Who can tell the future?
Most people are not that good at predicting the future of the economy and the stock market, but there are quite a few pretty talented people who are. Most importantly, they are willing to bet their money (and a whole lot of it) on their vision of the future, instead of just yapping about it on television with no real consequences to themselves (think Ben Stein or Jim Cramer). These people are hedge fund managers, especially those who follow directional global economy based strategies.
Hedge funds are run by smart guys. They strive to generate attractive risk-and-return patterns for their investors through a wide variety of investment strategies. Broadly speaking, these strategies could be classified as “search for alpha” (e.g. “equity market neutral”) and “bets on beta” (e.g. “global macro”). Alpha strategies aim at generating returns patterns that are not related to the market or any known economic risk factors. Beta active strategies, on the other hand, generate returns by taking positions driven by underlying economic factors. The best beta active hedge fund managers are pretty good as a group in anticipating which of the economic factors would deliver superior performance in the future. If we could only see these positions, we would’ve been able to peek into the future (as perceived by a group of really smart hedge fund managers)…
It is commonly accepted that “true” economic growth is the growth driven by technological innovation, and it is roughly approximated by a country’s GDP per capita growth. However, as I argued in an earlier post, short-term economic growth numbers could be distorted by monetary and fiscal policy choices. For example, a government may boost short-term GDP numbers by borrowing money through the sale of its long-term debt (say, twenty year bonds). By doing so, it employs the fundamental “time machine” feature of finance, which allows for the exchange of an uncertain future payoff for a certain payoff today. Ultimately, the repayment of the long-term government debt would be driven by the overall economy twenty years from now, i.e. people working, producing, consuming, and paying taxes then. Some of these people may not even be born today – how can we know for sure the number of workers and how productive they will be twenty years from now?
Cloning hedge fund indexes with liquid portfolios is hot these days. Major players, including Goldman Sachs, Morgan Stanley, Barclays, Societe Generale, and BNP Paribas, now offer hedge fund index clones. But guess what? These clones underperform the hedge fund indexes they were designed to replicate! The clone sponsors readily admit that, pointing to many technical reasons as to why that is the case (and a recent study by Ben Dor, Jagannathan, Meier, and Xu does a great job in explaining these). However, the most fundamental question is not usually mentioned at all – I mean, why is cloning expected to work in the first place?
Hedge funds charge hefty fees. Because they are that good (or so they claim)! They seem to provide good returns that have little in common with the overall stock market return (S&P 500), or U.S. bond market returns. But what is the source of their returns? Is it a stream of new and ever ingenious investment ideas generated by the hard work of a hedge fund manager, or could it be some “secret formula”, discovered long ago, and run by a computer, while the hedge fund manager is now busy golfing and fishing? An example of such a strategy would be just writing out-of-the-money put options on the S&P 500 index.
I, personally, have nothing against paying high fees for truly new investment ideas, generating high returns. For example, SAC’s 50% performance fee sounds like a fair deal for “sure-thing” returns generated by insider tips (oh, if only that strategy was legal)… On the other hand, I do have a problem paying a 20% performance fee as a “royalty” to a computer running a formula discovered a long time ago. However, if nobody else on the market offers returns based on the same (or similar) formula, then I am stuck with that hedge fund. And that is exactly what the situation was until recently.
Innovation is the ultimate driver of economic growth. Innovations big and small are essential for us to be better off tomorrow than we are today. However, it is also critical to sort out good innovations from wasteful ones. Good innovations then have to be adequately financed and nurtured in order to develop to their full potential. Financing potential breakthroughs in technologies “like we’ve never seen before” requires expertise, vision, and guts, as most radically new ideas may initially sound like “crazy talk”.
It is no secret that Main Street suspects that Wall Street high finance provides little meaningful contribution to society. Recent history suggests to a non-financial person that finance may in fact be taking rather than contributing. This opinion is expressed everywhere from Oliver Stone’s original “Wall Street” to the more recent Greg Smith’s “Why I am Leaving Goldman Sachs”. Even people in the finance industry have this nagging feeling about the purpose of life, as Matt Levine pointed out in his comment on Greg Smith’s article:
Smith is hardly the first banker to worry about whether his work makes the world a better place. Working at an investment bank involves trading off those negatives – stress, hours and a nagging sense of unfulfilled purpose – against the positive aspects of the job, which can be loosely summarized as “huge paychecks.”
The most effective investments … are investments in politics.
– Boris Berezovsky
Am I seriously quoting the late Russian oligarch about investments in politics? After all, Berezovky brazenly manipulated political outcomes in Russia for personal gain. Am I implying that investors do the same? Not exactly… While it is certainly not possible for a typical investor to manipulate the political landscape on such a grand scale, it is possible to achieve superior returns by taking the time to understand politics in order to anticipate developments that affect all financial markets.