Satyajit Das: Tilting at Windmills

By Satyajit Das, a former banker and author of Extreme Money and Traders Guns & Money

Richard Duncan (2012) The New Depression: The Breakdown of the Paper Money Economy; John Wiley, Singapore

Simon Lack (2012) The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to be True; John Wiley & Sons, Inc, Hoboken NJ

In Miguel de Cervantes’ Don Quixote the hero seeks to fight windmills that in his imagination are giants, despite the warning of his servant Sancho Panza. In English, the phrase “tilting at windmills” has come to be associated with attacking imaginary adversaries, based on a heroic, romantic and ultimately incorrect logic. Both The New Depression and The Hedge Fund Mirage share something of the Knight of La Mancha’s mis-placed idealism.

Richard Duncan is a practitioner, who has over three books – The Dollar Crisis, The Corruption of Capitalism and his new work The New Depression – sought to diagnose the ailments of the global economy. Mr. Duncan’s consistent and oft repeated argument throughout his trilogy is that the problems are caused by the over-extension of credit. Mr. Duncan is, of course, not the first or alone in this pre-occupation.

The rapid expansion of credit presaged both the Great Depression and 2007-2008 economic problems. Between the mid 1920s and 1929-30, debt as a percentage of US GDP increased from about 160% to 260%. In the run-up to the current crisis, debt to GDP reached over 350%.

Mr. Duncan attributes the credit growth to the demise of the gold standard. The end of the Bretton Woods system of fixed exchange rates and the de facto gold standard via the dollar’s link to gold, Mr. Duncan argues led to a rapid build up in debt and global imbalances, exemplified by persistent current-account deficits.

The explanation may well be broadly correct. However, it is inconsistent with the fact that a large expansion in credit took place in the 1920s when most currencies were linked to gold.

Mr. Duncan’s analysis relies on an extension of Irving Fischer’s theorem on the relationship of money supply and prices: MV=PT or money supply times the velocity of circulation equals the price level times the number of transactions. Mr. Duncan replaces ‘M’ with ‘C’ the total credit in the economy with V becoming the turnover of credit.

Mr. Duncan argues that the increase in C and some increase in V led to a steep rise in asset prices that led to the current problems. Mr. Duncan identifies the process whereby banks lent money against the collateral of overvalued asset prices, reinforcing prices rises, until the game of musical chairs ended. Few would disagree with the proposition. It lies at the heart of the now fashionable Minsky analysis of the financial processes underlying boom and bust cycles. Like Irving Fisher’s equation, Mr. Duncan’s revised formulation is a self evident truth; the amount of money spent equals the value of goods and services purchased.

At the ‘crisis attribution’ level (all books on the crisis need a pantomime villain), Mr. Duncan blames policymakers who presided over this rapid growth of credit. The thesis is one that has been well argued before elsewhere, perhaps more persuasively.

In this slim volume, Mr. Duncan does not delve beyond the surface of the argument and his imaginary enemies. The reality may be more nuanced.

Western economic systems require continued growth. The period of stagnation in the 1970s following the oil price shocks promoted a major policy shift including deregulation of crucial industries such as banking and hence credit creation. Credit became a way of driving growth, in conjunction with more market based economies. Increased debt in small doses may be useful in promoting growth. But over reliance on credit is more dangerous, even if it is inevitable if economic history is any guide.

The global monetary system is remarkably ad hoc, underpinned by economic theorems that are conjectural and unproved. As identified by Belgian-American economist Robert Triffin in the 1960s, the use of the dollar as the global reserve and trade currency required the US to run large trade deficits to meet the world’s demand for foreign exchange. As a self serving President Johnson argued: “The world supply of gold is insufficient to make the present system workable—particularly as the use of the dollar as a reserve currency is essential to create the required international liquidity to sustain world trade and growth”.

The complexity of the international finance may make it difficult to manage completely or successfully. Arguably, like the gold standard that preceded it, the Bretton Woods system was flawed at the outset as well as in its abandonment.

Mr. Duncan’s conclusions are problematic. In The Dollar Crisis published in 2002, he predicted a dollar implosion, as a result of a huge global imbalances and the credit bubble. The dollar remains in relative good health, despite the efforts of policy makers.

Mr. Duncan’s prognosis is romantic, although he eschews an idealistic call for a return to the gold standard. Seeing no realistic prospect of private consumption or investment driving real growth, he urges continued fiscal stimulus. Rather than encouraging private consumption or public spending, Mr. Duncan proposes an American solar energy initiative to create a new era of growth and prosperity. This is keeping with a previous suggestion of a $3 trillion US government investment in unspecified “21st century technologies over 10 years”. The New Depression proposed program would cost perhaps $1 trillion over ten years, and reduce the cost of energy by 90%.

Mr. Duncan’s approach is based on his view that conventional stimulus policies will create hyper inflation (which ignores the very low creation of credit and its lower velocity), depression or both.

It is difficult to assess whether the proposal is realistic. An obvious query is whether Mr. Duncan, a financial market professional, has the right disciplinary credentials for promoting such renewable energy initiatives to boost growth potential.

In any case, like the authors’ earlier recommendations of a rising minimum global wage, which has perhaps more to commend it, the chance of adoption is low.

The chance of a reversal of the monetary policies of recent years to restore financial integrity is also unlikely. Politicians of every persuasion like the illusion of control that power over money gives. While abandoning this power may be sound policy, it is unlikely that policy makers will willingly embrace it. As conservative politician William Buckley Jnr. knew: “Idealism is fine, but as it approaches reality, the costs become prohibitive”.

A different idealism permeates The Hedge Fund Mirage. Simon Lack, a former hedge fund profession, provides an insightful, if not original, critique of the industry.

