Through the Looking Glass

I don’t have to tell you that the investment world has gone somewhat insane since I wrote you a month ago. Imagine a margin call has been made on the entire economy, because that’s what’s happened. Our final number for September was down 6.25%. Amazingly, this was about in line with the hedge fund industry. Please note that this is a bit worse than the flash estimate we sent out about a week ago. This is simply because some of our underlying funds revised their numbers. That doesn’t happen often, but neither does a market like this. I was working at Salomon Brothers when the market crashed in 1987. That had an end-of-days feel to it as well, but it passed in a single day. For those in the financial industry – those left – and for investors in general, this has been much harder to stomach. I would anticipate that 25-30% of Wall Street will be laid off in the next six months, and perhaps 3000 hedge funds will throw in the towel. Neither of these are tragic events, macroeconomicly speaking, since the financial industry had become bloated, but there are scores of innocent people involved.

I get annoyed when I hear people talk about the Wall Street “bailout” plan. No one on Wall Street is getting bailed out, they’ve all been taken out and shot. I’m told that one Hamptons broker got nine new listings in a single day. While we may not weep for someone who is selling a summer house, the underlying reason is often that those individuals have been wiped out. Many people on the Street - people we know - are contemplating a vastly changed life, and only a very few had anything to do with our current predicament.

Still, if you have read these letters over the years, you know me to be an optimist, and that’s not changing now. Yes, we will have a recession (likely inflationary), but not a depression. Bad policy turns recessions into depressions. In the 1930s we tightened the money supply, reduced free trade, and raised taxes, all measures that reduced much needed liquidity. Today, we have a global policy response to reduce interest rates and inject liquidity. As of this writing, it appears to be slowly working. I do worry that Obama wants to raise a number of taxes including capital gains, and he is anti-trade as well. Moves in this direction, if he follows through on them, would be serious blunders. I suspect that recent events will undermine his ability to move in this direction (not to mention undermine his ability to implement enormous spending programs like universal healthcare).

Yes, there are more shoes to drop, including the CDS market, about which I warned in last December’s letter. But many things differentiate this from the 1920s or even the 1970s. For one, we always underestimate basic human ingenuity and its ability to transform society and create wealth. Every so often I find it useful – and reaffirming- to think about the incredible technological changes that have occurred since I got out of college. Heck, in 1984 the fax machine seemed miraculous. Where will the next incredible innovations come from? Biotech? Nanotech? New innovations that arise from a 100 fold increase in computational power? The answer is all of the above. Bad government can slow this process but not impede it entirely the way it once could. People and capital are much more fluid than they used to be.

The market has also turned its attention more towards the prospects of a bad recession and away from the credit crisis. Believe it or not, this is a good thing. Recessions come and go, but a possible total collapse of the international banking system definitely counted as peering into the abyss. If – if – we are passed this, then we have much less to worry about.

So life, and markets, will go on. Those that sell now will join others selling in a panic. How often does that work out? I think you know the answer. Securities of all kinds are getting terrible marks. Locking them in by selling isn’t likely to be a winning strategy.

Once we reach the far side, we will be in far better shape as an economy as all the leverage will have been wrung out of the system. I don’t know if you remember my letter of a few months ago where I spoke of visiting Indonesia. In 1997, the Indonesian currency, the rupiah, lost over 90% of its value. Can you imagine how calamitous it would seem if that happened here? Yes, the Indonesian economy suffered for a few years but today, rid of its excesses, it thrives.

There’s also a lot of money around. That certainly wasn’t the case in the 1920s or the 1970s. The sovereign wealth funds are loaded. Individuals have been liquefying. There have been billions of dollars raised for distressed funds over the last few months. There is money to come in and start buying. Which leads me to my next point…

The craziness has led to the most remarkable bargains we have seen in our lifetimes. This is what happens when you have forced liquidations. For example, you will recall we have an investment in a manager that buys SPACs, which are basically t-bills sitting in publicly traded trusts. Right now, because they have sold off, you can buy these with an implicit yield of 15%. Imagine, 15% t-bills! Actual t-bills yield close to zero. How could this be? It turns out that convertible arbitrage hedge funds were the biggest owners of these securities. These funds were just killed in September and are now facing massive redemptions, so they have been selling whatever they can, which includes SPACs. There are few buyers to be had.

