Author
Sebastian Mallaby
Year
2010
Review
Earlier this year, I read "The Power Law" because the history of venture capital is closely related to my industry's history. I enjoyed learning about a non-traditional asset class, and this book came highly recommended, so it seemed worth a shot. "More Money Than God" tells the history of hedge funds, how they work, and how they have evolved over time. I was seeking to extract some general principles, of which there were only a few. For the uninitiated, the book does a good job of recounting the noteworthy and transitional moments of the industry.
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Key Takeaways
The 20% that gave me 80% of the value.
- Theoretically hedge funds can outperform traditional money managers by taking less risk
- To do so, they need to be able to find under valued and over valued stocks (something efficient money hypothesis would say isn’t possible)
- How they might position:
- 1.5x leverage to buy undervalued good quality stocks
- Short over-valued bad quality stocks
- They look for asymmetrical risk
- Betting against a currency peg, it either holds, or goes in your direction. It’s unlikely to go in the other direction. So you can take a large position with relative safety.
- Larger funds find it harder to deploy capital quickly without moving markets. But they size can be helpful if you’re trying to deplete the reserves of a central bank whilst betting against a currency peg, or if you’re an activist investor
- Early hedge funds had a history of being the first to adopt new types of information collection and prediction. E.g. paying observers to visit coco plantations to see how the crop is developing
- The best hedge fund managers seem to be capable of reversing their position quickly. Able to ride a momentum trade up and down. Or if they realise they’re wrong, reverse a position entirely.
- Knowing everything about a just a small number of companies isn’t a winning strategy. You can only make big money when there’s volatility. So you have to know a little about a lot, and play where the volatility is
- The art isn’t seeing the crash, it’s picking the right moment. Feeling the mood change.
- Hedge fund managers look at second order consequences, and try to understand what people will do next
- Hedge funds can move the market, and they use that to their advantage
- Pile on with all you’ve got when you’re sure and you’re onto something
- Risk to reward ratio. Central banks are a gift, they’re powerful and predictable.
- High interest rates in Germany would force a devaluation of other currencies.
- On the day the pound was valued, the BoE had bought £1B before lunch. Soros became known as the man who broke the BoE
- Currency pegs were too vulnerable. One sided asymmetric bets were possible.
- Hedge fund fee structures
- Generation 1 · 20% of profits (Jones era)
- Generation 2 · 1% management fee + 20% of profits
- Generation 3 · 2% management fee + 20% of profits (Steinhardt era)
- Short-selling activism approach: Dig up bad news, take a position, talk about it.
- Long-activism approach: buy a stake, demand a change in strategy, talk about it gain support
- Replace CEO if you can
- Diversification doesn’t magic risk away. There often both hidden correlations and obvious correlations that are ignored (think how mortgages were bundled before 2007/8 crash)
- Assessing risks based on the past doesn’t prepare you for things that haven’t happened
- Soros and Druckenmiller originally lost money betting against the 2001 bubble, but they decided to trade with the momentum (despite not believing in the fundamentals) and rode the wave upwards
- Event driven hedge funds trade events (like takeovers). They can find themselves owning illiquid assets though
- Hedge funds with illiquid assets look stable, as they are the ones reporting the book value of their investments. It can make their risk adjusted returns look great, but they won’t report on the hidden volatility. In a crisis their value falls quickly
- In times of turbulence, animal spirits were more important. You need to weight ‘sentiment’ more and be able to shift modes. In stable times, arbitrage was better. In unstable times, following the trend is better.
- ‘It’s easier to focus if you don’t go home’ a quote from Jeff Bezos when he worked at a quant hedge fund
- Leverage accelerates upward quickly as you start losing and bets go against you
- If a fund has $100 to support $800 of positions (8:1)
- A 5% loss leaves it with $60 and $760 of positions (12:1)
- Everything becomes illiquid in a crisis. Nobody wants to buy anything at any price. Only the safest and most liquid assets are desirable
- I like the way a hedge fund manger thought about a chain of cascading probability…
- 50% chance of Morgan Stanley collapse → if that went down 95% chance Goldman would go → if Goldman went Citadel would go (because the trade unwinding would ruin their positions) !
- During the financial crisis… the FSA banned short selling of 23 financial firms, and the SCC banned short selling of 300 companies.
- If people think you’re company is failing, there’s almost no way to get good news out. If you book a call - the market will assume it’s bad news
- HedgeFunds needed both leverage and short selling. In a financial crisis, nobody wants to give you leverage, and the government can ban short selling of financial stocks
- HedgeFunds were getting privileged information and getting in trouble. Discarding burner phones was a regular occurrence
- HedgeFunds are generally small enough to fail, so they’re a good place for economies to put their risk
- It’s sensible to drive risk into firms that are small enough to fail (hedge funds).
- What makes risk? 1) Short term borrowing 2) Holding illiquid things
- What determines systematic risk of a hedge fund?
