Marginal Utility

by Tom Bozzo

A fund of fund(s) that funneled money — including a portion of the late Madison Cultural Arts District trust fund — into the Madoff scam is in Big Trouble:

Massachusetts regulators have sued the Fairfield Greenwich Group, one of the earliest of these so-called feeder fund managers, for fraud, saying it had repeatedly misled investors about how diligently it checked out Mr. Madoff’s operations over the years.

“Fairfield’s complete disregard of its fiduciary duties to its investors and its flagrant and recurring misrepresentations to its investors rises to the level of fraud,” [said the complaint].

Henry Blodget had nicely ripped Fairfield Greenwich's marketing claims a while back (Fairfield Greenwich also apparently forgets that the Internets remember all). If the rap can be beaten with a claim that those were mere puffery rather than outright fraud, then the law surely is an ass: performing rigorous analysis of investment managers' strategies is one of the (few) ways a fund-of-funds can justify its fees-on-fees [*]. An interesting question is why this is being handled as a state matter; maybe now that the Ted Stevens debacle is over, some Justice Department resources can be liberated.

One thing this points to is that the "accredited investor" concept — the "safe harbor" that allows hedge funds to escape much regulation by limiting their services to high-income, high-net-worth investors — deserves a place, however minor, on John Quiggin's growing rubbish heap of refuted ideas. Merely being rich (or at least upper-middle class) didn't make the Madoff suckers and suckers-of-suckers sophisticated. [**] There's really little more (if not much less) reason to think the well-to-do can evaluate complicated investment strategies than that they can reliably complete their own taxes. The MCAD trust's case shows that moderately rich institutions with very rich benefactors are not exceptions. Ultimately there's a reliance, possibly at a couple degrees of separation (part of the Madoff fraud that I leave to the sociologists), on actual expertise. As we've seen, when that's faked, bad things happen.

(Cross-posted at Angry Bear.)

-----------------------

[*] That is, substantively justify, as opposed to charging what convention and apparent market failure allows the market to bear.

[**] In U.S. securities regulation, "sophisticated investors" is a more restrictive category such that few funds apparently use it, presumably to avoid too narrow an appeal for funds.

Labels: Fraud, hedge funds, Market Failures

by Tom Bozzo

Earlier in the year I reviewed the investments held by the Madison Cultural Arts District's trust fund, which once had been intended to use stock market returns (and later alternative investment returns) to pay the Overture Center's construction debt and contribute to the Center's operations. I concluded that the fund was undercapitalized and needed to get cracking on fundraising. In September, the fund reached a point where it was to be liquidated to pay off the bulk of the construction debt, leaving the major donor and the city of Madison on the hook for the balance. We only recently, as lapsed Madison Symphony subscribers, received a fundraising letter.

An interesting detail is that when I'd reviewed the MCAD trust's assets, it held $17.9 million — just under 18 percent of its $100M portfolio of the time, in the Fairfield Sentry fund. (In early '06, they had an even greater exposure.) At the time, Fairfield Sentry was among the trust's high-flying investments, relatively speaking. I said "who knows" with respect to how Fairfield found its alpha.

Well now we know! Per Bloomberg (via), Fairfield Sentry was 100% invested in Bernard Madoff's mega-swindle! I hope they actually managed to liquidate their balance. If they did get out soon enough, then at least the MCAD trust may not have been the biggest of suckers in one respect.

Otherwise, big potential losers are Andrew Ang, Matthew Rhodes-Kropf, and Rui Zhao, whose April '08 NBER working paper concluded that funds-of-funds "on average, deserve their fees-on-fees." At a minimum, they should delete the Madoff suckers and recalculate.

Labels: hedge funds, High Finance, Madison

by Ken Houghton

Surely a hedge fund specializing in "adult industry investments" is either a sign of a recession or a sign of the Apocalypse.

(I'll be contemplating this at youporn.com [h/t Erin] for the rest of the day.*)

*Actually, I won't, and not just because I'm on a public computer. Too much Really Cool Stuff to read (all links gated; if anyone can find free links, e-mail me or post them in comments).

Labels: hedge funds, just life, Pornography

by Tom Bozzo

Quick background: The Overture Center, Madison's $205 million concert hall and arts center, was a gift from local philanthropist Jerry Frautschi (who made his fortune investing in American Girl, founded by his wife and sold for big $$ to Mattel). The gift was structured so that about half was put in a trust fund, intended to pay off construction debt and contribute to the Center's maintenance, assuming it made roughly 9% annual returns off stock market investments. The year was 1999. D'ohh!