Goodbye, Beta People

In the fund world, beta is what the market gives you, either a wind in your sails or in your face. Alpha is return attributable solely to skill. We had an interesting discussion in our office about how there are “alpha people” and “beta people” on Wall Street. In bull markets, Wall Street creates legions of beta people, who prosper because they were assigned to a fortunate desk out of their training programs. It’s always good to be in the right place at the right time, but nowhere so much as Wall Street. Naseem Taleb wrote about this at length in his first book, “Fooled by Randomness.” Well, the beta people are toast. The bloodletting has only just begun. I suspect a lot of alpha people – those who really create value – will get caught up in occupational violence as well, but they should fair a lot better.

What Would Sir John Do?

The late John Templeton was a long time client of mine, and a great man. My annual trips to the Bahamas to see him were ostensibly about my teaching him about what we were doing, but really most of the teaching went the other way. The recent turmoil reminded of something he said to me once. “Scott, I like to help people,” he began. As Templeton was one of the great philanthropists of our time, I expected to hear about his latest charitable initiative. “When they are desperate to buy,” he continued, “I like to help them by selling. And when they are desperate to sell, I help them by buying.”

Had Sir John lived another year, I don’t doubt what he’d be doing right now.

The Emergence of a New Asset Class?

Normally, hedge funds are the most nimble of investors. When market inefficiencies occur, they are often in the best position to exploit them. Right now, because of all the forced selling, there are more blatant market inefficiencies than at any time in our lifetimes, the kind of opportunities hedge funds can only normally dream about. Except, hedge funds are facing their own redemptions, so they are actually among the investors being forced to sell positions at crazy valuations (as in the example I gave with the convertible arb funds selling SPACs). The irony abounds.

What if a fund didn’t have to deal with any redemptions? That fund would be in pig heaven right now. The fact is that many wonderful trades sometimes need time to season. Liquidity providers almost always do better than liquidity consumers. This is something the endowments figured out a while ago. This leads me to how I believe the hedge fund industry must reinvent itself. The new model will have less leverage and longer lock-ups, probably two or three years. In essence, there will be a new asset class between the traditional hedge fund model and the private equity model. There will be the added advantage of emphasizing a longer period over which investors should judge returns. People simply have to be weaned of this need to see steady positive returns every month. I’ve been trying to come up with a catchy name…hybrid funds? Middie funds? Feel free to submit your ideas – perhaps we can name an asset class.

The product will be somewhat difficult to sell, as investors like liquidity (as such, overpaying for it). That’s why these new funds should have a lower fee schedule, probably 1 & 15. That would be a fair deal all around.

A Hard Rain

A Hard Rain

It’s not a-gonna fall, it fell in sheets over the last few days. What a spectacle over the weekend on Wall Street as golf games were canceled all across Greenwich and town cars crowded the streets outside the once imposing towers of capital. I just spoke to my old college roommate over at Lehman, who described the scene. He said that he entered work this morning through a gauntlet of reporters, and that most employees did actually show for work. The place is very, very quiet. Some minimal trading is being allowed, mostly to wind down positions. People are quietly speaking on their cell phones, trying to figure out their next moves. Most won’t have one. Whatever jobs there were on Wall Street were taken by people from Bear. Ironically, screwing up first turned out to be an advantage.

Ok, so maybe his call was a little early…

How horribly wrong things have gone. Personally, I normally pay the doomsayers little heed; as a matter of probability they are almost always wrong. The key word here is almost, because this time they got it right. As I watch AIG shares falling 40% this morning, it is clear this is no longer contained to the housing market or Wall Street.

