“Greed is good,” trader and arbitrageur Ivan Boesky told our MBA class of 1984. He arrived with a stretch limo and an entourage, wearing a fur coat and an expensive Italian suit. He explained that his job was to find opportunities that others missed and that the trade-off in risk and reward was real. Those willing to accept more risk–the risk of losing money because a ship sinks or a drug fails–should get the bigger payout when the exotic cargo comes into port or the cure for disease proves successful.
The risk part is the problem. How can you minimize the risk and still receive high enough payouts to cover costs? Entourages aren’t cheap. One answer is a hedge fund.
Hedge [ hej ] :Noun/verb:
–a row of bushes or small trees planted close together, especially when forming a fence
–Finance. to enter transactions that will protect against loss through a compensatory price movement.
Compensatory Price Movement
The original idea of a financial hedge was to reduce risk through a contra-investment, one making money in the opposite direction. When blue chip stocks fall, your “hedged” bet rises. Or, you hedge through timing, by purchasing short-term positions to complement long-term investments.
Hedging, or protecting against loss, can also be done through diversification, another fancy term that means smaller bets across multiple investments, not putting all your eggs in one basket. I always thought basketification would be more descriptive.
The difference between the rich and the poor is the risks the rich people take. However, hedge funds involve higher risk when compared to mutual funds. Although it attracts higher returns.From “Hedge Funds: Simple Guide to Investing for Beginners”
In modern parlance, hedge funds go a little further. First, they operate on limited partnerships, operating on borrowed capital. Translation: borrow that capital from the uber-rich. The funds are handled by “professional fund managers.” Translation: charge really high fees. One 20-year study showed that fund managers kept 2/3 of the profits in their funds. The fund managers received huge incentive bonuses in good years, but didn’t have to pay investors during loss years. On the other hand, when investments earned 35% in a year when the market earned 2%, the uber-rich didn’t look at the manager fees much.
Complexity Is a Key Strategy
Yet, there are only so many strategies and so many investments. Opportunities to make a little extra–with so much money flowing through global investment pipelines–such returns will be quickly swallowed up by rising prices. Hedge managers often turn to strategies that become increasingly complex and funds become like hedge mazes, obscuring the How.
For example, fund managers thought that if they bought mortgages made to low-income borrowers, they’d reap the high interest as a reward. While the borrowers had a risk of defaulting, if they only took a slice of that risky/rewardy loan, they could match it with safer borrowers, more likely to pay. Combining “slices” of these loans would lower the risk and hedge the bets.
What they also did, though, was combine a lot of slices of the risky loans together in tranches called “mortgage-backed securities.” As the 2008 financial crash proved, the complexity of the approach obscured that the risk had multiplied rather than lowered.
Even worse, some hedge fund managers had themselves hedged. In other words, they placed bets against what they sold to the investors. When their complex strategies dropped in value, they’d make a profit but not pass it on.
The Unspoken Truth of Investment Information Theory
In my second-year Finance class, we dove deep into beta analysis, random walks, and information theory. Several of these notions had been developed by Economics Nobel Prize winners who were professors at the university where I studied, hedge mazes full of calculus. In 1984, this was the future of investing: complexity and analysis could create opportunity.
One day, a student asked, “If Eugene Fama’s (Nobel prize winner) Efficient Information Theory shows that the stock market absorbs information into its pricing, then how can anyone make money?”
The professor responded, “Have you ever invested in the market?”
“Did you make money?”
The student turned beet red.
This was the Unspoken Truth of investing, the hidden fee behind all these diagrams and Greek letters. Information is not efficient; information is not evenly distributed. Information is imperfect. And humans, who manage funds, are run by emotions rather than calculations.
What hedge fund managers and arbitrageurs discovered is that the easier way to high earnings is to get information other people don’t have. Thus, one after another–from Ivan Boesky to Raj Rajaratnam to Bill Hwang (in March 2021 no less)–the investing geniuses often violate insider trading laws in order to get those extra rewards. Next stop: jail, scrounging in dumpsters in your underwear, and lifetime bans from trading.
Greed is not so good. Greed is expensive.