After years of 2% annual returns, the trust fund represented insufficient collateral for the bankers, so a refinancing plan was hatched, and approved in late 2005, that required the City of Madison to guarantee a portion of the debt. The plan would work just great as long as it attained an 8.25% annual average return and the trust balance stayed over $104 million. That also hasn't worked out so well, as noted here a week-and-a-half ago.

My question has been, how have the Overture trust fund's managers managed to screw up so badly? Well, other than the obvious reason that 8.25% is well above any sane person's idea of a risk-free return. Courtesy of Isthmus executive editor Marc Eisen, I've seen a spreadsheet with a summary of the Overture trust's investments, and can only conclude that the investment choices never gave them a serious chance. For junkies of mid-sized institutional asset management stories, some gruesome details are after the jump.

I'd divide the trust fund's management into two eras, the Cash Era and the Alternative Investments Era.

The Cash Era ran from late 2005 to late 2006. The trust fund's balance ranged from $106.2 million to $109.3 million over the period, and 46% to 61% of that was held in "cash equivalents." The balance was in "general equities" (which I take to be meant generically, and not the firm General Equities) and Fairfield Sentry Ltd., a hedge fund. The higher cash percentage was sustained for the latter two-thirds of the year, when the trust turned a good portion of its Fairfield Sentry holdings into cash equivalents. My naive calculation from the spreasheet says that the equitites returned 4.6% and the Fairfield Sentry fund returned 8%. In 2006, you could have made right around 5% with a very good money market fund, such as the institutional share class for Vanguard's Prime Money Market fund. The upshot was that their weighted average return was right around 5% for the year. With that asset weighting, the trust had to make 12.7% off the non-cash-equivalent assets to reach the 8.25% target. 2006 actually was a good year for stocks — Vanguard's Total Stock Market index fund returned north of 15%. They chose a bad year not to be 'seeking beta.'

The interesting question is why they stayed in cash for so long post-refinancing. Pardon me for thinking that the financial geniuses behind the refinancing might have had an investment plan ready to roll upon approval. None of the obvious answers — they didn't have a plan, the Cash Era represents an inept plan, and they chose a deliberately defensive position to avoid the political embarrassment of a quick I-told-you-so from refinancing opponents — is confidence-inspiring.

The Cash Era ended in late-2006, as the cash-equivalents gradually moved into a series of other investments. At the end of the series I've seen (3/14/08), only 2% of the Overture trust is held in cash equivalents. I call this the Alternative Investment era as it was kicked off with a roughly $15M investment in "Highbridge Fund," which appears from the value of holdings to be the quasi-hedgey Highbridge Statistical Market Neutral fund (as of 3/14, 21% of the fund's holdings). Stakes in Pimco All Asset fund (a fund of Pimco funds, 16%), principal protected notes (PPNs) from JPMorgan and Barclay's (the latter purchased with the proceeds of the "general equities,"14% and 8%, respectively), additional investment in Fairfield Sentry (18%), and "JPMorgan muni's" (20%) followed.

It's hard to reliably track performance across the board because of apparent asset sales and purchases, but nothing has come especially close to putting in an 8.25% return over the period. The highest-flyers, the Fairfield and Pimco funds, have had 1-year returns around 6%. The Highbridge 1-year return was 1.2% (they've done relatively well YTD), the munis are up 2% over the 7-month period they've been held, and the PPNs down. The upshot is that the trust is showing a weighted average return around 3% for the last year, far below the target. Granted, all I need to do is look at my 401(k) performance to see that it's been a tough year through the end of March — I'm down 3.3%, though then again my five-year average is 9.7%. An irony is that while Madison Cultural Arts District Treasurer told the Cap Times that it would be "a very unfortunate change" if the creditors forced the assets into Treasury securities, which might be true now, had they actually been in Treasurys all along, they'd have ridden the bond market's flight to quality well past their return goal for the past year. Whatever the skills of the MCAD, investment timing ain't it.

The better question, perhaps, is what the prospects would be for this asset mix to earn 8.25% on average in the future. The underlying assets for the PPNs could be anything, so it's hard to say there. The munis won't under foreseeable interest rate environments. Pimco All Asset seems to be tuned to produce single-digit annual returns. Highbridge hasn't exactly been minting 'alpha,' and who knows about Fairfield Sentry. If the PPN investments were selected at least for perceived safety before the fact (actual performance notwithstanding), then I'd have to say it isn't going to happen. If nothing else, the MCAD seems to have done a good job of picking relatively high-cost holdings, which just increases the return that has to be earned from the underlying assets for the trust to net 8.25%.

