The best way to handle risk: hedge funds

By Reuters Staff
July 6, 2010

Mockdollar

The following is a guest post by Sebastian Mallaby, the Paul A. Volcker Senior Fellow for International Economics at the Council on Foreign Relations and the author of More Money Than God: Hedge Funds and the Making of a New Elite. The opinions expressed are his own.

If only U.S. lawmakers were better acquainted with Jim Simons. If they understood this hedge-fund billionaire, the financial regulation now emerging from Congress might look different.

Simons is a poster child for the hedge-fund industry. His team of scientists in Long Island manages a black-box fund called Medallion, which has been up every year since 1990, usually posting gains of well over 50 percent. In several years over the past decade, Simons is said to have earned more than $1.4 billion—the amount, in today’s dollars, that J.P. Morgan accumulated during his entire lifetime. The legendary Morgan was known as Jupiter because of his godlike power over Wall Street. Hence the title of my history of hedge funds: More Money Than God.

The golden algorithms that drive Medallion’s profits derive partly from the mathematics of code-breaking, and partly from the related field of computerized translation. But lawmakers don’t necessarily need to know that. All they need to grasp is that Simons and his scientific colleagues are not the sort of people whom you find on Wall Street—and that the flaws that brought on the financial crisis are much less pronounced at hedge funds.

Crises occur when everybody crowds into the same misguided trade—emerging-market assets in the mid 1990s, mortgage securities in the mid 2000s. But Simons doesn’t follow crowds; he is a nonconformist and contrarian. When he worked for the Pentagon’s code-cracking unit, he not only refused to respect his overlords’ Vietnam policy—he denounced it in the New York Times, and was fired for his outspokenness. He chain-smokes intensively and refuses to wear socks. He seldom drives without exceeding the speed limit.

The quants whom Simons collected around him are also far from being crowd-followers. Henry Laufer, who holds the title of chief scientist, is so blissfully indifferent to the rest of the world that when a close colleague refused to speak to him for weeks, Laufer failed to notice. Peter Brown, one of the two translation experts who have run the company since Simons’s retirement, used to go about the office on a unicycle. I once asked Brown what he thought of the famous founder of another hedge fund. Brown shrugged; he had never heard of him.

In short, Simons’s faculty of quants does not think like the rest of the financial industry. It does not hire people from the rest of the financial industry, either, and has little in common with academic finance. For a while Simons’s scientists picked through finance journals, looking for ideas that could be traded profitably. But they soon concluded that none of the ideas worked. When I visited Simons’s Long Island campus, a star statistician had stuck an article to his office door. “Why Most Published Research Findings are False,” the title proclaimed, summing up the faculty’s disdain for the crowd’s wisdom.

Just as the Simons team is too independent to follow the herd, its incentives make it safer than most financial companies. Unlike much of Wall Street, which manages other people’s money, the Medallion fund consists mainly of the managers’ own savings. Unlike big banks and investment banks, which know they have a taxpayer backstop because they are too big to fail, the Simons faculty knows that if it messes up, nobody will stage a rescue. The mix of skin-in-the-game plus small-enough-to-fail cannot guarantee success, of course. But it encourages the firm to manage risk prudently.

The financial reform now emerging from Congress is built upon an understandable impulse: To squeeze risk out of the financial system. But financial risk will never disappear, so the real question is what sort of firm will manage it most safely. Because they are mavericks with healthier incentives than their rivals, hedge funds have nurtured a paranoid and contrarian culture that makes them good custodians of risk—not perfect, but certainly superior. They came through the 2007-2009 crisis relatively unscathed. And contrary to myth, the average hedge fund is leveraged just two to three times, a fraction of the 25 times or so that was common at investment banks on the eve of the credit crisis.

If lawmakers understood the virtues of hedge funds, they would have written a bill that actively promoted them. Instead, their legislation will hamper Simons and his followers in myriad small ways, forcing them into pointless registration with the Securities and Exchange Commission. Tragically, a basic truth is being missed: Investment risk is not going away, and the best way to handle it is to entrust it to hedge funds.

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