Somewhere buried in the history of hedge funds is the answer to this underlying dilemma: How did a reasonably good way of managing money become so haphazard, perilous, and, often, just plain dumb?
It’s really impossible to say with any certainty, evidence being so scarce, but there is a chance that, once upon a time, hedge funds were an intelligent place to put your money. There’s very little data to support, or contradict, that proposition, the pre-1995 numbers being so lousy, but it’s plausible enough. That’s because hedge funds, as originally conceived, made a lot of sense in much the same way other antiquated 1940s institutions—such as the United Nations and urban renewal agencies—made sense as originally conceived.
Firm believers in efficient markets acknowledge that even though stock picking is generally an exercise in futility, there are inefficiencies in the markets—false perceptions contributing to stock-price anomalies—that sometimes can be exploited by sharp traders. As we saw earlier, Wall Street has embraced an antidote to the poison of the EMH, a theory of investing called behavorial finance, which holds that the market is subject to overemotional buying or selling that can be exploited by investors. EMH adherents agree that there are market inefficiencies, but that these occur randomly and that investors cannot consistently take advantage of them. Thus the EMH holds that “savvy stock pickers” and “proven stock-picking systems” are just random by-products of the laws of probability.
Hedge funds in their heyday, their Trygve Lie era, might have been able to give the EMH a run for its money. They were at one time small, nimble, and secretive enough to be able, theoretically, to exploit market inefficiencies systematically. Their business model was, and is, also sensible—in theory.
The creative genius underlying hedge funds lies in application of that word hedge. No question about it, early hedge funds lived up to their name. They hedged. Hedging is a sound thing to do if you know what you are doing, and is very much the antithesis of the kind of risk taking that hedge funds are known for nowadays. Hedge funds have changed so much from their origins that it makes you wonder why they are still called hedge funds. They should be called something else. Maybe “hedgeless funds,” or maybe something that has two syllables and a similar sound, such as “retch funds.”
The concept of hedging to reduce risk predates modern stock markets entirely. Rice farmers in Japan were hedging their crops in the seventeenth century, and by the 1630s you could buy and sell futures contracts on tulip bulbs in Europe. The problem, virtually from Day One, was that the same mechanisms that are used in hedging could also be used for speculation. An extreme example was the Dutch Tulip Bulb Mania of 1637, which is described in Charles Mackay’s 1841 book, Extraordinary Popular Delusions and the Madness of Crowds. “Every one imagined that the passion for tulips would last for ever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them,” said Mackay. All that one needed was a Dutch Artie Levitt, watching sternly from his leather armchair, to make the 1990s analogy complete.
The principle behind forward contracts was simple—the ability to sell something today for delivery tomorrow. Modern hedging arrived in the United States in 1848, with the founding of the Chicago Board of Trade. This provided farmers in the Midwest with a reliable way of selling their crops ahead of the harvest to lock in a price. If it turned out that the market price at the time of harvest was higher than the price of the contract, the farmers took a paper loss. Meanwhile, they’d already been paid for the contract, and all they had to do was deliver.
Hedging guarded against the possibility of a bumper crop causing prices to fall through the basement. That could mean ruin. It thus took some of the weather-dependent uncertainty out of farming. *
Nineteenth-century midwestern grain farmers probably didn’t know it—no, make that definitely didn’t know it—but they were bold pioneers on the frontiers of finance. The hedging in which they engaged was adopted, pretty much intact, by Wall Street financiers in the years preceding the crash of 1929. Like the honest, hardworking midwesterners from which they shamelessly stole this technique, trading desks of investment banks went long and short simultaneously.
The farmers went short when they sold the contract. Short is Street parlance for selling something you don’t own, whether that is bushels of wheat or shares of stock. Long means owning something. The farmers became long when the wheat, sorghum, or corn sprouted out of the ground.
On the Street, traders would buy stocks that they felt were likely to increase in price, while short-selling roughly the same dollar amount of less desirable stocks. A more recent variation on this theme, called pairs trading, involves doing that with different stocks in the same industry. The aim is to take advantage of superior gains in the better stocks, while exploiting price declines in the lousier stocks.
