I used to have a colleague who was a huge believer in the efficient-markets hypothesis. All he owned in his personal and retirement accounts were index funds -- he thought it impossible for individuals to beat the markets over time and scoffed at those who thought they could.
So one day, we are sitting on the desk, and the news comes across the tape that
was going to join the
. Yahoo! starts rocketing -- something on the order of 10%, as I recall. And he starts ranting, "Look at all these idiots ... they're all buying this stock just because it gets added to the S&P. How stupid could you be?" Then he reflects for a moment and it dawns upon him: "Wait a minute ...
one of those idiots!"
The anecdote is funny but true. Now we are seeing a similar pattern occur, and this time it is sad but true. We all know that capitalism is Darwinism. But these are really interesting times, when what index you belong to -- or, maybe more importantly, what index you
belong to -- matters more for your survival than your fundamentals. (Granted, not many fundamentals look stellar nowadays.) This is the paradox of efficient markets.
As I write this, we are seeing a couple of household names begin to implode:
Bank of America
. As a Pavlovian response, many traders are reflexively scooping up the double-levered short-side ETF, the
UltraShort Financials ProShares
, either because they are too lazy to do actual research or, worse, because they have been told that this is a good idea. They do not care about sorting out the strong from the weak; they're just trading a concept, neatly packaged.
Obviously, I have
about this before, but today it looks like 20% to 30% of the volume in
could be attributed to activity in SKF (and this on a day when JPM releases earnings). That's a pretty significant chunk of daily activity.
I won't belabor the levered ETF story any more, but I use it to illustrate a different point. If all we end up doing is trading indices, and the indices are the puppet masters that pull a stock's strings, then isn't capitalism failing its mission of allocating capital to companies that are in search of financing? That is the true paradox of efficient markets: If we all believe we cannot beat the market, then how do we even decide on the composition of the indices?
I mean, no one is buying individual stocks, so we don't need to look at individual fundamentals. I guess we are all reliant on the marketing guys somewhere to tell us what to do next and which companies are deserving of our capital (no offense to the marketing guys of the world, I used to be one...). Rather than do our homework, we'll all do what we're
This isn't just commentary for individuals. The consultants and mutual fund watchdogs have gotten the asset-management community so tightly wound up about "tracking error" that most all of them are closet indexers as well. Thus, for the vast majority, the only way to survive is to look just like everyone else. "Relative return" is the mantra. I am positive that those who were down only 38% when the market was down 40% are thrilled to death.
The best comment that I ever heard when seeing a bond fund manager was, "Yeah, we were really bearish on WorldCom, so we underweighted it vs. the index." They balanced the risk of tracking error with the risk of default and lowered their position by 30% -- meaning they still held on to 70% of something that they had serious doubts as to whether or not would make it. And that was a bold call. When tracking error clouds your judgment so much that you ignore the fundamentals, well, then you really aren't "managing money." You are managing a position vs. an index. And appropriately, your fees should be under attack from a pure beta vehicle.
So what about alpha providers, the "absolute return" managers? "Absolute return" is the sophisticated euphemism for hedge funds, and as we've now seen, the term "absolute" does not always mean "positive," as we were taught in math. The "Yale model," which everyone rushed to imitate, told us to diversify -- across asset types, across management styles. It seems to have broken down as of late -- asset correlation has gone to 1.
But in actuality, that is not quite what happened. What happened was that asset
correlation went to 1. When the financing rug got pulled, all assets tumbled. Thus the idea of diversification didn't matter if most strategies required funding and funding was nowhere to be found.
At first, when I saw the hedge-fund mavens on TV seemingly inciting panic over the credit crisis, I thought it was because they were short financials and were yelling fire in the proverbial movie house. But now, upon reflection, it may have been that they were inciting panic because they themselves were panicked. They were getting lines pulled and were facing liquidations and grasping at straws. The more they "hedged," the more they brought down existing positions.
Of course, it didn't help that there was tremendous group-think in the hedge fund industry. Everyone owned
, everyone owned
, everyone owned
, and everyone was short
. This is curious, because weren't hedge funds supposed to be those that proved markets were inefficient?
The problem here is easy to oversimplify ... so of course I'll attempt to do just that! While at Goldman Sachs, I put together a team to cover hedge funds for credit derivatives. At the time, there were maybe 20 people across the Street who actively covered hedge funds in this area -- that's 20 "idea disseminators"... not a lot of diversity of opinion, and every idea was recycled. And of course if you were a hedge-fund manager, you ran into your peers at the private jet terminal in West Palm, or shared hors d'oeuvres in the suite at the Super Bowl, and you chatted about "what's cheap" (then surreptitiously BlackBerried yourself in case you forgot the ticker you just heard about).