Mr. Lack’s thesis is simple, if distressing for investors – hedge fund returns are not all they are cracked up to be. He presents his claim provocatively: “if all the money that’s ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good”.

Mr. Lack’s argument is that hedge fund returns are grossly overstated. A typical hedge fund makes most of its larger percentage return early in its history when it is small. This means that a small percentage loss in later life when it is much larger can lead to a loss in dollar terms than gains to that date.

The dollar gain or loss argument is important although it has been made before. Author Richard Bookstaber in A Demon of Our Own Design argued that percentage returns can be misleading. In its first 18 years, Julian Roberston’s Tiger Fund generated returns of 30 percent per annum. In its last two years, the fund made losses of 50 percent. Taking the losses into account, Tiger returned 25 percent per annum over its life. Starting life in 1980 with $10 million, it had $22 billion under management by 1998. The fund’s highest percentage returns were on a small dollar base. The losses came from a larger base (a 50 percent loss on $22 billion is a loss of $11 billion). Tiger may have lost more dollars than it made over its life.

Mr. Lack outlines familiar arguments. Historical returns exclude funds that fail or no longer accept new investment -survivorship bias. Only funds with a successful track record report performance—backfill bias. The difference between the best and worst performing funds is large, placing a premium on fund selection. Funds of funds add cost which detracts from return. Most really good hedge funds are closed to outside investors. Controversially, The Hedge Fund Mirage claims hedge fund managers have taken the largest share of the investment profits (over 80%).

Mr. Lack indulges in some sensational hyperbole (essential these days to gain media attention and sell even a modest number of books earning the author less than the minimum legal wage in Sudan). But for the most part, the book reaches sensible if unremarkable conclusions, highlighting the importance of fund selection, avoiding indexes and averages, the importance of risk management and avoiding any invitation from Mr. Madoff and his ilk to invest. For investors seeking alpha, high average returns are meaningless, like a comfortable average ambient temperature where your feet are in the oven and your head is in the refrigerator.

Unlike Mr. Duncan, whose prescriptions have not budged the needle on the Richter scale, The Hedge Fund Mirage has extracted a predictable, earth shaking response from the hedge fund industry, through its lobby group -Alternative Investment Management Industry (“AIMA”). In a series of opinion pieces, articles, a 24 piece ‘research paper’ and ‘commissioned’ academic research, the AIMA has sought to highlight methodological, mathematical and factual errors.

Mr. Lack probably can’t believe his luck as the AIMA’s rabid attacks have provided that most useful fuel for book sales – controversy. Financial Times journalist Paul Murphy drew the analogy to Mel Gibson’s The Passion of Christ, whose success at the box office was guaranteed by the fact that the film managed to upset every Christian group who took up arms against the work.

The AIMA criticism is also framed in ancient Aramaic, borrowing from The Passion of Christ. The central controversy is based on the appropriate measure of returns – dollar weighted or time weighted. The AIMA have resorted to that great modern invention – global best practice standards, which advocate time-weighted data for assessing hedge fund performance but dollar-weighted return for private equity assets. The detailed data used by Mr. Lack is not explicitly outlined making it difficult to independently assess the competing claims.

Both sides to this arcane controversy have sought the idealistic high ground. It is useful to remember writer Aldous Huxley’s observation that “idealism is the noble toga that political gentlemen drape over their will to power”.

Whilst amusing, the exchange, which may have to do with livelihoods (hedge fund managers and Mr. Lack’s advisory business), does not advance greatly the debate regarding hedge funds, their performance and role in financial markets.

A confluence of events may have boosted hedge fund returns. Initially, small funds and state managers may have benefited from regulated inefficient market. Macro funds high returns have been the result of the growth of emerging economies, the end of communism in Eastern Europe, world trade and deregulation of financial markets.

Some hedge fund managers are undoubtedly exceptionally skilful. Soros, Tudor Jones, and James Simons, an ex-mathematics professor and former code breaker, have outstanding records. Others undoubtedly boost performance using investment Viagra, leverage and investment in illiquid or complex securities. Some managers have sought an information edge, testing the boundary of insider trading and market abuse.

In reality, hedge funds occupy an artificial evolutionary niche in financial markets. Their existence is heavily reliant on the restrictions placed on normal investment vehicles. The ability to short, use leverage and focus on absolute returns defines hedge funds. But increasingly, their existence has also become a way of charging higher fees. As one manager candidly admitted: “a hedge fund is just an excuse to charge two and twenty; they do not do anything else very different”.

The Hedge Fund Mirage does not address these issues. It also does not explore the issue of the feasible size of hedge funds and their broader influence on financial markets.

Whatever the truth or dare of these arguments, The Hedge Fund Mirage provides a welcome and wry antidote to the hilarious and excessively serious hagiographies about hedge funds and hedge fund managers – see Sebastian Mallaby’s More Money Than God and Maneet Ahuja’s The Alpha Masters. Most authors and journalists behave like pre-pubescent girls in the presence of Justin Bieber when near these Lords of Money. They suffer from a phenomenon first diagnosed by John Kenneth Galbraith: “Nothing so gives the illusion of intelligence as personal association with large sums of money. It is also alas an illusion”.

Perhaps in a concession to his American ancestry, the Singapore resident Mr. Duncan is more earnest, believing that he can influence policy. True to his British heritage, Mr. Lack recognises that most hedge-fund books are written by “proponents”. He recognises that the industry won’t change any time soon.

The books are examples of a new emerging sub-genre in financial literature – Quixotic Tracts. The primary characteristic is an impractical idealism, lofty and romantic ideas and belief in extravagantly chivalrous standards of behaviour. The ideas in both books – sensible economic management and efficient investment behaviour- are probably beyond the human race in its current stage of evolution.