There are plenty of disadvantages to doing this. First, and most obviously, is that you might pick the wrong stocks. The second possibility is that you might pick the right stocks and the market goes against you. In a market crash, your longs and your shorts decline, so you’ll do a lot better than investors who are totally long. You’ll be protected, or hedged, much the same as that nineteenth-century farmer who sold his corn ahead of a bumper crop.
In the kind of tulip-craze-type market rallies that we saw in the 1990s, a long-short strategy is hurt by all those short positions, because of the principle that “a rising tide lifts all boats.” Still, short-selling was generally a sensible investment strategy—if, and only if, the fund manager had researched a stock thoroughly enough that he could get information not available to the general public. What’s nice about the short-selling end of the transaction is that you gain in two ways—from any possible decline in the cost of the stocks, and also from interest you can scrape up from deploying the proceeds of the stock sale into Treasury bills or money-market instruments. So that gooses returns still further—again, assuming the trader is not a bum.
The first hedge funds used that basic formula—though how, and where, or by whom, is lost to history. We know that the term hedge fund was coined in the mid-sixties, and was first used to describe the investment fund that was founded in 1949 by a former financial journalist named Alfred Winslow Jones. Since hedge funds were considered rich men’s playthings through the 1980s, they weren’t counted or even thought about very much. Press coverage was scarce, and though these funds were definitely not totally unregulated, the SEC was definitely looking the other way. Nobody even knows for sure if Jones was the first hedge fund manager. The SEC, in a 2003 study of hedge funds, calls him “one of the first.” What we do know is that Warren Buffett was another hedge fund manager in the sixties, thereby adding to the subsequent glory of the thing.
Aside from actually hedging, early hedge funds differed from ordinary investments in two primary respects—they could charge a performance fee, and one had to be rich to buy into them. One of the philosophical underpinnings behind securities regulation is that the very wealthy are not just different from you and me, but also smarter, perhaps more noble, and better able to take care of themselves. The “$1 million = accredited investor” equation was set in 1982, when $1 million really meant “rich enough to ignore.” Today it just means “prosperous enough to be ripped off.” By 2005, inflation, as measured by the Consumer Price Index, had eroded those 1982 dollars by a tiny fraction over one-half. So all the borderline millionaires who buy into hedge funds nowadays are comparative schleppers by 1982 standards.
Short-selling was what made hedge funds sexy. Mutual fund managers do not ordinarily engage in that kind of trading, so hedge fund managers had, again in theory, that much of an advantage over their white-bread brethren. Back in 1990, when there were only about $1 billion or so of them, hedge funds reeked of a kind of venturesome, snazzy, white-shoe snob appeal. They had a certain panache, a kind of genteel but iron-fisted British Secret Service reputation, because of their aversion to publicity—which was genuine at the time—and because of their willingness to go against the tide of Wall Street hype.
Until the early 1990s, hedge funds were under everybody’s radar screen. They were hard to locate. There was no hedge fund association, no newsletter, none of the other outward manifestations of full-fledged industryhood—including no involvement in the scandals that wracked Wall Street in the eighties. Mike Milken, Drexel Burnham Lambert, and the rest had nothing to do with hedge funds. They were untouched by the insider-trading scandals of the time.
Those were the innocent years. They were so innocent, so clubby, so intimate, that hedge funds didn’t shield their managers from liability. Now, that’s innocent. They were the days when a good many managers, filling the role of liability-bearing general partners in the limited-partnership structure of most hedge funds, didn’t incorporate to prevent themselves from being ripped to shreds in the event of a lawsuit. Another sign of how carefree things were was that hedge funds, by and large, didn’t impose a mutual-fund-style management fee until the 1990s.
It took only a couple of years into the decade before such gentlemanly vestiges of a more genteel era went out the window. Hedge funds were fast becoming an industry, with all the manifestations thereof, including a bona fide scandal. It happened in 1991, and the subject of the scandal was a bond-trading scheme that was so routine that the people doing it didn’t give it a second thought. Salomon Brothers, the investment bank and trading powerhouse, had a stranglehold over the U.S. Treasury bond market. Solly did what Wall Street firms do when they have a stranglehold over something, which is to tighten the noose until the eyes pop out and roll on the floor. Traders at Salomon apparently decided to control the market for Treasury notes—and they decided to let in some of their best customers.