This brings me back to my main point — the MCAD is undercapitalized, and they should get cracking on raising money. That was something that was supposed to have been facilitated by keeping the facility in the hands of the MCAD instead of under direct city ownership, but a capital campaign seems to have become a priority only now that they're in the soup. If they want to make good on the facility's promises, and shut us critics of their financing misadventures up, they need to raise a lot.

Return to the Marginal Utility main page.

Labels: hedge funds, High Finance, Madison

by Ken Houghton

Metro reported yesterday that CBS's Les Moonves was so impressed by Britney Spears's appearance on How I Met Your Mother that they decided to make her the centerpiece of a show—a remake of the Mary Tyler Moore Show.

It wasn't until I read the link at this post from Steve Gould of EoB that I realized that yesterday was more than the traditional birthday of our cat.*

So I'm gullible. But even I'm not as gullible enough to believe the claim of Lehmann's CEO today that he has evidence that hedge funds "conspired" to destroy Bear Stearns by short-selling.

It's not that I don't believe multiple hedge funds shorted the firm, or even that some of them spoke with each other. But the conversation was more likely,"Are you short BSC?" "Better believe it. You too?" "Of course." than some clandestine activity.

Let's be clear: when your firm is leveraged over 30x itself, when most of your revenues come from an area that hasn't generated enough volume to support your structure in over a year (even after two major rounds of layoffs), and when your swap spreads blow out by a factor of 15 or 20 in the course of a few weeks, short sellers (who have to risk a lot more capital than derivatives traders) are the least of your concerns. Or just the icing on the cake.

Mark Gilbert mostly gets it right here:

U.S. and U.K. regulators are wasting their time threatening traders who profit from speculation about the deteriorating health of the financial community. The gossips aren't to blame for the demise of Bear Stearns Cos., and they won't be at fault when the next firm goes bang, either.

Brokers, futures traders, collateral managers and compliance officers are ranking their counterparties from strongest to weakest, and choosing to stop doing business with whichever company comes bottom. If the same name gets crossed out on every list, it spells game over for the loser -- deserved or not.

And, to be clear, when you have done Jack about it in the month leading up to the day before Ben Bernanke decides he needs to help you because no one else will, two dollars a share is for the other shareholders; getting punched out in the gym (note the correction at 7:53a.m. on 3/28) is Getting Off Easy.

But the seeds of Alan Schwartz's destruction-by-inaction were, as Gilbert notes, planted in 1998:

In his 2001 book When Genius Failed, Roger Lowenstein details the Fed's crucial 1998 meeting to convince Wall Street that it should shoulder the financial burden of keeping Long-Term Capital Management LP afloat or risk financial meltdown.

James Cayne, the CEO of Bear Stearns, told his peers—including Philip Purcell of Morgan Stanley and Herbert Allison of Merrill Lynch—that his company wouldn't join the 14 securities firms paying for the rescue.

"In unison, the CEOs demanded an explanation," Lowenstein writes. "This only made Cayne more resolute. Bear had enough exposure as a clearing agent, Cayne said. He wouldn't say more. Suddenly these paragons of individual enterprise seethed with communitarian fervor. Purcell of Morgan Stanley turned beet red. He fumed, 'It's not acceptable that a major Wall Street firm isn't participating!' It was as if Bear were breaking a silent code; it would pay a price in the future, Allison vowed."

Only the Stevens Levitt and Dubner might be surprised by that reaction. The rest of us noticed that, when rumors of an illiquid Lehmann started spreading, the first thing that happened was that Goldman Sachs trotted out a Senior Executive to confirm that they view Lehmann as (something like) "a strong, viable competitor."

When rumors started about Bear, there was about three days of silence, followed by the negotiations of March 14-16 to avoid Chapter 11 on the 17th.

That may be a case of revenge being a dish best served cold. Maybe the calls were made and no one was willing to do what Goldman did for Lehmann.

But all of the other evidence is that upper management just didn't realise that its job isn't to manage departments so much as to manage public perception by making certain that anything that might worry investors—say, the market for your CDS swap spreads going well past junk levels—is handled quickly and publicly.

That's why they pay the CEO—and the Board of Directors—the big bucks and bigger stock options. In early March, several "leaders" of BSC proved they were overpriced.


*No picture, in keeping with this plea.