Thanks to those chasing the Yale model, we had ever-growing pools of assets in search of alpha. And with a cost of capital equal to "2 and 20," there was a paucity of good original ideas to support the growth -- and just as important, the hurdle rate -- so even if an idea was recycled, you'd take it.
Let me state here that I do think a lot of the trades hedge funds put on were indeed less risky; as a result, the "spreads" they achieved were below market returns, so they enhanced them with leverage in order to get large enough returns to accommodate the fee structure. If, in a given industry, I am long X and short Y, I have eliminated a lot of the market risk and indeed a lot of the XY sector risk; I have focused on the idiosyncratic risk of each company, making a bet that X will outperform Y. With some (maybe even the bulk) of the risk eliminated, I may lever that trade up 4-to-1, 6-to-1, 10-to-1. Most of the time, if I have done my research correctly, that trade pays off with less risk than one may take by just being outright long X or outright short Y. In isolation, this leverage shouldn't provoke alarm.
The problem arises when everyone starts doing that same trade. With more and more hedge funds being supported by funds of funds (who would "diversify" a portfolio of alpha for you), who were bringing in more and more capital and layering more and more fees on top of it, "good ideas" (that is, ideas that cover the fee hurdle) became scarcer and scarcer. And look out if someone got cold feet anywhere along the chain.
Let's say Hedge Fund A charges 2 and 20, then Fund-of-Funds B charges 1 and 15. A respectable 12% gross return by Hedge Fund A ends up becoming less than a 6% net return to the end Fund-of-Funds investor. Fortunately (?), some private banks understood this, so they offered one-and-a-half-to 1, or 2-to-1 or 3-to 1 leverage on this low-risk fund-of-funds investment to "augment" one's returns.
Now let's assume you are the private bank's customer and put up $1 million for their low-risk, diversified (and augmented) fund-of-funds product. But watching the news every night is disturbing your sleep pattern, so you call up your private banker and say, "You know, let's take some chips off the table, just for the time being..."
So the private bank, in order to give you back your $1 million in capital, calls up Fund-of-Funds B and redeems $2 million or $3 million, depending on how "augmented" your investment was. Fund-of-Funds B in turn then calls up Hedge Fund A and redeems $2 million or $3 million. Remember, those 12% returns generated by Hedge Fund A were a series of low-risk trades, enhanced by leverage. In order to meet the redemption, Hedge Fund A needs to unwind one or more trades.
So let's just say, to simplify, the private banker had all the money in Fund-of-Funds B, and Fund-of-Funds B had all their money with Hedge Fund A, and Hedge Fund A had one trade on -- X vs. Y. Hedge Fund A needs to buy back Y and sell X. And let's say this trade was levered 5 to 1. The $1 million investment by the private investor was levered to $2 million by the private bank, which was put into Hedge Fund A via Fund-of-Fund B and levered into a $10 million X-vs.-Y position.
The subsequent selling of X and buying of Y confounds others who have the same position on. In fact, it may alter the spread. This may lead to a margin call at other firms ... which will beget more unwinding. Margin calls spawn margin calls. Lather. Rinse. Repeat.
The result may lead to a depressed stock price for X, which was once a market darling. The rating agencies, despite their mandate to rate long-term fundamental credit risk, see the stock price go down and decide that maybe "Mr. Market" knows something they do not ... and that the lower stock price may inhibit X's ability to raise capital. So, just being prudent, they decide to place the ratings of X on review for downgrade ... and that virtually ensures that X's ability to raise capital will be impaired.
Diversification means nothing when leverage is applied. We have seen asset
correlation go to 1. Alpha, meet beta. Beta, meet alpha.
We have all just been witness to what Hyman Minsky was talking about with markets being inherently unstable. We have seen all of his phases and moved from "hedge finance" to "speculative finance," and yes, apparently we have even seen some "Ponzi finance." It's a shame that
Stabilizing an Unstable Economy
was out of print for so long -- we all could have used it these past few years...
Of all the Nobel Prize-winning modern financial market theories out there, perhaps none is more important today than those of game theory and behavioral finance. Fundamental analyses or derivative theory need not apply. Companies' profit potential and corporate assets aren't really swinging around by 5% to 10% a day, are they? Of course not, but if I believe others think you may have to sell, well, then I need to act. What matters most right now is what you think others think everyone else will do ... because of the paradox of efficient markets, nothing else matters.
Boy, aren't efficient markets fun?
At the time of publication, Oberg had no positions in the stocks mentioned.
Eric Oberg worked in fixed income, currencies and commodities for Goldman Sachs for 17 years before retiring as a managing director.