- Size of capital + leverage + markets operate in (liquid / illiquid)
- If you’re measuring the performance of all hedge funds, you have to take into account survivorship bias (they return 7.7% after fees, a chunk of which is ‘Alpha’)
Deep Summary
Longer form notes, typically condensed, reworded and de-duplicated.
- Why hedge funds?
- Theoretically they can outperform traditional money managers by taking less risk
- To do so, they need to be able to find under valued and over valued stocks (something efficient money hypothesis would say isn’t possible)
- How they might position:
- 1.5x leverage to buy undervalued good quality stocks
- Short over-valued bad quality stocks
- They look for asymmetrical risk
- Betting against a currency peg, it either holds, or goes in your direction. It’s unlikely to go in the other direction. So you can take a large position with relative safety.
- The dynamics of investment change as the size of your fund grows (the amount of money you have to put to work)
- It becomes harder to deploy capital quickly (without moving markets)
- But size can be helpful too → if you’re trying to deplete the reserves of a central bank betting against a currency peg, or if you’re an activist investor
- Early hedge funds had a history of being the first to adopt new types of information collection and prediction.
- For example… paying observers to visit coco plantations to see how the crop is developing
- Predicting the weather to better predict harvests
- Using early computers to calculate correlations between stocks for the first time
- The best hedge fund managers seem to be capable of reversing their position quickly
- In two different ways…
- When they realise their initial position is wrong, and reversing it
- When they ride something to the bottom, and then bet on it to go back up if it looks like it went too far
- Knowing everything about a just a small number of companies isn’t a winning strategy
- What happens if they are stable?
- You need to know a little about a lot, so you can play where there’s going to be volatility and opportunity
- Jones bet the 1987 crash all the way down. He then bet that the Fed would intervene. It was asymmetric at that point. If they did he’d profit if they didn’t then the position wouldn’t move
- The HF managers that had come from the equities world did less well in the 1987 crash. They’d done lots of research on their stocks and struggled to let them go. The new HF managers were more agile and ready move, and faired better
- The art isn’t seeing the crash, it’s picking the right moment. Feeling the mood change.
- There are hidden patterns in human behaviour.
- Traditional Fund managers react differently to crashes at different times of the year. Fall earlier in the year and they might go to bonds to get their return
- Hedge fund managers look at second order consequences, and try to understand what people will do next
- Jones was self aware, thought about second and third order consequences of his trades
- Jones could move the market, and used that to his advantage.
- He’d build a position slowly - then double down on it making a bunch of noise
- The brokers and traders would then react, making it a reality
- The more powerful and well known he became, the more influence he had
- Druckenmiller joined Soros at Quantum. Came from a stock picking background. Style was about meeting people and to get an advance warning. Technical analysis, to see when market would correct.
- Pile on with all you’ve got when you’re sure and you’re onto something
- Risk to reward ratio. Central banks are a gift, they’re powerful and predictable.
- High interest rates in Germany would force a devaluation of other currencies.
- Known as the sterling trade. Druckenmiller bought German Currency and shorted Lira and sterling.
- Describing the risk...
- He would lose 0.5% if wrong, but win 15% if it broke out.
- Thought the probability of a breakout in the next 3 months was 90%
- The BoE only had £44bn in reserves, which limited their upside an informed the size of the position they’d need to take
- They outmatched the BoE. The bank announced an additional $700m of support, but they’d just taken a position as big as that against the currency, and they weren’t the only ones.
- Soros sold sterling to everyone, the pound was knocked out of the band
- On the day of the collapse, the BoE had bought £1B before lunch. They called the PrimeMinister to raise interest rates (2%). The pound didn’t respond. John Major said (3%) raise for the next day, the pound didn’t respond
- The BoE spent £27B. Quantum had sold £10B. Soros made more than £1B.
- Soros became known as the man who broke the BoE
- Quantum would go on to repeat the same trick and earn $1B from Swedens devaluation
- Currency pegs were too vulnerable. One sided asymmetric bets were possible.
- Steinhardt was a shadow bank. Loaned short and borrowed long. He leant out every $1 one hundred time, 10x more than normal banks
- In 1992 the number of HedgeFunds went from 1000 to 3000.
- Hedge fund fee structures
- Generation 1 · 20% of profits (Jones era)
- Generation 2 · 1% management fee + 20% of profits
- Generation 3 · 2% management fee + 20% of profits (Steinhardt era)
- Hedge fund bets were getting so big, they were making markets really unpredictable for central bankers. Their actions had unintended consequences. If they all needed to sell at the same time, there would be no liquidity and shocks would happen . All made worse by leverage and brokers enforcing margin calls on everyone
- Getting big enabled Soros hedge funds to take down currency pegs by outgunning central banks… but get too big and you couldn’t make the same return on the fund and had to find more opportunities
- Thailand defended against Soros and Drunkenmiller, used 2/3 of their war chest. They raised interest rates and liquidity went down. Eventually they collapsed and Soros made $750m
- They would lose $800m on an Indonesia play
- Diversification doesn’t magic risk away. There often both hidden correlations and obvious correlations that are ignored (think how mortgages were bundled before 2007/8 crash)
- Assessing risks based on the past doesn’t prepare you for things that haven’t happened
- Long term capital management couldn’t exit their trades, everyone knew what they were doing, followed them in, so there was nobody to sell to
- Tiger nearly lost out on a big trade against the yen … as banks went against them causing them huge losses. When seeing a big spread though, Tiger realised that liquidity was drying up, they doubled down and turned the tide….
