How Hedge Fund Investing Exploded

What began as a hedge became high risk...

IT IS SAID that, in ancient Rome, triumphant generals returning home would parade around the city, writes Tim Price of Price Value Partners.

While crowds would gather – no doubt attracted by the prospect of bread and circuses – a slave stationed at his rear would whisper into the general's ear "Memento Mori...Respice post te hominem te memento."

In other words: "Remember that you, too, will die. Look to the time after your death and remember that you're only a man."

The medieval period is particularly rich in the memento mori in art. This correspondent has a (plastic) skull on his desk at home given at some fintech conference a few years ago for some reason. The point being, like that of the Roman slave, to remind us of our own mortality, and at the same time to remind us to make the most of the limited time we have on this earth.

To resort to Latin for a second time: sic transit gloria mundi. How quickly the glory of the world passes away. Seize the day.

Clients of the Tampa-based hedge fund OptionSellers.com were granted their own lesson in the transience of human affairs back in 2018, when the president of the company went onto YouTube to apologise for blowing the fund up after some ill-judged speculations in the oil and natural gas markets.

We know neither James Cordier nor his former business, OptionSellers.com, so we can't tell whether his tears on the video are crocodilian or absolutely genuine. But we would make the following observations.

The term 'hedge fund' used to mean something. It meant that high net worth investors sought a hedge against the inherent risk of traditional financial markets (ie, stocks and bonds) by diversifying into a form of investment vehicle that attempted to mitigate that risk. 'Hedge funds' did not start out as speculative investment vehicles, far from it. The original hedge funds were, as their name implies, looking to hedge risk, not to add to it.

But as the hedge fund community grew in size, a seemingly endless number of greedy chancers jumped on board, attracted by the opportunity to charge clients both a 2% annual fee on assets under management and, typically, a 20% share of any positive performance on top. Just the 2% (the so-called "carried interest") would make any reasonably sized hedge fund manager rich, irrespective of their subsequent returns. The 20% performance share would, however, ensure riches beyond the dreams of avarice for the luckier high stakes gamblers out there.

Volatility in the oil and natural gas markets is nothing new. What James Cordier refers to as the ship swamped by a rogue wave has happened on innumerable occasions before. See, for example, Amaranth.

Amaranth Advisors, at its peak, was a hedge fund that had $9 billion under management. Although the fund had started out as a specialist in a strategy known as convertible arbitrage (which typically involves the purchase of convertible bonds and the simultaneous sale of related common stock), by 2005 the fund had shifted its focus onto energy trading and the natural gas market, influenced by its Canadian trader Brian Hunter.

There's just one thing you need to know about the commodities market. It's volatile. Hunter speculated wildly in the natural gas market and ended up losing $6.5 billion.

Long story short: hedge funds have morphed over the last 30 or so years from a relatively low risk way for wealthy private investors to diversify their portfolio risk into a Wild West of entirely unconstrained strategies ranging from conservative to ultra-aggressive, and in which the principle of 'hedging' and portfolio insurance has been cast to the winds. Given the 2% and 20% model that some hedge fund managers still use, you can hear the sound of the world's smallest violins playing just for them.

There are no such things as 'rogue waves' in the financial markets. Or rather, if there are, then the traders blindsided by them have no fundamental understanding of the inherent wildness of markets.

The requisite book for interested readers is Benoit Mandelbrot's The (Mis)Behaviour of Markets. The following extract is from our own book Investing Through The Looking Glass, which devotes almost an entire chapter to Mandelbrot. Investors – especially those engaging with the commodity markets – are strongly advised to consider the following of Mandelbrot's observations.

Rule 1: Markets are riskier than we think. And certainly riskier than conventional financial theory thinks. Price movements do not happily track the bell curve. Extreme price swings are not the exception. They are the norm.

Rule 2: Trouble runs in streaks. Or as Shakespeare put it, "When sorrows come, they come not single spies / But in battalions!" Market turbulence does not arise out of a clear blue sky and then disappear. It tends to cluster. A wild market open may well be followed by an equally desperate full trading session. A chaotic Monday may well be followed by an even more chaotic Tuesday.

