I don’t follow n+1 — “a twice-yearly print journal of politics, literature, and culture” — but they carried an interesting Interview With a Hedge Fund Manager back in January:
I didn’t go to business school. I did not major in economics. I learned the old-fashioned way by apprenticing to a very talented investor, so I wound up getting into the hedge fund business before I think many people knew what a hedge fund was. I’ve been doing it for over ten years. I didn’t even know what a hedge fund was when I first had this opportunity. I’m sure today I would never get hired.Really?
Yeah, it would be impossible because I had no background, or I had a very exiguous background in finance. The guy who hired me always talked about hiring good intellectual athletes, people who were sort of mentally agile in an all-around way, and that the specifics of finance you could learn, which I think is true. But at the time, I mean, no hedge fund was really flooded with applicants, and that allowed him to let his mind range a little bit and consider different kinds of candidates. Today we have a recruiting group, and what do they do? — they throw resumes at you, and it’s, like, one business school guy, one finance major after another, kids who, from the time they were twelve years old, were watching Jim Cramer and dreaming of working in a hedge fund. And I think in reality that, probably, if anything, they’re less likely to make good investors than people with sort of more interesting backgrounds.
Why?
Because I think that in the end the way that you make a ton of money is calling paradigm shifts, and people who are real finance types, maybe they can work really well within the paradigm of a particular kind of market or a particular set of rules of the game — and you can make money doing that — but the people who make huge money, the George Soroses and Julian Robertsons of the world, they’re the people who can step back and see when the paradigm is going to shift, and I think that comes from having a broader experience, a little bit of a different approach to how you think about things.
What’s a paradigm shift in finance?
Well, a paradigm shift in finance is maybe what we’ve gone through in the sub-prime market and the spillover that’s had in a lot of other markets where there were really basic assumptions that people made that, you know what?, they were wrong.
The thing is that nobody has enough brain power to question every assumption, to think about every single facet of an investment. There are certain things you need to take for granted. And people would take for granted the idea that, “OK, something that Moody’s rates triple-A must be money-good, so I’m going to worry about the other things I’m investing in, but when it comes time to say, ‘Where am I going to put my cash?,’ I’ll just leave it in triple-A commercial paper, I don’t have time to think about everything.” It could be the case that, yeah, the power’s going to fail in my office, and maybe the water supply is going to fail, and I should plan for that, but you only have so much brain power, so you think about what you think are the relevant factors, the factors that are likely to change. But often some of those assumptions that you make are wrong.
He has a few things to say about statistical arbitrage:
People actually call it “black box trading,” because sometimes you don’t even know why the black box is doing what it’s doing, because the whole idea is that if you could, you should be doing it yourself. But it’s something that’s done on such a big scale, a universe of several thousand stocks, that a human brain can’t do it in real time. The problem is that the DNA of a lot of these models is very, very similar, it’s like an ecosystem with no biodiversity because most of the people who do stat-arb can trace their lineage, their intellectual lineage, back to four or five guys who really started the whole black box trading discipline in the ’70s and ’80s. And what happened is, in August, a few of these funds that have big black box trading books suffered losses in other businesses and they decided to reduce risk, so they basically dialed down the black box system. So the black box system started unwinding its positions, and every black box is so similar that everybody was kind of long the same stocks and short the same stocks. So when one fund starts selling off its longs and buying back its shorts, that causes losses for the next black box and the people who run that black box say, “Oh gosh! I’m losing a lot more money than I thought I could. My risk model is no longer relevant; let me turn down my black box.” And basically what you had was an avalanche where everybody’s black box is being shut off, causing incredibly bizarre behavior in the market.
He also explains how CDOs work:
They buy mortgages, and then they package them and they tranche the pools of mortgages up into various tranches from senior to equity. So, basically you have a number of tranches of paper that get issued that are backed by the mortgage pools and there’s a cash flow waterfall, the cash comes in from those mortgages, a certain tranche has the first priority. And then you have descending order of priority, and the hedge fund would usually keep the last piece, which is known as the equity, or the residual, as opposed to the stuff that was triple-A, that’s the most senior paper. So if you had a pool of half a billion dollars of mortgages, maybe there would be 300 million dollars of triple A paper you would sell to fund that, and then there would be smaller tranches of more junior paper. And the buyers of that paper, particularly the very senior paper, the triple-A paper, were not experts, they’re not mortgage experts, they say, “It’s triple-A? I’ll buy it.” This is money market funds, accounts that are not set up to do hardcore analysis, they tend to just rely on the rating agencies. And again the spread that they’re getting paid is very small, so they don’t really have a lot of spread to play with to hire a lot of analysts to go and dig in the mortgage pools and really understand them, they kind of rely on the rating agencies, and that’s their downfall. It’s kind of an interesting interaction in the sense that a lot of this mortgage project was almost created by the bid for the CDO paper rather than the reverse. I mean, the traditional way to think about financing is “OK, I find an investment opportunity, that on its face, I think, is a good opportunity. I want to deploy capital on that opportunity. Now I go look for funding. So I think that making mortgage loans is a good investment, so I will make mortgage loans. Then I will seek to fund those, to fund that activity, by perhaps issuing CDO paper, issuing the triple-A, double-A, A, and down the chain.” But what happened is, you had the creation of so many vehicles designed to buy that paper, the triple-A, the double-A, all the CDO paper… that the dynamic flipped around. It was almost as if the demand for that paper created the mortgages.
[...]
What tends to happen in financial markets, is bad things happen when you really divorce the people who take the risk from the people who understand the risk. What happened is that that distance in the sub-prime market just increased and increased and increased. I mean, it started out that you had mortgage companies that would keep some of the stuff on their own books. Sub-prime lenders, it wasn’t a big business, it was a small business, and it was specialty lenders, and they made risky loans, and they would keep a lot of it on their books.But then these guys were like, “Well, you know, there are hedge fund buyers for pools that we put together,” and then the hedge fund buyers say, “You know what? We need to fund, we need to leverage this, so how can we leverage this? Oh, I have an idea, let’s create a CDO and issue paper against it to fund ourselves,” and then you get buyers of that paper. The buyers of that paper, they’re more ratings-sensitive than fundamentals-sensitive, so they’re quite divorced from the details. Then it got even more extended in the sense that vehicles were set up that had a mandate to kind of robotically buy that paper and fund themselves through issuing paper in the market.