- Technology bubble 1990s.
- The market can stay irrational longer than you can stay
- The 2001 tech stock bubble
- Soros and Druckenmiller originally lost money betting against the bubble, but they decided to trade with the momentum (despite not believing in the fundamentals) and rode the wave upwards
- The Dotcom bubble wiped out Tiger
- Event driven hedge funds would trade events (like takeovers)
- These funds could have high returns but could also find themselves owning some pretty random assets and could fall foul to local market traps and nuances of industries they didn’t fully understand.
- Illiquid assets bring opportunity and risk in equal measure
- Hedge funds with illiquid assets look stable, as they are the ones reporting the book value of their investments. It can make their risk adjusted returns look great, but they won’t report on the hidden volatility. In a crisis their value falls quickly
- Renaissance Capital → Simons recruited a bunch of super smart mathematicians. Loved the idea of having computers trade for him.
- Launched the Medallion fund.
- Spotted sequences - that repeat
- Focused on short term signals, as they were both easy to find and more valuable (as they were more frequent)
- Expanded to other markets
- Always hired mathematicians never economists
- Discovered a large number of small discrepancies
- Simons made $1.6b in personal profits in a single year
- Algorithms had to determine a) what to bet on b) how much to bet
- Z-score - probability of win, higher payoff
- In times of turbulence, animal spirits were more important. You need to weight ‘sentiment’ more and be able to shift modes. In stable times, arbitrage was better. In unstable times, following the trend is better.
- ‘It’s easier to focus if you don’t go home’ a quote from Jeff Bezos when he worked at a quant hedge fund
- Leverage accelerates upward quickly as you start losing and bets go against you
- If a fund has $100 to support $800 of positions (8:1)
- A 5% loss leaves it with $60 and $760 of positions (12:1)
- There’s often a race to dump and liquidate from all quants if things turn. This effect caused the quant quake of 2007
- Many piled back on leverage on the way back up, reading the early signs
- Too many quant funds, chasing too few edges, with too much leverage, profits deteriorating
- If you think a firm is going bust, you can short junior bonds, and hedge by going long senior bonds
- The US housing market was normally segmented by state. CDOs lumped states together, and assumed that risks were reduced (but clearly a black swan could change that)
- Short-selling activism approach. Dig up bad news, take a position, talk about it.
- Long-activism approach, buy a stake, demand a change in strategy, talk about it gain support
- Replace CEO if you can
- HedgeFunds would give dairy farmers loans, using cows as capital. But there’s no way they could turn up in Ukraine and claim the cows
- Paul Jones → 2008 - high interest rates and an absence of fear → this is going to be the ugliest 3rd quarter in history → a leveraged financial system in a credit crisis → became an asymmetrical bet
- S&P went down 4.7% on the day Lehman went bust.
- Liquidity dried up. Nobody wanted to hold any loans at any price
- Everything becomes illiquid in a crisis. Nobody wants to buy anything. Only the safest and most liquid assets are desirable
- Exotic or Illiquid loans become worthless
- 50% chance of Morgan Stanley collapse, if that went down 95% chance Goldman would go, if Goldman went Citadel would go (because the trade unwinding would ruin their positions) …. chain effects of probability!
- FSA banned short selling of 23 financial firms. SCC banned short selling of 300 companies.
- Citadel - there became a rumour, that the FED was in Citadels offices. “I can’t get rid of the rumours”
- There’s almost no way to get good news out. If you book a call - the market will assume it’s bad news
- Citadel were smart because they’d raised longer term capital, not reliant on short term loans… helps with liquidity in a crisis
- HedgeFunds needed both leverage and short selling. In the financial crisis, nobody wanted to give leverage, government banned shirt selling of financial stocks
- Also in a crisis, everyone wants to redeem to get their money out! Making liquidity issues worse
- HedgeFunds were getting privileged information and getting in trouble. Discarding burner phones was a regular occurrence
- The issue is HedgeFunds feed brokers commission, brokers feel under pressure to leak information
- HedgeFunds are generally small enough to fail
- Government insurance increases risk taking, which requires more insurance
- Types of last resort lending are growing
- Leverage is growing
- It ends in governments going bust
- All the regulators failed in 2008
- What makes risk?
- Short term borrowing
- Holding illiquid things
- It’s sensible to drive risk into firms that are small enough to fail (hedge funds).
- Don’t regulate them, but allow them to get too large
- If you’re measuring the performance of all hedge funds, you have to take into account survivorship bias (they return 7.7% after fees, a chunk of which is ‘Alpha’)
- What determines systematic risk:
- Size of capital + leverage + markets operate in (liquid / illiquid)
- Hedge funds that are too risky should be regulated - like investment banks