The Case for Edge Funds

“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.