Saturday, January 08, 2011

More Money Than God

At his death in 1913, J. Pierpont Morgan had accumulated a fortune of $1.4 billion in today’s dollars, earning the nickname “Jupiter”, the king of gods.

Today, hedge fund managers earn more money than god. In 2006 Goldman Sachs awarded its chief executive, Lloyd C. Blankfein, an unprecedented $54 million, but the bottom guy on Alpha magazine’s list of the top twenty-five hedge-fund earners reportedly took home $240 million. That same year, the leading private-equity partnership, Blackstone Group, rewarded its boss, Stephen Schwarzman, with just under $400 million, but the top three hedge-fund moguls each were said to have earned more than $1 billion.

Why they got that much? The answer lays in the fee system. Most of the funds have incentive fee, normally 20% of the profit they made. If they buy equity at $100 million and sell it at $200 million, the fund operating companies get $20 million. The company usually pays out all profits as salary every year.

The history of hedge fund started when Alfred Wilson Jones started his investment company. 20% of incentive fee, long & short strategy, leverage, and changing investment methodology to seek for alpha – these four characteristics remain the essential concept of hedge funds. Like most financial institutions, Jones took clandestine approach. Hedge funds have been cutting edge of finance theory.

The book titled “More Money than God” is the precise dictionary of the hedge funds at cutting edge. The book covers the following gurus and their hedge funds:

- Michael Steinhardt (Steinhardt, Fine, Berkowitz and Company): contrarianism based on intellectual confidence and intuition / father of blocktrading

- Julian art Robertson (Tiger Management): shot-seller based on his skeptic characteristic / one of the most long-lived hedge fund

- George Soros, Jim Rogers and Stanley Druckenmiller (Quantum Fund): belief in reflectivity - finding market distortion and make profit out of it / macro bet based on the view on how the world would turn out to be

- Paul Tudor Jones (Tudor Investment Corporation): Betting on the deals where the potential loss is limited while potential gain is large – earned from black Monday and Japan bubble

- John Meriwether (Long Term Capital Management): Investment based on financial theory – belief that in long term market is efficient ; asked investors long-term commitment of three years / too high leverage

- Tom Steyer (Farallon): Merger arbitrage and the other event driven style / man with frugal living

- Jones Simons (Renaissance): Quants fund established by mathematician & code-breaker / hired no economists but scientists

- Nick Maounis (Amaranth) : Multi / changing strategy (MA arbitrage, Convertible bond arbitrage, bond, etc)

- John Paulson (Odyssey Partners): Loner and Contrarian / Capital structure arbitrage – shorted mortgage securities believing that subprime was the 21st century-version policy error

- David Einhorn (Greenlight Capital): shorted financial institutions / battle against Richard Fuld of Lehman Brothers

There have been arguments on their compensation. They do provide liquidity to the market and enhance market’s price adjustment mechanism through the trading. In that sense hedge funds take positive role in the market. The question is whether the high compensation is justifiable for the sake of market stability and efficiency they allegedly provide. Not sure the answer for now, but I think the key is incentive and information. Bad incentive and information induce bad behavior. If we want to alter the current compensation scheme, do not jump into the naïve / straight-forward regulation but into the revision of incentive scheme.

Two key lessons to me:

1. You may be able to beat the market for a while, but almost impossible to beat it forever unless you’re always the smartest in the market

The art of speculation is to develop one insight that others have overlooked. When Alfred W. Jones started his business, it took 20 years until he is caught up by the market. Now that information technology progressed, competitors immediately catch you up even if you come up with the new investment methodology. The golden time is getting shorter. If you manage much money, it’s more difficult to be clandestine. That is why George Soros said on Apr 28 2010:

“We have come to realize that a large hedge fund like Quantum is no longer the best way to manage money.”

2. Rough correctness is better than accurate wrongness

Taleb mentioned this point too. When you look at the collapse of LTCM and relative longevity of Tiger Management and Quantum Fund, you may sense that we need some sort of slack (which is reflected in D/E ratio). We human being with limited ability make decision based on limited information. We may be right more cases, but cannot be always right. Need the slack for rainy days.


Sebastian Mallaby, “More Money Than God: Hedge Funds and the Making of a New Elite”, Penguin Press HC, 2010

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