foolish Way, which dis­cusses the myopic and nar­row focus of hedg­ing tac­tics. Also, please see our essay on uncer­tainty man­age­ment for our broader per­spec­tive in the area.)

So for all the hyper-​frenetic, high fre­quency trad­ing, etc., many equity funds seem to pro­vide noth­ing more than a volatile play on the equity mar­ket – not exactly our def­i­n­i­tion of “hedge.” 

Then again, many fund man­agers received HUGE rewards on the upside and faced lim­ited losses on the down­side; so, they seem to be much bet­ter pro­tected. Oh, we get it! Never mind. We see why they’re called hedge funds. It is for thee, not me.

How­ever, an uncer­tainty remains: were fund man­agers try­ing to fool investors or were they just fool­ing themselves?

Now Lend and Shut-​up, Mr. Fed Chairman!

Tonight, The Wall Street Jour­nal reports that the Fed Will Lend Directly to Cor­po­ra­tions. They mean the Fed­eral Reserve will lend to non-​financial corporations.

This is the first sen­si­ble action that we’ve seen any­one in the fed­eral gov­ern­ment take since the finan­cial cri­sis began. No, we’re quite seri­ous. The Pres­i­dent, Con­gress, the Trea­sury, the Fed: all dis­as­ters: seem­ingly ner­vous and clue­less but with­out the good sense to hide either emo­tion from each other or from the Amer­i­can people. 

We’ve argued that the ridicu­lous bailout plan will fail. (See almost any­thing we’ve writ­ten in the past sev­eral weeks.) We also think that the Sep­tem­ber panic-​speeches of Bernanke and Paul­son were equiv­a­lent to shout­ing “Fire” in a the­ater, and if Pres­i­dent Bush had any remain­ing inter­est in the coun­try or econ­omy, he would have fired Paul­son and asked Bernanke to resign for their shame­ful behavior.

This evening we just fin­ished writ­ing Even a Per­fect Bailout Will Fail. In it and many of other recent posts, we men­tion that the prob­lem is the banks and the banks, alone. That prob­lem is the gen­eral and jus­ti­fi­able lack of con­fi­dence in them, includ­ing – or should we write espe­cially – their lack of con­fi­dence in each other is the prob­lem. Even if all the bad assets were exchanged, would the reader trust the banks and their management’s?

Reg­u­lar read­ers will note that for quite some time, we’ve been ask­ing why the losses seem so con­cen­trated? The short answer is that they seem con­cen­trated because they are con­cen­trated. Lax man­age­ment begat poorly-​structured incen­tives, which begat exces­sive risk-​taking, which begat risk con­cen­tra­tion, which begat the mas­sive losses. (Those who would argue that such rea­son­ing is faulty – and there are some – would have to claim that the finan­cial firms are vic­tims of very, very, bad luck, but there doesn’t seem to be much evi­dence of that.)

As far as we can tell, it is not the rest of the econ­omy – not yet, at least. There are areas of the coun­try that have been over­built, and cities like Char­lotte and New York will suf­fer because they rely so heav­ily on the banks and the finan­cial ser­vices indus­try for income, spend­ing, and taxes, but in many places the econ­omy has been remark­ably resilient. 

We see the panic-​speech and a lack of a clear artic­u­la­tion of (1) the prob­lem, (2) the place­ment of blame, and (3) the pro­posed solu­tion and how it would work as the largest prob­lems fac­ing the gen­eral econ­omy, and we see it as the rea­son why the Dow has lost over 1,400 point since the plan was approved. At best we can hope that our politi­cians and gov­ern­ment offi­cials shut-​up before they can cause too much harm.

So, we applaud the Fed, the lender of last resort, for ful­fill­ing its mis­sion and act­ing rather than talk­ing. Banks are the prob­lem, and this lat­est action avodis them and goes directly towards mit­i­gat­ing the prob­lem. By the way, new read­ers may be inter­ested in our alter­na­tive bailout plan: A Bet­ter Solu­tion (than a gov­ern­ment takeover).