Having said this, the pain is going to be felt much more acutely on Wall Street than Main Street, at least for now. Unlike the dot com bubble, the wrath of which was felt by speculators everywhere, this one is a direct hit on the New York tri-state area. Let’s look at just four companies, all based in Manhattan, and look at the amount of wealth that has been destroyed:

A hard rain, indeed. Consider that large percentages of the above losses were taken by employees of the firms. It was standard practice, particularly at Lehman, to award much of compensation in restricted stock, locked up for as long as five years, and as a matter of course most hold on to their stock even after they didn’t have to. That is – was - the culture. If this sounds familiar, it should, because Enron employees did much the same thing, although the scope of this is considerably larger. The tax base in the tri-state area is about to go to hell, as is the real estate market. Oh, I forgot that already went to hell. Well, it’s going there again.

I have been pondering Wall Street’s problems for some time. On one level, it’s a complicated thicket. On another, it’s not. It seems to me that the entire mess boils down to two issues: leverage and “other people’s money.” Perhaps you remember an historical survey I did recently on hedge fund blow-ups. The conclusion was that once you accounted for the small number of frauds, the rest blew themselves up with too much leverage. The story is no different with firms like Bear and Lehman. Both were levered about 30-1. A 3% move against you and - poof! - your capital’s gone. It’s not complicated.

One of the principle causes of the Crash of 1929 was equity leverage. Back then, you could borrow 9 dollars for every dollar of equity. This was rectified later by Regulation T, which limits borrowing to 1-1. The problem is, there’s never been any similar cap on leverage in the credit area. You might remember that last January I wrote that a real problem in 2008 would likely be something known as the “credit default swap.” The CDS market has grown from zero to $44 trillion in about a decade. It is loaded with counter party risk and unfettered leverage. That market is coming home to roost, particularly with the issues at AIG, which was a big factor in the CDS market. (Incidentally, where Lehman is concerned, I don’t think the systemic risk is large. My understanding is that people have been reducing their counter party risk with Lehman for months.)

I am no fan of increased regulation, but there need to be reasonable limits on credit leverage, whether it’s mortgages, credit default swaps, or fixed income arbitrage books. Some sort of macro, top-down regulation is vital. What I’d hate to see is the sort of overly wrought, intrusive regulation often written by clumsy politicians in times of crisis.

The other issue at the heart of this is “OPM,” – Other People’s Money. Simply, you’re not as careful with it as you are with your own. Imagine you are a trader at Merrill Lynch. Merrill has allocated a certain amount of capital for you to manage, none of which belongs to you, or for that matter, the managers who allocated it. It belongs to Merrill Lynch shareholders. How will you invest the money? Prudently? The problem is, your interests and Merrill shareholder interests are totally different. There is a well-travelled path that makes you rich in the short-run and Merrill shareholders poor in the long-run.

Any number of strategies will do. I have written about this in the past. Typically, you might choose some “risk averse” arbitrage strategy and then apply gobs of leverage. The resulting flight path is, statistically, several years of robust profits followed by a crack-up. You, the trader, get a big chuck of the profits during the fat years but lose nothing when things hit the wall.

Now take this model of a single trader and imagine it’s a whole investment bank and you have some idea of what’s been going on. This never happened in the days of private partnerships because it was partner money. Billy Salomon would have come down to your desk and fired your ass. Unfortunately, we can’t go back to the private partnership model because the capital demands of the global financial marketplace are too great. Someone smarter than I will have to come up with a working model for the 21st century. But OPM and easy credit have proven a toxic cocktail.

Is there any silver lining? Perhaps. For one, there are still deep pockets of liquidity in the world, particularly in the sovereign wealth funds. Back in the 70s, the last really long funk for the U.S. economy, no one had two nickels to rub together, and no one had ever heard of sovereign wealth funds. (Note of discomfort: all this liquidity is in the hands of foreigners, so expect them to keep buying up choice U.S. assets.) Second, people sometimes forget that the housing market, the source of all our misery, has built in support that no other market enjoys: 300 million people have to live somewhere. No one has to own stocks. That doesn’t mean we’re done, it’s just means that there’s a natural floor somewhere.

