Tom Wolfe in his 1980s best-seller, The Bonfire of the Vanities, described investment bankers as “the masters of the universe”. That description was soon outdated in the 1990s because hedge fund managers assumed the mantle. Just consider two simple facts. In 1990, hedge managers managed assets worth $39 billion. At the peak of 2007, the figure had grown to a staggering $3 trillion. Equally staggering is the amount of money successful hedge fund managers earned in 2008, the top 10 more than $10 billion between them. Quite clearly, the returns hedge funds make can be substantial, given the high fees they charge for services rendered. But there was a downside — the losses can be substantial too — as some discovered in the credit crunch market upheaval that started in 2007. But in the swings and roundabouts, hedge funds became the “In” thing if you were looking for a “gravy train” as Sebastian Mallaby tells us in his definitive work drawn from insights into higher mathematics, economics and psychology in More Money than God: Hedge Funds and the Making of a New Elite (Bloomsbury/Penguin India, Special Indian Price, Rs 599).
Begin from the beginning. While most people have heard how much hedge fund managers have made, very few are clear what they are or what they do. To get a hang what the game is about, it is best to start with Philip Goggan’s Guide to Hedge Funds: What they are, what they do, their risks, their advantages (Profile Books, Indian reprint 2011, Rs 295). Coggan, who was the economics editor with The Economist and earlier with the Financial Times, has covered the fundamentals in six easy-to-read chapters: Hedge Fund Taxonomy; The Players; Funds-of-funds; Hedge fund regulation; Hedge funds: For or Against; and The Future of Hedge funds. Of course, More Money than God covers the same ground too, but this is an easier read and once you have grasped the rules of the new game, Mallaby’s big tome becomes that much simpler and enjoyable.
Mallaby has written the book for a wide range of readers, from hedge fund managers and finance professors to the intelligent common reader interested in markets, economics and finance.
The story begins with Alfred Winslow Jones, an eccentric who at different times in his life worked on a tramp steamer, studied at the Marxist Workers School in Berlin, a friend of Ernest Hemingway and other outsiders. Like many top hedge fund managers, Mallaby tells us that Jones didn’t learn the ropes at Goldman Sachs or Morgan Stanley, did not go to business school, nor did he have a PhD in quantitative finance. What he did have, however, was an unerring instinct for money like all successful fund managers possessed.
Jones launched the fist “hedged fund” meant to use leverage to enhance equity exposure along side short sales to protect one’s downside, and he first conceived the concept of “performance fee” whereby his fund would keep for itself 20 per cent of the profits. Mallaby tells us with his fund’s returns at 5,000 per cent, investors didn’t mind parting with 20 per cent of the profits. Many commentators today feel that 20 per cent is too high a fee to be paid but Jones quite rightly believed that the anticipation of substantial returns would concentrate the minds of portfolio managers. Besides, Jones argued that “performance fee” was an expense and could be written off against the profits; others like Mallaby think it is a tax dodge. Jones’ performance-fee innovation still forms the basis for the hefty returns of hedge fund managers.
With Jones as the introduction, Mallaby provides a continuous history of investment vehicles which he calls “loners and contrarians”, the very “individualists whose ambitions are too big to fit into established financial institutions”. These individuals can’t be tied down by regulations and red tape. They defy the conventional wisdom about efficient markets and could be described as “edge funds” for their managers offer investors returns uncorrelated with the markets.
Mallaby explains that markets are efficient only if the liquidity is perfect; and when liquidity is not perfect, markets can be highly dicey or fickle. Mallaby takes the case of Steinhardt who offered liquidity where it didn’t exist, especially when it came to a large block of shares. He was able to negotiate discounts in return for liquidity which eventually returned to his original investors 480 times their initial investment. Fund managers can do this but only if they have a large amount of cash to play around with; if they don’t have a fall-back strategy, it is simply not possible to achieve such high returns.
Mallaby’s story of the Hungarian immigrant George Soros is inspiring, considering that he started off in London as a busboy and once told by the head waiter at a restaurant that if he worked hard he would some day be his assistant. Soros made it to the London School of Economics and although he didn’t do well academically, he learnt that markets were anti-efficient and that it was possible to make money by trading on faulty human reasoning.
Hedge funds have sometimes been described as “casino capitalism”, that success depends on the luck of the draw. But it is also a play on the vagaries of the human mind which Mallaby’s story-telling brings out beautifully.
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