Labels: hedge funds, High Finance, leverage, liquidity, The Old Firm

by Tom Bozzo

The last few nights, I've been enjoying Roger Lowenstein's When Genius Failed: The Rise and Fall of Long-Term Capital Management. At least, I've been marveling at its parallels with the present crisis — not principally because of JM's latest round — in-between thinking that I might sleep better were I reading "Call of Cthulhu" as a chaser to a late-night screening of Alien.

The density of Famous Last Words and Unheeded Cautionary Lessons is too high as to make a comprehensive review possible (yet 'nobody' saw the current crisis coming), but here are a few favorites:

Removal of these financing constraints [margin rules] would promote the safety and soundness of broker-dealers by permitting more financing alternatives and hence more effective liquidity management... In the case of broker-dealers, the Federal Reserve Board sees no public policy purpose in overseeing their securities credit.

That's Alan Greenspan, testifying to Congress in 1995.

[Fama] argued that Black Monday had been a rational adjustment to a (one-day?) change in underlying corporate values. On the other hand, Lawrence Summers... told the Wall Street Journal after the crash, "The efficient market hypothesis is the most remarkable error in the history of economic theory." (p. 74)

And that's saying something?!

Almost imperceptibly, the Street had bought into a massive faith game, in which each bank had become knitted to its neighbor through a web of contractual obligations requiring little or no down payment... "Credit limits for customers are an essential tool for credit risk management," [The New York Fed] warned. [emphasis in original]

Shockingly, the warning was in a letter to Wall Street banks, not business undergrads.

Writing in the prestigious Journal of Finance, Andrei Shleifer of Harvard and Robert W. Vishny of Chicago presciently warned that an arbitrage firm of Long-Term's type could be overwhelmed if "noise traders" pushed prices away from true value... [T]hey predicted that, in such a case, arbitrageurs would "experience an adverse price shock" and be forced to liquidate at market lows. Merton... pooh-poohed the notion that markets could be overwhelmed. (p. 111)

Merrill's willingness to finance its client was part of a pervasive climate of financial laxity, palpable in Wall Street's eagerness to underwrite emerging markets. (p. 130)

Let's play "substitute the asset category!

The comforting notion that global financial cops would always be there to put matters right was now exposed as a fallacy. This time, there was no rescue by the IMF, no hurried bailout by Robert Rubin or the Group of Seven Western powers... It "punctured a moral hazard bubble" that had been inflating expectations... Investors, at first singly and then en masse, concluded that no emerging market was safe. In seventy years, Russia's Communists had not succeeded in dealing markets such a telling blow as did its deadbeat capitalists. (p. 144)

Most of us survived 1998, but we'll see if our deadbeat capitalists can one-up their Russian counterparts...

Labels: hedge funds, High Finance, Personal Finance Advice of Alan Greenspan

by Tom Bozzo

Yesterday's NYT included a refreshing moment of sanity as Stephen Labaton and Jenny Anderson (I've praised Ms. Anderson's work in an earlier installment of this series) report on Senate hearings on the tax treatment of "carried interest." The lede:

Pension fund and tax specialists told Congress today that a proposal to more than double the tax rate of executives at private equity firms and hedge funds, which invest money from pension funds, would have a negligible effect on the returns provided to pensioners.

I could pick a nit or two with the "more than double the tax rate" wording. It would not have decreased the accuracy of the statement to have said "proposal to close a tax loophole used by executives at private equity firms and hedge funds to pay less than half the tax rate on ordinary income." But that's about all the beating of the press here. [/Dean Baker] The rest of the piece is an unrelenting demolition of the funds' rather incredible claims that the special tax treatment of the managers' income benefits Joe and Jane Six-Pack and preserves the Entrepreneurial Spirit of America. Read the whole thing.

Here's an interesting quote from Sen. Max Baucus:

“The data says to me that hedge funds and private equity funds may need pension funds more than pension funds need private equity or hedge funds,” Mr. Baucus said. “And that means that hedge funds and private equity funds may not have the economic power simply to pass along increased costs to pension funds.”

To the first part, I can only say "no kidding" or "heh indeedy." On the second, Baucus's causal link may be questionable, but if he's otherwise right, it would be good for Econ 101 economics, which otherwise would have some 'splainin' to do as to how the 2-and-20 fee structure could withstand such massive entry.

Oh, and the hedge fund managers' incomes could be taxed at Clinton-era marginal rates for ordinary income without hurting the Ferrari dealers any more than the pension funds, really.