Rule 3: Markets have their own personality. The father of value investing, Benjamin Graham, famously created the manic depressive character Mr Market to account for the stock market's constant oscillations between greed and fear. But when individual investors, institutional fund managers, hedge funds, day traders and sovereign wealth funds come together in a real marketplace, a new kind of market personality emerges – both greater than, and different from, the sum of its constituent parts.

Mandelbrot suggests that market prices are determined by endogenous effects specific to the inner workings of those markets, rather than by exogenous, external events. For example, his analysis of cotton prices during the last century showed the same broad pattern of price variability when prices were unregulated as they did in the 1930s when cotton prices were regulated as part of Roosevelt's New Deal.

Rule 4: Markets mislead. In Mandelbrot's words, "Patterns are the fool's gold of financial markets." The workings of random chance create patterns, and human beings are pattern recognition experts. We see patterns even where none exist and financial markets are especially prone to statistical mirages. Following from this, bubbles and crashes are inherent to financial markets and "the inevitable consequence of the human need to find patterns in the patternless."

Rule 5: Market time is relative. Just as the market has its own personality, so it has its own time signature. Professional traders often speak of a fast or slow market, depending on their assessment of volatility at the time in question.

In a fast market, things like market-, stop- or limit orders have limited utility. Prices don't necessarily glide smoothly within narrow ranges. Sometimes they gap down or leap up, effortlessly vaulting beyond price limits presumed to protect portfolios from ruin.

Traditional economists – if they've thought about the financial markets at all – have tended to treat them as a kind of closed system that obeys rigid and pre-set natural laws. Mandelbrot showed that the financial markets are altogether wilder than that. Another class of economists would recognise the inherent unpredictability of financial markets and the broader economy, and give them both the respect they deserved – the so-called Austrian School.

Far from trying to maximise returns for our clients, we are trying to do something far subtler: participate as much as possible in the upside potential of the investment markets, while attempting to limit the downside as far as practicable. To this extent our investment objective is asymmetrical. We're not interested in simply tracking the market – if we assume, as it is for most people, that "the market" is essentially the market for common stocks. We're far more interested in absolute returns than market-relative ones. Unfortunately for all of us, most fund managers don't think that way.

Don't allow exploded hedge fund managers to control the narrative. Only by understanding the risks inherent in investing (and in speculative trading) do we have a chance of navigating the squalls to come, and of our portfolios surviving them. A third of a century of working within the financial markets has convinced us that our greatest enemy is ourselves; more specifically, our genetically inherited 'fight or flight' response honed over hundreds of thousands of years has limited application in financial markets that mankind has only experienced over the last two centuries or so. Our brains have not yet had time to evolve to cope with the psychological trauma of market risk or of suddenly realised financial loss.

At a time when many markets are struggling to find technical support, notably Big Tech stocks, and there are multiple political threats gathering on the horizon, it's worth bearing in mind that there are two component parts to equity investing. There's the underlying business which investors have fractional ownership of, and then there's the stock market, which will go wherever it wants. As equity investors, we should be most concerned by the underlying performance of the companies we own, not by the daily meanderings of the stock market. In the context of great 'value' opportunities, the only real purpose of the stock market is to create bargains for our consideration from time to time.

Unfortunately, the underlying performance of most companies is only reported by the financial media on a quarterly basis, if that. But at the very least, it seems madness to be led by the daily gyrations of the stock market when it's the company's own profits and revenues and cash flow that actually dictate its market value over the medium term.

Charlie Munger's famous quote about not caring when Berkshire Hathaway stock lost half its value is a typically hard-nosed articulation of this point. But he happened to be right. Equity investing can lead to terrific longer term wealth generation, but it requires a steely attitude and a willingness to buck the mood of the crowd. Not everybody has those characteristics. But then, not everybody is going to make money from their equity investments. The stock market has a tendency to shift money and profits from weak hands to strong ones.

To paraphrase Charlie Munger, if you can't stand the heat, don't stay in the kitchen. But if you choose to leave the kitchen, chances are you will end up in the poorhouse.