“The difference between stupidity and genius is that genius has its limits.”–Albert Einstein
Many years ago, I took a girlfriend to Bermuda. There we met a lecherous English playboy married to what turned out to be a fabulously wealthy daughter of really old money. We figured this out when we accepted their invitation to lunch, at their cottage, on their island, in Paget Sound. Over lunch, Peter the Playboy inquired as to what I did. I said I was a floor trader on a commodity exchange. I expected this to be well received–I was only 25 and it seemed rather dashing. It wasn’t.
Peter said. “I never really had much respect for you guys. I mean, the only thing you do is stand around trying to make a buck.”
This from the mouth of a gigolo, no less.
He caught me flat-footed. Up to that point, all prior conversations on bucks had to do with quantity–not quality. I’d never distinguished between good and bad bucks.
True, I’d profited from hurricanes and floods. I’d also gotten killed being short during hurricanes and floods, selling farmers insurance in case their crops got wiped out. Net/net, a wash, I figured.
I had no snappy reply for him then, but his implicit premise got under my skin. I reasoned that society does not let you do much of anything unless society thinks you’re contributing to its well being. Virtually anything that’s legal has some rationale predicated upon benefiting the “greater good.” You gamble in a licensed casino, in theory, because it provides entertainment to a beleaguered public–and at those prices, it better. Business can lend money at high rates–but only up to a point–after which they arrest you for loan sharking. (The government will tell you at what rate of interest that distinction occurs.) Same with drugs, which is absolutely one of the most profitable industries in the history of the world. Society decides which drugs you can sell and how they are dispensed; anything outside the boundary results in time served. You’re allowed to do all of these things provided they contribute to the grail of the greater good. Years later, I found out economists call this function, “utility.”
Given that line of thinking, I thought I must be contributing something to the greater good.
Capital markets work on the same principle. If I was making money, I must have been providing some service society thinks is valuable. What was I doing that deserved an economic return?
The answer, I believe, has to do with the nature of the capital markets themselves. They are a vast collection of discontinuous preferences, or “utility functions.”
Markets, when deconstructed, are a never-ending series of transactions. Buyer meets seller and price is discovered. Next transaction, please! But anyone who has been on the front lines can tell you the process is rarely that clean. It’s noisy; a constant series of mismatches between buyers and sellers based on the participants’ respective differences in time horizon, balance sheet, outlook, asset flows, leverage, bond covenants, gamma, net exposure, VAR, allocation mandates, convexity, and so on, ad infinitum. And that’s before we get to exogenous shocks.
Even a cursory glance at a chart of anything will show periods of congestion, interspersed with sudden, sharp accelerations or declines. These are occasioned by mismatches in liquidity.
These liquidity mismatches do not happen simply on a transactional basis. They can happen over much broader time horizons with large asset flows. Assets flowing into growth stocks, to choose one example, routinely push valuations past supportable levels to accommodate investors’ inclinations (occasionally, manic compulsions) to buy. There are structural limitations on shorting in many of the world’s larger asset pools, which also create liquidity imbalances.
The way our free market system works is that it encourages capital to take advantage of these mismatches in ways that tend to limit the collateral damage. The mismatches exist because there are disparate preferences in the market place. Put simply, to function smoothly, markets need sellers when everyone wants to buy and buyers when everyone wants to sell. In regulated markets, the opportunities are fairly well controlled. In unregulated markets, you can do almost anything that doesn’t involve a physical exchange of gunfire.
Of course, I didn’t figure all this out back then. I just knew I was contributing to the liquidity in the cotton market. As a profession, it was lacking in the warm-glow-at-night dimension. Still, the hours were good, and I was my own boss.
Years later, after I had become involved in, and shortly after we completed the sale of, TASS Research to Tremont Advisers (now Tremont Capital Management Inc., Rye, N.Y.*), (Please read the 11-page disclaimer at the bottom of the website, which says you can’t sue me even if I tell you to pour PCBs on your cornflakes in the morning.), my partner at the time decided to put out a “white paper” stating the statistical and intellectual arguments for hedge funds. The paper we put out, titled “The Case for Hedge Funds,” has been downloaded over 30,000 times from HedgeWorld.com.