For the hedge fund industry, it looks like this could be the worst year on the books, although not catastrophic, by any means. I would argue that 2008 is a great argument for hedge fund investing because in the middle of the biggest financial crisis in decades they have managed to preserve capital, at least for the most part. Few alternatives have come close.

The pain this year is in the drip, drip, drip. The last really bad year for hedge fund was 1998 when the industry lost about 5%. This loss was due entirely to a very sudden drawdown in one month when Long Term Capital roiled markets. The slower, drawn out losses are in many respects harder for investors to take.

election 2008 - Crunch Time Cometh

As you know, in 2004 I built a presidential election model that had a great deal of success predicting the outcome of the Bush/Kerry race. In passing, I have shown the 2008 version to you in a couple of previous letters, but I thought it might be a good time to delve a bit deeper, given the calendar.

As a reminder, the model is built off state-by-state futures markets (see intrade.com). It has long been demonstrated that political futures markets, which tap the views of thousands of people who put their money at risk, are better predictors than polls. That is not to say, however, that they are sure-fire accurate, especially this far out. Further, they will exhibit a great deal of volatility between now and the election, although not nearly as much as polls. But for now, let’s see which way the wind is blowing.

Things look quite rosy for Barack Obama. The model, which you can view in full in the attachment, has him winning the election, 300 electoral votes to 238. 270 are needed to win. (We ignore the popular vote since it holds no relevance as to who actually gets elected.) As usual, a small number of states are really the only ones that matter, but here again, Obama looks to be in good stead:


Imagine these states to be on a shifting ladder, where they all move up and down in probability together over time. So in other words, if Obama wins Florida, it means he will have already trounced in the other states. Worrisome for McCain is that Ohio is the usual fulcrum point, and right now that looks like a comfortable win for Obama. Ohio was a toss-up in 2004 and Bush’s win there sealed the election. If Missouri remains the toss-up state this time it won’t really matter, McCain is cooked.

The U.S. has not knowingly elected a liberal since 1964. Jimmy Carter turned out to be one, but didn’t run that way. Bill Clinton ran and governed as a centrist, for the most part. Certainly, the country is more conservative now than it was in 1964. But if a liberal is ever to be elected, now would seem to be the time.

The market knows that Obama has several significant historical winds at his back. First, we are coming of the natural fatigue that results when one man holds the White House for eight years. Second, that man is deeply unpopular. Third, the economy is flagging. Fourth, the Iraq situation, which really is more of a police action now than a war, drags on. On top of this, Obama is an excellent campaigner. In contrast, I have no idea what McCain has been doing the last few months. Interestingly, McCain has some excellent ideas on taxes and health care (I was surprised), but he doesn’t seem to have enough conviction to pound the table on them. It is critical that he start soon.

What remains to be seen is if Obama can survive the public’s scrutiny of his own platform, which at this point, is as unknown to the public as underwear to Paris Hilton. What is clear is, in contrast to his mantra about change and post-partisanship, he is, in fact, a conventional leftist. He wants to raise taxes of every kind, including income, capital gains, and social security. He wants some form of socialized medicine. He appears antithetical towards free trade. Et cetera. All these measures seemed designed to move us in the direction of the EU, which troubles me greatly from an economic standpoint. The good news is that he is already tacking (slightly) to the right on some issues now that he has dispatched Clinton Inc. And history shows that most presidents, once installed, must compromise towards the center.

It is worth remembering that prognostication at this point on the election’s outcome is largely meaningless. George Bush Sr. trailed Mike Dukakis by 17 points right around this time. Gerald Ford trailed Carter by a whopping 30 points and almost won. Had the election been one day later, he undoubtedly would have, his momentum was so strong. So, at this point, I show you all the data mostly for fun. We will track it over time together.