Labels: hedge funds, High Finance, Inequality

by Ken Houghton

There has been much discussion (often heated enough to cover Tom's household energy needs) about "marking to model." (Tanta at CR has been especially good on this issue.)

I have no conceptual problem with marking to model so long as (1) actual trading prices are not significantly different from the model and (2) the model used is consistent.

Apparently, the SEC is starting to share that last concern:

U.S. regulators are scrutinizing the books of Wall Street's largest investment banks amid questions they are hiding losses from subprime mortgages, people familiar with the inquiry said.

The Securities and Exchange Commission wants to see whether firms are calculating the value of subprime-mortgage assets on their books the same way they calculate those values for their brokerage clients, such as hedge funds.

Note that the same method doesn't require the same price. But especially assets that are Held for Sale (HFS) are supposed to be marked with the best information available. This may not have been happening:

Wall Street banks are in a sensitive period as turmoil in U.S. mortgage markets generate losses for investors and push some lenders into bankruptcy. Yet few investment banks have disclosed significant subprime losses in recent periods.

The scrutiny may also help pinpoint whether hedge funds accurately report their results to investors, the Journal reported, citing an unnamed source. Regulatory checks into how firms calculate values of certain assets could boost the accuracy of performance reports to investors. [emphasis mine]

The first rule of reporting losses is that you can survive if you detail the entire problem upfront. If you report an $8 million loss the first day and $4 million more the next, you'll run into more problems than if you report $12 million on Day 1.

Liquidity and Transparency: they're not just for text books any more.

Labels: hedge funds, High Finance, Moral Hazard, Personal Finance Advice of Alan Greenspan, principal/agent problems, subprime

by Ken Houghton

Felix Salmon gives a briefing of how difficult it would be to show collusion in CDOworld. Select excerpts:

Firstly, the big banks are not generally big holders of CDO tranches. The whole reason why CDOs exist in the first place is that they're a mechanism for moving risk off the balance sheets of the sell side, and onto the balance sheets of the buy side.

English translation: Your pension fund is SNAFU.

Part of the reason is that they don't need to collude in order to hold on to their CDOs. CDOs, by their very nature, are a buy-and-hold investment. There's almost no liquidity in them, and the explicit tradeoff in the CDO market is that investors get a higher coupon by giving up liquidity.

The perversity of it is that in a vibrant market, you shouldn't have to buy a CDO. But that's another post.

You can't short something which never trades, and as far as I know no one is writing credit protection on CDOs. There are lots of people writing credit protection on MBSs, including subprime-backed MBSs, but they're a different instrument entirely.

This is why, all those posts ago, I compared this "meltdown" to the Structured Note market. I tried at one point to go short a Structured Note (don't ask) and cover it in the Repo market. After almost a full day, no one could find it. As with CDOs, the assumption is that you will Hold to Maturity. You bought it, you own it—even if it breaks.

And, most preciously:

One option is to address the general topic without quoting my question [presumably the post's title, "Why There Aren't Anti-Collusion Lawsuits in the CDO Mess," in question form) and without mentioning magic words like "antitrust" and "collusion."

Frankly, I'm not clever enough to answer this question without quoting it and without using the magic words.

It's arguably not collusion when everyone, working in their own self interest, does the same thing—just as it wasn't collusion when they bought the paper in the first place. And the glut of hedge funds created in recent years makes it fairly clear that a "barriers to entry" argument will fly about as well as, say, Amaranth did late last year.

If I were thinking lawsuit, I'd be using terms such as "fiduciary responsibility" and "prudent" and looking at mutual fund investments in hedge funds: low-hanging fruit may not be the tastiest, but it is the most accessible.

Labels: Antitrust, Economics, fiduciary responsibility, hedge funds, subprime

by Ken Houghton

The Epicurean Dealmaker: Marks in the Sand is a good explanation of what happens if you actually mark a levered position to market and find out that your model and the market disagree.

most notable is the coda, which notes the short-term needs of a "long-term" position:

That is one of the instructive lessons from the Long-Term Capital Management implosion: Meriwether and his colleagues were convinced all throughout LTCM's long collapse that the market was irrationally selling into all their positions. They did not want to liquidate because they knew they were right about their portfolio's underlying value. Guess what? In retrospect, they probably were right. But that didn't help them avoid the forced liquidation and takeover of LTCM to meet their Wall Street financiers' margin calls.

A strong stomach won't help you when you've borrowed a lot of money and your broker wants it back.