As later set forth in a Justice Department lawsuit, two of the leading hedge funds of the time—Steinhardt Management Corp. and Caxton Corp.—“each bought large, leveraged long positions” in Treasury notes in April 1991. It was such a large position, $20 billion, that it was larger than the $12 billion in notes that the Treasury had actually issued. At the same time this was happening, other traders were going to short those notes. Shorting anything, a bond or a stock, involves borrowing something and then selling it. One of the risks of shorting is a short squeeze, which can happen when a major market participant controls the market in a stock, and forces the short-seller to buy back the stock at a higher price. That makes a profit for the short-squeezer and a loss for the short-seller. As alleged by the Justice Department, Steinhardt and Caxton were the short-squeezers—a bit ironic, by the way, because hedge funds are more often the victims than the perpetrators of short squeezes.
This wasn’t some penny-stock promoter putting the arm on traders trying to dump their stock. The feds’ accusations described a massive scheme. A short squeeze of Treasury bonds would actually move the market, pushing bond prices higher and interest rates lower. Something like that would require massive capital, verve, dedication—and brass balls. “Brass balls” was practically the middle name of the hedge fund managers involved. Steinhardt Management was run by Michael Steinhardt and Caxton was run by Bruce Kovner, both duly-certified, cape-wearing Superinvestors noted for their willingness to take massive bond and stock bets. Could Superinvestors have been making money by gangbanging the government bond market, cheek by jowl with some of the more cretinous traders at Salomon Brothers? They denied it—vigorously, I might add—even as Salomon Brothers itself was turned inside out for doing the same thing. They denied it right up to the minute that they settled, at which time they stopped denying it but didn’t admit anything either.
In December 1994, the two firms reached a settlement with the Justice Department and the SEC, settling the allegations without admitting or denying that anything had happened. They agreed to pay penalties and forfeitures totaling $76 million.
Seven years later, Steinhardt started denying again. He had this to say in his memoirs: “While denying wrongdoing throughout, we had reached the point where we needed to move on. The continued distraction of protracted litigation had taken its toll.” It does, doesn’t it? Oh, well. At least it was all worth it, despite the “distraction” and legal fees and threat of criminal prosecution—waived by Artie Levitt’s SEC and the Justice Department in return for no admissions to anything and some bucks. Not enough bucks, it seems. Steinhardt bragged: “Despite the enormous burden of the Treasury scandal, our bond bet had been a huge win for our investors. From mid-1990 through 1993, we had made more than $600 million on our interest rate view.”
What all this proved (apart from the idiocy of settlement agreements not forcing people to admit guilt) was that hedge funds had arrived. They were now in the big leagues. They had cornered a portion of the bond market, or at least the Justice Department was still saying that even while Steinhardt was neither admitting nor denying in the agreement, and denying later in his memoirs. In announcing the settlement, Anne K. Bingaman, assistant attorney general in charge of the Justice Department’s antitrust division, told a different story than Steinhardt did years later. She maintained in the Justice Department announcement of the settlement, nondenials notwithstanding, that “Steinhardt and Caxton joined to corner the market and to inflate the price of securities in the largest and most important securities market in the world.”
The Salomon Brothers scandal had taught the hedge fund industry a whole bunch of lessons. One was that they had to cover their posteriors. That business about general partners having personal liability might have worked in the clubby, gentlemanly old days, when hedge funds were sold over cognac and cigars, but it simply would not do in this vibrant, modern, market-cornering era. As lawyers from the law firm of Arnold & Porter observed in October 1993 in a paper presented to a hedge fund conference, “Although there may be marketing reasons for the general partner to be an individual, this is generally undesirable, since, as a matter of law, the general partner has unlimited liability.”
It certainly would be undesirable if the general partner’s name happened to be David J. Askin.