Odds Are

While we’re on prediction markets, I offer you the following contract odds for events this year (unless otherwise indicated). There are an ever-increasing number of propositions.

Hurricane to make landfall in New York 7%
Avg. global temp. to be among 5 warmest years 7%
Bird Flu observed in U.S. 14%
Guantanamo to close 30%
Osama caught/killed 12%
U.S. or Israel strikes Iran 31%
Hugo Chavez leaves office 10%
A 9.0 earthquake strikes anywhere 7%
Average gas price over $5 on Dec. 31 7%
Drilling in ANWR approved 9%
John Paul Stevens to be next Justice to depart 68%
Arata’s cold fusion results replicated 22%
Higgs Boson particle observed 47%
Top U.S. tax rate in ’09 greater than 40% 13%

When Hedge Funds Blow - A Historical Survey

The biggest single impediment I see for investors contemplating an investment into hedge funds is “blow up” risk. How can they not, with all the hype? The media enjoy little more than the self-immolation of a hedge fund - Rich Guys Get Theirs! Blow-ups score a 10 on the CNBC schadenfreude scale. (Note: for institutional investors, blow up risk translates more specifically into “headline risk,” which is basically the risk of losing one’s job if a hedge fund you invested in ends up in the papers for the wrong reason.)

How common are hedge fund blow-ups? How often do they happen? What do they do to returns? These are questions I wanted to get to the bottom of.

Fishing around, I found surprisingly little research on the subject, so I thought it might be useful to conduct a survey of our own. Specifically, we will look at hedge fund blow-ups through the years to see what kind of conclusions we can draw. For the sake of argument, we will call anything greater than a 50% loss a blow-up.

Hedge Fund Blow-Ups – A Brief Historical Survey

1994

Askin Capital Management
David Askin, a star mortgage trader of the day, can lay claim to being the father of the modern hedge fund blow up. Interestingly, the industry had gone from its inception in 1948 to 1994 without a notable hair ball. (Of course, the industry was tiny back then.) Askin ran a mortgage fund that specialized in some of the complex mortgage instruments that had recently come into existence. If this doesn’t sound familiar, perhaps you’ve just returned from a long vacation. The Fed raised rates unexpectedly, crushing the risky “principal only” tranches in which Askin had loaded up, with leverage.
Losses: $600 million
Cause of death: Excessive leverage, concentration

1997

Niederhoffer Investments
Famed investor, author, squash champion and philodox Victor Niederhoffer gets squashed himself by a leveraged bet on Thai stocks.
Losses: $130 million
Cause of Death: Concentration, excessive leverage

1998

Long Term Capital Management
The ne plus ultra of hedge fund blow-ups. John Merriwether’s LTCM cratered when third world credit problems led to a sudden repricing of risk. Their book, seemingly diversified, was basically long risk and short safety. 40-1 leverage (accounts vary) led to margin calls they couldn’t meet and, subsequently, a Fed-engineered bailout by Wall Street. “When Genius Failed,” an account of the collapse, is recommended reading.
Losses: $4.6 billion
Cause of death: Excessive leverage

2000

Manhattan Fund
Run by Michael Berger, a native Austrian, this fund shorted technology stocks from 1996-1999. Oops, a tad little early on that trade. Losses prompted Berger to falsify his track record, which caught up with him by 2000. Arrested, he skipped bail and remained on the lam until he was caught last year in Austria.
Losses: $400 million
Cause of Death: Fraud

Laser Advisors

Run by former Goldman partner Michael Smirlock, Laser concealed a series of bad bets on options by falsifying position prices on exotic securities. Smirlock spent three years in the Big House and now does charity work.
Losses: $70 million
Cause of Death: Fraud