Contrast this with Brad DeLong's comment at the bottom of the quoted post summarizes the actual economics if the market decides not to call its own bluff:

As long as underlying asset values don't collapse, this is a redistribution: those hedge and other funds leveraged and without liquidity lose big, and those hedge and other funds that are liquid gain big. The caravan moves on, and the returns of those who make it down the California side of Donner Pass look very impressive, with the flesh-stripped bones of the illiquid and their investors scattered near Donner Lake for future archeologists to examine.

Jimmy Cayne is already describing the funds as "a blip on the radar" (per a former co-worker). Rich Marin may disagree. Whether he has company is left as an exercise, though not an academic or intellectual one.

The previous paradigm—Structured Notes—did not end in disaster. But no one was leveraging them.

Labels: Brad DeLong, hedge funds, Market Failures, The Old Firm

by Ken Houghton

(Moved up due to addition of Part II, below)

This is the closest I'm going to come to saying anything directly about The Old Firm: If things had been done differently at the time of LTCM, we might not be talking about Bear so much right now. Via Naked Capitalism, this Bloomberg Exclusive:

Bear Stearns Cos. is getting a taste of its own medicine.

It was Bear Stearns, the biggest broker to hedge funds, that nine years ago declined to join 14 other investment banks in the bailout of Long-Term Capital Management LP. Then last week, as New York-based Bear Stearns pleaded for help to rescue two of its hedge funds teetering on the brink of collapse, many of the same firms refused to come to its aid.

Merrill Lynch & Co., which pumped $300 million into LTCM, said no and seized $850 million of bonds held as collateral for loans it had made to the funds. Lehman Brothers Holdings Inc., JPMorgan Chase & Co. and Cantor Fitzgerald LP also pulled out, leaving Bear Stearns to sort through the wreckage of bad bets on subprime mortgage bonds and collateralized debt obligations.

As I noted previously, there is good reason that Bear trades lower than its comps. "[T]he most sharp-elbowed culture on the Street" may be a competitive advantage, but then there are the (rare?) times when "collegial" is more important than competitive—most often, in a time of crisis.

PART 2: There was, of course, a time when Cayne thought differently, as noted in When Genius Failed:

Labels: hedge funds, Market Failures, Naked Capitalism, subprime, The Old Firm

by Ken Houghton

Bought at Strand Books today:


A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation by Richard Bookstaber.


Lempriere's Dictionary by Lawrence Norfolk*

Two books attempting to make sense of a world in which the underlying reality often is difficult to see.

*Yes, it's an additional copy. One can never have too many, especially when there are daughters who should learn how prose can be written.

Labels: hedge funds, investment strategies, just life

by Ken Houghton

UPDATED with DD links.

Suppose I declare publicly that I'm robbing pension funds. (Just to be clear, I'm not.) And suppose there are several pension fund managers who are helping me? (Just to be clear, they're not helping me.)

You would assume that I would be arrested, no? Or at least forced to talk with George Mitchell. And that people would try to stop me from doing it. And, when they found out about it, they would (rightly) object that it was done, probably noting that the pension fund managers (if not I) have a "fiduciary responsibility." (This, by the way, dovetails to the answer I would give to this post by Brad DeLong: absolutely, since the integrity of the system is otherwise compromised; reputational risk didn't used to be something with which firms took chances.)

The last thing anyone would expect would be to find people argue that, since I was robbing pension funds, robbing pension funds should be made legal.

Ladies and gentlemen, I give you Tyler Cowen (as noted previously, via DeLong):

2. Hedge funds exist because mutual funds do not deliver "complex investment strategies." In part this is because mutual funds are regulated.

4. Investment advisors with fewer than 15 clients do not have to register with the SEC.

5. Regulations restrict the compensation of mutual fund advisors in various ways, typically requiring symmetric treatment of gains and losses (if a dollar of profit leads to a bonus, a dollar of loss must lead to a penalty). That is why mutual fund managers are compensated in proportion to the size of their funds, not their performance. This is not obviously efficient, and of course hedge funds pay for performance.

6. Hedge funds don't have to disclose information to investors, other than by contractual agreement.

7. Diversification and redemption requirements make it harder for mutual funds to exploit some profit opportunities, or to hedge in particular manners.

8. The number of mutual funds that try to replicate hedge fund strategies is growing rapidly.

9. Available data on hedge fund returns are nearly worthless.

Follow the pieces:

1. (2) mutual funds are regulated and part of that regulation minimizes (restricts) their attempting "complex investment strategies."
   
2. Also (7) the ability of people to manage their own money (be able to move it from one fund to another, subject to regulation) limits the ability of mutual fund managers to take some risks while hedge funds.
   
