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Go 'Inside the House of Money'

TSC Staff

Sometimes when I walk out onto the street and look around, I get so bearish that I think about buying a bloody castle in Scotland and moving up there with a couple of loaded shotguns and a truckload of canned foods.

When you look at the whole world and see what it's built on, it's not sustainable. It is totally, clearly not sustainable. The biggest thing that scares me is that we are about four meals away from total anarchy. I don't know how much food you have in your house, but if there is a run on the food supply with nothing available in supermarkets or restaurants, we are in deep trouble. Anarchy on the streets. I think about that often!

-- Inside the House of Money, Revised and Updated (page 362)

This excerpt from the revised and updated edition of Inside the House of Money might have seemed a humorous exaggeration when the book was first released in 2006. Global economies were booming, and markets from real estate to emerging markets to commodities were roaring. Wall Street titans and hedge fund managers were the masters of the universe, raking in seven- to 10-figure salaries for making bets in world markets.

Fast forward to today and the world seems ominously close to the one predicted above by an anonymous London-based currency specialist, one of 13 interviews with global macro hedge fund managers that make up Inside the House of Money. Even midway through 2008, inflation remained the main preoccupation as commodity markets continued to rally and oil was pushing $150 per barrel. But as the subprime crisis became a full-blown international credit, debt and solvency crisis, banks began to teeter on unsustainable levels of leverage and a host of scandals compounded an already pervasive lack of confidence.

As risk assets of all kinds were sold en masse, the receding tide exposed many hedge funds for what they were: leveraged market beta plays. Although it now seems clear that hedge funds broadly were far less leveraged than the banks, which are now dragging down the real economy, hedge fund performance suffered, with even some celebrated household names losing 50% to 90% of their (investors') assets.

Almost without exception, funds that performed well in the recent environment were funds that understood the global macro picture. Whether a manager called him- or herself equity long/short, fixed income, commodity or other, understanding the broader macro backdrop became paramount.

Contrasted with the top-down, active trading and disciplined risk management focus of most global macro funds, managers focused on bottom-up, longer-term valuation approaches tended to be among those most disappointed, as they decried markets, saying they are "irrational" and "oversold," creating a "perfect storm."

The book's conclusion is simply the famous and now often-cited quote by Keynes: "In the long run, we're all dead." Some markets might in fact be cheap at current levels. But can you stay solvent long enough to capitalize on such "value?" As many managers in the book belabored well before it was fashionable to do so, this game is all about liquidity, liquidity, liquidity.

Inside the House of Money was born from a simple question: What is macro? Where other hedge fund strategies are relatively straightforward (buying or selling stocks, for example), global macro managers can bet on any instrument, in any market, anywhere in the world. As one interviewee describes it in the book, global macro is "the willingness to opportunistically look at every idea that comes along, from micro situations to country-specific situations, across every asset category and every country in the world. It's the combination of a broad top-down country analysis with a bottom-up micro analysis of companies." The lack of understanding by the investment community of how global macro managers build their portfolios, construct their trades and decide on what bets to make is what prompted the effort to produce the book.

A brief history of hedge funds at the start of the book explains how in the beginning, all hedge funds were global macro. But then, hedge funds gradually attracted institutional capital, forcing them to become more specialized in order to stand out amongst the increasingly competitive marketing landscape. And much of this specialization translated into illiquidity in 2008.

Although many are calling for the death of hedge funds, we have been here before, notably in 1970 when Carol Loomis of Fortune wrote a piece entitled "Hard Times Come to the Hedge Funds." In 2000 the death knell was sounded once again for global macro hedge funds, ironically just as they began to come into their own after the dot-com crash.

Hedge funds will once again survive the current crisis, but in a much slimmed-down form. There are talented money managers out there that can produce outsized profits year in and year out. There just aren't 10,000 of them. The future of hedge funds will most likely include fewer funds, more transparency and smaller asset bases, with successful managers focused on risk management, using liquid instruments to trade in a more volatile world. Illiquid, "long-term" positions will go the way of private equity.

Inside the House of Money offers a time capsule's look at the preoccupations of global macro managers during the "Great Moderation," some of whom have become huge winners, while others have gone out of business. Reading about the lead-up to the current crisis, albeit with perfect hindsight, helps put the financial calamities of 2008 in perspective. As investors globally try to navigate the minefield ahead and the hedge fund industry returns to its roots of the 1980s and 1990s, the updated and revised Inside the House of Money is worth a read (or a reread) to help understand the world ahead.