Ashbury Capital Partners

This one, at $8 million, is a rounding error but it’s too funny to leave out. Manager Mark Yagalla told investors he had averaged 80% in his personal account for nine years. He was 23 years old. Hmm. He blew most of the money on his girlfriend, a Playboy centerfold by the name of Sandy Bentley. Among other thing he bought her furs and, yes, a Bentley, which she promptly sold for cash. Yagalla bought himself a helicopter. When his assets were seized the centerfold dumped him, news of which was promptly reported to Ripley’s Believe it or Not.
Losses: $8 million
Cause of Death: Fraud

Marque Partners

Rob Littel, a pal of JFK junior’s, had a magic black box that promised to churn out 20% returns regardless of market direction, only he wouldn’t explain it to anyone. Which makes sense, since all his box did, apparently, was eat money. Shortly thereafter he started lying about returns. Pleading poverty, he paid a paltry a paltry fine to the SEC. Immediately after this, he signed a book deal for a nice advance to write about JFK’s secrets, a book called “The Men We Became.” From ripping off investors to selling out a dead friend, Littel is currently not considered a candidate for the Integrity Hall of Fame.
Losses: $120 million
Cause of Death: Fraud

2001

Integral Investment Management
The Chicago Art Institute suffered most of the loss here when this relatively unknown fund turned out to be a low-level scam. The term “headline risk” became widely used after this case, as the Institute had egg all over its face. The fund-of-funds industry, with its implicit protection from embarrassment, took off in the aftermath.
Losses: $70 million
Cause of Death: Fraud

Lancer Group

Lead manager Michael Lauer manipulated the prices of penny stocks to inflate investment performance. Morgan Stanley got taken in by this one, as did former Sotheby’s Chairman Al Taubman.
Losses: $200 million
Cause of Death: Fraud

2002

Lipper Convertible Fund
Ken Lipper was a former Deputy Mayor of New York City. He was a former Salomon Brothers partner and Columbia professor. He even wrote the book “Wall Street” that later became the Oliver Stone movie. (Greed is good!) None of this meant, apparently, that he wasn’t a scam artist. His fund got killed in the convertibles market so he started falsifying returns. Julia Roberts got taken in by this one which, I know, is hard to believe.
Losses: $350 million
Cause of Death: Fraud

Beacon Hill Asset Management
These guys got tripped up by the mortgage market (I sense a developing theme…) and started falsifying returns. Does that ever work out? Just curious. Lots of institutional names got caught up in this one, and it ranks as the biggest fraud to date.
Losses: $800 million
Cause of Death: Fraud

Eifuku Master Fund
This was a Japanese fund, the name of which, if only slightly mispronounced, must have phonetically captured the sentiments of its founders. (Do not try to figure this out in front of your children, at least not out loud).
Losses: $300 million
Cause of Death: Concentration, excessive leverage

2004

Sterling Watters
Angelo Haligiannis, a college drop-out from Queens, raised $27 million, mostly from friends and family, by lying about his returns. Haligiannis skipped on his bail and was arrested two years later in Greece.
Losses: $27 million
Cause of Death: Fraud

2005

Portus Group
Set up as a Canadian hedge fund for the little guy, Portus accepted investments for as little as $5000. Money allegedly used to buy stocks was diverted to pay expenses.
Losses: $150 million
Cause of Death: Fraud

Bayou Group

Your basic Ponzi scheme with returns fabricated to cover losses. Only these guys took it a step further: they actually started their own accounting firm – complete with the waspy, fiduciary-sounding name of “Richmond Fairfield” – to sign off on fraudulent audits. Founder Sam Israel was just sentenced to 20 years.
Losses: $450 million
Cause of Death: Fraud

Wood River
How’s this for a hedge fund strategy: put 80% of your money in one high tech stock. That’s exactly what Wood River did, investing in a stock called Endwave, which promptly fell from $54 to $10 a share. One problem was that the fund’s marketing materials spoke much about benefits of diversification. Another was that Wood River never bothered to tell the SEC they owned 45% of Endwave.
Losses: $200 million
Cause of Death: Concentration, fraud

