Sebastian Mallaby on Hedge Funds
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
ins, 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 ce 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
: 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)