In Praise of Hedge Funds?

The weekend edition of the Wall Street Journal featured a long article in defense of hedge funds as a stabilizer in our financial system.

Distilled to its essence, the article cites several features of hedge funds which contribute to healthy market dynamics and don't drain taxpayers.

Specifically, it notes that hedge funds, due to the owners/managers receiving a sizable share of the funds' profits, tend to: identify genuine profit opportunities which make positive, risk-adjusted returns; manage risk better than insured public financial entities; through their ability to short equities, contribute to pricing efficiencies; don't require nor expect public funds to rescue them from failure.

All these points are true. The one caveat comes at the end of the piece. Sebastian Mallaby, the author of the long editorial, contends that the average hedge fund is much less leveraged than the average bank. That may be true, but it's not the averages that should worry us.

Rather, as noted in my comments on Scott Patterson's recent book, The Quants, here and here, and a related post here, leverage and risk management are the Achilles Heels of these outfits.

In this later post, I describe Larry Kelly's risk management theorem, derived from Shannon's information theory. Ed Thorp, the godfather of the modern quants, mentioned so lavishly in Patterson's book, revered Kelly and his Criterion. Kelly's Criterion is absolutely crucial in its focus on risk management via bet size.

None of this made it from Thorp to his progeny, nor, really, into Patterson's book. Patterson mentions Kelly in an aside so vague it originally escaped my attention. Luckily, a retired Bell Labs colleague lent me Poundstone's tome on Kelly.

It's leverage that makes otherwise-reasonable strategies toxic. Especially when, as Patterson did emphasize, several large hedge funds are pursuing the same instruments and investing with similar strategies.

As I've written in earlier posts, blame the lenders, usually commercial banks, for not adequately supervising hedge fund positions and risks. Blame the hedge fund managers for being ignorant of Kelly's work.

Mallaby's lengthy ode to hedge funds is sensible until that last, fatal passage about leverage.

If too much capital is employed, and leveraged up, by several investors, into the same positions, that, in itself, makes for an inefficient, risky market. With today's lightning-fast trading systems, it's virtually impossible for all that capital to exit without losses. Those losses then magnify the downward price spirals in the markets for the affected instruments.

I'm not at all sure that most of the offending hedge fund managers who came so close to death prior to the TARP's rescue learned anything. In Mallaby's ideal world, they would have been wiped out, and more prudent hedge funds would have, in a Darwinian consequence, survived to expand and fill the vacant market niches.

But that's not what happened. So it's debatable whether, in even today's environment, nearly two years later, large, highly-leveraged quantitative hedge funds are a benefit to our financial system.

Mallaby didn't explicitly endorse the quants, but most of his modern examples were quantitative funds. And it is precisely this variety which is vulnerable to such large, immediate losses from over-use of leverage.