KL Group
This one was fraud from the outset. Perhaps recognizing their own limitations, they never even tried to make money. The proprietors, three Koreans, skimmed $150 million from the Palm Beach society crowd, all the while claiming 125% returns (note to future scammers: don’t overreach, 25% is far more credible, and the Ponzi scheme will last longer). Money was used to live large, however briefly.
Losses: $130 million
Cause of Death: Fraud

2006

Matador Fund
Famed investor, squash player…wait, this guy again? Victor Niederhoffer becomes the first hedge fund operator to blow up twice.

Blow-up Artist Niederhoffer

Losses: $190 million Cause of Death: Excessive leverage

MotherRock L.P.
Big bet on natural gas futures goes the wrong way.
Losses: $230 million
Cause of Death: Concentration, excessive leverage

Amaranth Advisors
A sophisticated, $9 billion hedge fund in Greenwich gives most of their capital to a 29 year-old energy trader in Canada, who then makes a gigantic spread bet on natural gas futures with 8-1 leverage. Ka-Boom.
Losses: $6.4 billion
Cause of Death Concentration, excessive leverage

2007

Sowood
Caught off guard by a sudden widening in credit spreads (see Long Term Capital), Sowood announced a 57% loss. Founded by ex-Harvard endowment wiz Jeff Larson, the fund counted Harvard as one of their core investors. Harvard took a $350 million hit, which amounted to a 1% hit to their endowment.
Losses: $1.5 billion
Cause of Death: Excessive leverage

Bear Stearns High Grade Structured Credit Strategies Fund
This mouthful of a fund was the canary in the coal mine of the credit crisis last February. A big bet on subprime mortgages goes horribly wrong.
Losses: $1.6 billion
Cause of Death Concentration, excessive leverage

2008

Carlyle Capital Group
This $230 million fund was founded in 2006 by the eminence grises of the private equity arena, the Carlyle Group. The purpose was to buy mortgages using tons of leverage. Oops.
Losses: $220 million
Cause of Death: Excessive leverage

You should be seeing a theme here: hedge fund blow-ups are almost always caused by fraud or excessive leverage (concentration is also listed, but almost all these examples would have survived with less leverage). Also notice that of the non-frauds, every blow-up was in a fixed income related fund, especially in the mortgage area.

A critical point here, though, is that the money lost in the non-fraud cases was not actually lost by the industry as a whole. Invariably, these losses were in instruments like futures (from whence the leverage), where every loser has a winner on the other side of the trade. So Amaranth’s pain was someone else’s gain, and that someone else was more than likely another hedge fund. When Bear’s hedge fund was blowing up because of sub-prime, John Paulson’s fund was on its way to the biggest payday in hedge fund history for exactly the same reason. So you see, most blow-up risk is really fund-specific. It is not an industry risk.
Ergo, blow-up risk is really only about fraud.

Hunt Taylor was a well-respected hedge industry veteran, known as a real free thinker. I was fortunate enough to have met him casually before his tragic death in a motorcycle crash last year. Hunt was perhaps the first person to put fraud blow-ups in context. Specifically, he added up all the blow-ups to assess the overall impact on the industry. I have taken the liberty to add to his work here:


Source: Hennessee Group

No doubt I missed a few small ones, but they won’t add up to much. The big point here is that fraud-related blow-ups have been 0.039% annual drag on industry performance since 1994. That’s 4 basis points. If you add up all the losses it comes to $2.9 billion. That’s a big number, right? No, it’s not. A couple of weeks ago, GE dropped 14% in one day. Know how much investors lost? $47 billion!

This is worth restating: all the hedge fund fraud losses since the dawn of the industry add up to about 1/20th of what GE cost investors in a single day. And yet institutional investors galore own GE but won’t touch hedge funds because they are terrified of fraud, which they call “headline risk.”