Hedge Funds: Corruptors of Youth?
by
Ross M. Miller
Miller Risk Advisors
www.millerrisk.com
June 26, 2006
[This commentary appears in the July/August
2006 issue
of Financial Engineering News.
This is the raw, unedited version of that commentary.]
Hedge funds cemented their reputation as the place to be
when the Federal Reserve dedicated a three-day conference to them at the
exclusive (until I arrived) Sea Island resort in mid-May. CNBC provided
frequent live reports from the event, and Fed Chairman and former National
Spelling Bee contender Ben Bernanke showed up for dinner on the first
evening of the conference.
The title of the conference was "Hedge Funds:
Creators of Risk?" During the first formal presentation, which had
co-author Atanu Saha pinch-hitting for random-walk king Burton Malkiel, I
got the feeling that the organizers may have briefly entertained using the
title that graces this column.
Mr. Saha came out swinging. Most of the audience, which
included a bevy of hedge fund managers as well as central bankers from the
UK, Canada, Japan, and Korea, undoubtedly heard his story before. The
phenomenal performance of hedge funds as an asset class in recent years
must be adjusted to account for two common statistical biases,
survivorship bias and backfill bias, both of which can artificially
inflate returns. (These biases only affect hedge fund returns in the
aggregate, not individually.) Survivorship bias comes from the fact that
the major sources of hedge fund data drop funds from their sample when
they either liquidate or stop reporting data because they no longer need
to attract new investors. Backfill bias is the opposite phenomenon—many
hedge funds only begin to make available their past performance when there
is something good to report.
While there is no reason to question that survivorship
and backfill bias can make hedge funds appear less attractive as an asset
class, how Mr. Saha framed this result raised many eyebrows. The pivotal
PowerPoint slide of his presentation showed that before considering
survivorship and backfill bias, hedge funds in aggregate outperformed the
S&P 500 index; however, when the biases were accounted for, the
returns dipped below that benchmark. (PDFs of the papers presented at the
conference—but not the accompanying PowerPoint slides—are available here.)
When the floor was opened to questions, it was
immediately pointed out by a hedge fund manager that not only was the
S&P 500 index a most inappropriate benchmark for hedge funds, but that
the unbiased returns still beat the standard, but still flawed, benchmark
of T-bill returns by an impressive margin. Most significantly, in a market
where alpha rules, that premier Greek letter was never mentioned. Whether
or not hedge funds create risk, it is standard practice for them and their
investors to consider their performance taking both their strategy and
properly risk-adjusted returns into account.
Mr. Saha's presentation, however, will most likely not
be remembered for these technicalities, but rather for his recommendation
that hedge funds, like their mutual fund brethren, be required to report
their holdings to the public periodically. The motivation for this
recommendation appeared not to be to protect potential hedge-fund
investors, but rather to provide researchers with better data.
Once the focus of the conference shifted from what came
off as a wholesale indictment of hedge funds to a more reasoned discussion
of them, it became clear that there was an invisible elephant in the
ballroom with LTCM tattooed on its forehead. (I do not know if they were
invited, but none of the former principals of Long-Term Capital Management
were present at the conference.) Even Chairman
Bernanke's dinner speech, which warned against the overregulation of
hedge funds, used LTCM as its point of departure.
Bernanke's main message was that leverage, something
both LTCM and its financial facilitators had in abundance, was the true
villain that lurked behind hedge funds. The Fed sheds no tears for hedge
funds that lose their own money, what bothers the Fed is when their losses
exhaust their equity and spill over into the financial system. Call it a
house of cards, a string of dominoes, or whatever gaming metaphor strikes
your fancy, but the extreme interconnectedness of the global financial
system makes it easy for losses to propagate from one financial
institution to another.
Losses that ripple out from one hedge fund or a group of
them pursuing similar strategies could quickly turn into a tsunami that
devastates the global economy. Such nightmare scenarios are at the center
of what has come to be known as systemic risk. This risk to the financial
system is not readily amendable to standard quantitative techniques or,
for that matter, rigorous analysis of any kind. Proper analysis of any
form of risk requires that you understand it—systemic risk is all about
the vast expanses of unexplored financial territory.
When it comes to systemic risk, hedge funds as such are
not the real problem. Hedge funds, many of which do little or no hedging
of their positions, are simply financial structures that were, until
recently, basically unregulated. It does not take a hedge fund to engage
in the types of activities that so worry the protectors on the global
economy. As several speakers at the conference noted, further regulation
of hedge funds would just than drive them either underground or overseas
or else morph them into something else entirely.
Although no one came out and said it, the real risk that
"hedge funds" pose is their growing ability to outwit the
financial system. One need not go back to the time of powerful trusts and
robber barons for an example of the co-opting of the financial system by a
clever few: George Soros's "breaking" of the Bank of England in
1992 will suffice. (The only appearance of the Great Palindrome on Sea
Island was as a bullet point on a PowerPoint slide that its presenter
diplomatically skipped past.)
The problem with hedge funds, if you view them from the
central bankers' perspective, is that they are, in some real sense,
corruptors of youth. Back in the Days of Disco when I was still in
graduate school, a hedge fund manager or two could be found lurking the
halls of physics buildings in search of the stray Ph.D. who was having
trouble getting or keeping a good post-doctoral position. Driving a taxi
was considered a noble alternative to working for something as shady as a
hedge fund back then.
Times have certainly changed. Now hedge funds are
battling it out with the likes of Google to nab the top students from the
most elite universities. If there is someone out there with the talent to
break the Bank of England (or one considerably larger), the odds that he
or she is working for a hedge fund have risen greatly. But financial
regulators' obsession with LTCM and leverage misses the central point. The
big winners are more of a threat to the financial system than the big
losers. Survivorship bias matters so much for hedge funds because the big
losers quickly fall out of the game. The big winners are, the way the
system is currently set up, free to continue playing.
Of course, the possibility of winners sucking an
unbounded amount of capital out of the system is largely precluded by the
dominant thread of financial theory espoused by Professor Malkiel, the
professors formerly at LTCM, and almost all central bankers. Perhaps they
are all right. Perhaps there is someone out there who can prove them
wrong. In time, we may just find out.
Copyright 2006 by Miller Risk Advisors and Financial
Engineering News.