3. Hedge funds do not necessarily answer to their investors (6), and where said investors generally are required to commit their funds for a defined period of time. (LTCM was five years; most hedge funds require at least one.), and
   
4. We don't know that hedge funds outperform mutual funds.* Indeed, it's not the way to bet, since (by dd's rules, especially Good ideas do not need lots of lies told about them in order to gain public acceptance and Fibbers' forecasts are worthless.) if they did, they would all be advertising their performance, not (9) keeping it quiet—especially when the regulators start sniffing.

(Note also that any time an economist says "of course," he's unlikely to be telling the strict truth, as with [5] above. The general rule of "2 and 20" links the hedge fund managers compensation to the amount of funds invested [2% of assets] and the gain of the fund [20% of the profits]. HOWEVER, the gain of the fund will be proportionate to the assets invested. If your "hedge fund" has $100, you can make a $200 or $500 "bet," but not a $2,000 one. In all cases, the maximum return of this portion of compensation is limited by the initial investment. So, in both cases, the hedge fund manager is realistically being compensated for the Assets Under Management, just as the PM is.**)

So mutual funds are attempting to imitate hedge fund strategies. Or, in some cases, investing in hedge funds. Now, since the MF has more than 15 clients, one would assume that the hedge fund would have to report. One would likely be incorrect.

In such an atmosphere—with your pension funds and mine being invested in a manner that is not reported, not conducive to easy access, and (to be direct) not legal, all for an unpredictable relative return, but with higher upfront costs—one would think that a sane economist would consider the "prudent investor" rule*** and decry this activity.

Ladies and gentlemen, Tyler Cowen:

Overall I was struck by how much hedge fund activity is an artifact of regulations, and not necessarily beneficial regulations. Deregulating some aspects of mutual funds may be an alternative to regulation of hedge funds.

"Not necessarily beneficial." Which part is that: the part that requires investor access, the part that requires investor consent, or the part that requires reported returns with enough information that the investor can make the first two decisions?

*This is not to suggest that Vanguard, Fidelity, et al. don't try to hide their lesser/loser funds. But those were reported, so at the very least an analyst or an economist could tell that they existed and don't any more, and report that accordingly.

**This ignores the so-called "real estate agent" problem.

***This used to be known as the "prudent man" rule, iirc.

Labels: Econbrowser, hedge funds, Market Failures, Tyler Cowen

by Ken Houghton

Working on a longer rant, but why not leverage Mark Cuban at Blog Maverick?

I'm far from a sophisticated investor, although I guess I am an accredited investor because of my networth. As I have written before, I'm a big believer that whenever you do a business deal with people you don't know, particularly buying and selling stocks, you always look for the sucker. If you don't see the sucker, then you are the sucker.

Good basic rule. And more detail about why there is a severe principal/agent problem in the making:

Appeasing hedge fund investors is a very, very different business than making shareholders happy.

If a shareholder sells their share of stock, the hedge fund wont really care. Sure, they want the stock price to go up. They own shares of stock in the fund, and as the stock price goes, so goes some percentage of their networth. That should be enough for them to do whatever it takes to increase the stock price, right ? Maybe

Increasing the price of a share of stock is as much marketing to create demand for the stock as it is earnings of the fund.We also call this increasing the P/E of a stock. There are dozens of ways to increase the PE of a stock that is showing a profit. Hedge fund investors care about 1 thing. Cash. Money that is returned to them. Shareholders care about the price of the stock. One is capital returns, the other is capital appreciation.

That difference is just common sense, but its significant....

They can't be responsive to shareholders and investors with the same story

Read the whole thing, and think carefully about what it means when a Mutual Fund invests in a Hedge Fund.

Labels: Economics, hedge funds, investment strategies, Moral Hazard, principal/agent problems

by Ken Houghton

I'm not saying anything. But the pieces should give you a better picture of what hedge funds do than Tyler Cowen is wont to present (via DeLong).

Not to mention this.

UPDATE: Tanta at CR provides a helpful summary.

Labels: Brad DeLong, Economics, hedge funds, Moral Hazard, mortgage, subprime, The Old Firm

by Tom Bozzo

To crack the ranks of the top 25 hedge fund managers in 2006, you would have needed to take home $240 million. The top dog made $1.7 billion.

Quote of the Day honors go to J-Brad. [*]

“There is some question as to what the hell they are doing that is worth” that kind of money, said J. Bradford DeLong, an economist at the University of California, Berkeley. “The answer is damned mysterious.”