I took on the task of writing the section on why hedge funds make money, and came to regret it. After weeks and weeks of missed deadlines, I understood why one kind of fund or another made money, but I had no unifying theme. They all seemed to approach it differently. I finally turned in something that danced around the core of the issue, explaining how, but not why the funds made money.
But I couldn’t let go of it. The Saturday morning after I submitted my piece, I turned my attention in a different direction. I’d been focusing on the funds. I looked instead at the markets themselves. Virtually all of the funds were capturing some mismatch between buyer and seller, albeit in different markets. There were distressed funds buying what corporate bond funds were mandated to sell because a company’s rating had slipped. There were convert funds buying a company’s convertible based not on its credit but the volatility of its stock. There were risk arbs that would buy your holdings in the target months ahead of the closing of an announced deal, freeing up your capital and taking the risk that the transaction wouldn’t be consummated off your hands. There were fixed-income arbitrage funds buying mortgage pools and allowing homeowners to lock in a rate, and special situation funds buying stub equities nobody else wanted.
As I cycled through the list of hedge fund strategies, it occurred to me that various funds used different advantages to capture their excess returns. These could range from cheaper transaction costs to superior information to structural anomalies. But, in all cases, they were being paid for providing the same economic function: supplying liquidity in the form of risk capital to the world’s capital and derivative markets.
The system breaks down when it’s not liquid. I recently saw a presentation by the Deputy Minister of Finance of Mexico. One of the points he made is that they are trying to increase the liquidity in their stock markets so they need more short sellers and more leverage. Markets offer a return to participants that provide liquidity with sufficient skill.
Derivatives don’t work without risk capital because the function of a derivative is the transference of risk. A farmer has to go to the bank to borrow money to buy seed and pay workers. It’s going to be a while before his crop comes in, and he has no idea what price it’s going to fetch when it does, but right now cotton’s going for 68 cents a pound and at that price, he can turn a profit. Wouldn’t it be nice to have some kind of deal where he could sell his crop at the current price, but not have to deliver the cotton until it’s out of the ground 10 months from now? Now you have a derivatives contract; a futures contract, to be precise, and all derivatives are built as a means to transfer risk.
All you need now is someone to sell it to: that could be a risk-averse natural buyer, who doesn’t want to take the chance of having to pay a higher price for cotton next year, but usually it’s a speculator. Who else would want to buy next year’s cotton crop for 68 cents?
If he can’t find a natural buyer or a speculator, the farmer has to ask the bank to speculate on next year’s cotton prices – an experience not unlike asking them to lend money so he can bet on Villanova plus 6- 1/2 in the NCAA semi-finals.
What does the speculator want? Simple: he wants a discount.
That discount, (or premium, as the case may be), is an edge. It’s how the whole business works.
Most hedge funds do not derive their returns from the creation of “alpha,” as it’s commonly understood. At least, not the way I see it. “Alpha,” in common investor parlance, bespeaks money management “genius at work.” In my experience, hedge funds derive the bulk of their returns from the systematic collection of “edges”–rewards they collect in return for the provision of liquidity. Buying a mis-priced bond or an unloved small-cap. Providing bridge financing to a triple-C credit or buying an illiquid trade claim. But that involves the systematic taking of risk, and that’s the utility of most hedge funds. This is more than a trifling semantic distinction. Investors are not well served by mistaking perspiration for inspiration.
Now, these are sweeping statements. Not all funds exploit “edges,” as I’ve defined them, and “alpha” does exist. Some funds are earning their returns be being canny investors, and not simply by being liquidity providers. But it’s a question that demands an answer. Why does a given fund make money? Absent a persuasive answer, my money goes elsewhere. My personal preference is to invest with providers of liquidity who do so with uncommon skill.
Of course I want a brilliant investor managing my money, but genius has its limits.
And what I want is more than just the fastest driver on the track.
I want the fastest car.
I want an edge.
*TASS Research is the information and research unit of Tremont Capital Management Inc., Rye, N.Y., which is a minority investor in and strategic partner of HedgeWorld.
Contact Bob Keane with questions or comments at: [email protected].