Darn straight.

From the industry side, Jim Dunn of Wilshire Associates is quoted as saying he's happy to pay for 'alpha,' the return independent of the 'market' that hedge fund managers supposedly extract from thin air (justifying their extraordinary compensation).

Well, here's where #3 on the list ($1.3 billion in earnings last year) got his alpha, per the Times:

Mr. Lampert ... has $11 billion of his $14.6 billion ESL fund in the retailer Sears Holdings. Last year, Sears stock rose and with it, Mr. Lampert’s fortune by about $1.3 billion.

Can someone explain to me why that isn't just a canny stock pick? Who's paying hedge fund fees for let's bet the farm on Sears?!

Kudos to Jenny Anderson and Julie Creswell of the NYT for reminding their readers that managers' compensation structure means that they can earn extraordinary compensation in return for middling returns on large funds. We remain mystified as to why massive entry hasn't competed away the obvious excesses of the traditional hedge fund fee structure. Maybe Susan Athey can answer that one.


[*] Should we economists give each other nicknames like that? Uh, maybe not.

Labels: hedge funds, The New Gilded Age

by Ken Houghton

Conversation a few days ago:

"You know what someone should do? Launch a takeover bid for Barclay's."

"Aren't they bidding to take over ABN Amro?"

"Exactly. So most of the hedge funds are short Barclay's."

"And long ABN."

"So they would get squeezed on both sides."

As it turns out, that might have been the right strategy. Wonder how much exposure Jim Hamilton's pension fund has??

Labels: banking, hedge funds, investment strategies

by Ken Houghton

It's a catty summary, to be certain, but not an unfair one in this Self-Delusional NYT piece. First admit the truth:

Today’s decision, which followed months of study by a presidential working group, reflected both the strong antiregulatory philosophy of the administration and the formidable new clout and influence of the wealthy hedge fund industry. Three of the major economic policy makers in Washington — Treasury Secretary Henry M. Paulson, Robert K. Steel, who is the under secretary of the Treasury, and Joshua Bolton, the White House chief of staff — are all alumni of Goldman Sachs, which in the last decade has evolved into perhaps the most significant player in the private equities market.

And only then get around to letting readers know that the games are being played with Other People's Money:

Millions of Americans do not qualify to make investments in the funds, which are pools of largely unregulated assets, but they are unknowingly exposed to the risks associated with hedge funds through their pension and retirement accounts.

James Hamilton at Econbrowser—one of the premier analytical economists in the country, and perhaps the closest thing to my political and temperamental opposite in all of the blogsphere (Tom's mileage likely varies significantly)—thought about hedge funds and, instead of leaping to a likely conclusion, examined the available data. The scary thing is that he comes to the same conclusion I do:

When I heard about the disastrously irresponsible investments made by the Amaranth hedge fund, my first reaction was, who would be so stupid to have put up the margin requirements for such a scheme? The answer turned out to be found in my own backyard-- the San Diego County Employees Retirement Association apparently donated over a hundred million dollars to this worthy cause.

He follows this will three paragraphs of fascinating detail; follow the link above. His conclusion from those 'grafs is:

But as far as I'm aware, there's no place you can go to find an audited statement of the assets and liabilities of these "alpha fund managers", so there's no way to verify exactly what the nature and magnitude of the risk is that's being palmed off on the county. We have only the word of the county fund managers that they're doing something smart. They in turn are likely basing their own confidence primarily on the word of the alpha fund managers. At least in the case of Amaranth, we know how much that word is worth, and it ain't $233,830,268. [emphasis mine]

He has a specific recommendation as well:

But when the buyer is acting on behalf of the government, to me it seems very appropriate for the government to set statutory limits on the extent to which managers' interests can be permitted to deviate from those of the beneficiaries. Specifically, I recommend that California's County Employees Retirement Law be amended to specify that if one calculates the sum of all investments, pledges of collateral, financial liabilities and exposures, and margin deposits and calls made by a county retirement fund in institutions for which there are not publicly available annually audited balance sheets of those institutions' assets and liabilities, the sum of all such commitments across all such institutions can not exceed 10% of the retirement fund's total gross assets.

On one side, we have James Hamilton, stating that there is not enough transparency in the hedge fund industry to allow unlimited investment by government-run funds in hedge funds. On the other side, we have "[t]he Bush administration and senior regulators."

Anyone else feeling less well about their 401(k)/403(b)/IRA??

Labels: Bushonomics, hedge funds, pension funds, retirement