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Monday, October 02, 2006

Luck as Marketing Illusion

which bets aren't worth making? I continue to be surprised and bemused by the various responses to Amaranth's fall from grace.  I suppose we shouldn't, however, be at all surprised that Jim Cramer has gotten in on the act.  And we all know how Cramer loves to point fingers.  Who is to blame?  Everyone.  DealBook tells us:

First, there are the clients — pension managers at 3M and San Diego County — who “rushed headlong” into the fund. “Pension managers simply don’t have the sophistication and experience to properly assess and monitor hedge funds’ performance,” Mr. Cramer asserts.

Then, he says, there are the investment banks that act as prime brokers, earning fees by providing trading and other services to hedge funds -– “the Morgan Stanleys, Bear Stearnses, and Goldman Sachses of the world.” These “fawning brokerages, of course, have no incentive to tell the clients that a firm like Amaranth is wrong to take down tons of borrowed money to bet on dubious strategies like the totally unknowable weather patterns that determine the direction of natural-gas futures.”


Mr. Cramer also casts blame on hedge-fund consultants as well as managers of funds of hedge funds. This last category of asset managers “can’t understand the hedgies’ strategies either,” he writes. “Most funds-of-funds people would not be smart enough to run hedge funds, yet they’re happy to take the money of those who want to invest in them.”

As for the inevitable calls for government regulation, Mr. Cramer says they are mostly “a waste of time.”

“The only government regulation we need is a prophylactic one: If you aren’t rich or your clients aren’t rich, you shouldn’t be in hedge funds.”

The element I continue to have trouble with here is that anyone is to blame at all.  The view that someone should be held to account beyond what has already passed requires a certain perspective on markets that I do not share.

Cramer's reaction is, unsurprisingly for those of us who know anything about Cramer, badly conflicted.  On the one hand, he insists that fund-of-funds people and pension managers (who many consider among the "smartest money") aren't smart enough to make the investment decisions required to run a hedge fund.  This, the implication that smart but not "smart enough" individuals are not suited for the business, implies that only some kind of ubermensch financial superbeing is.

In my view this is a fiction, the disbelief of which is suspended in no small measure by its tendency to deify hedge fund managers who, unsurprisingly and along with aspiring hedge fund managers, tend to be the whispering sources of this mythology in the first place.  We are to believe, therefore, that "luck" or "fate" simply is not a factor.  I call this the "myth of inaccessibility."  The market gods are only merciful to those who know the sacred rituals and make the appropriate sacrifices with the proper chantings.  To the rest, those outside the secret clergy orders, dazzling returns are closed.  A very catholic approach really, this hedge fund manager as a "proxy to the market gods" setup.  Does this make recent news (subscription required) in the Wall Street Journal (via Abnormal Returns) the second enlightenment movement in capital markets?  The first was, perhaps, the boon of the "after-work" or "at-home" equities speculator as made possible by e-trade.  (And we saw where that ended up).

Luck is only an illusion, in the world in which Cramer lives, blinding the less intelligent.  To those unable to understand the complex dynamics of financial systems like the ubermensch caste.  Of course, some strategies are obviously luck alone to Cramer, and therefore folly (probably because it would be impossible to suspend the disbelief of the public when selling the ability to predict them- and therefore the value of "experts," like Cramer, is measured in figures that approach zero) such as the "unknowable weather patterns that determine the direction of natural-gas futures."  These, Cramer shrieks, would be dubious to bet on.  (As if the movements of the S&P 500 index were an open book to Cramer).  What maniac would borrow money to do so?  (We will politely decline to make references to the titans in the insurance business at this time).  Here, like with the roulette table, luck is real.  This is the "act of god" clause.  Elsewhere, where god is bored with human affairs, or perhaps sleeping, luck is but a mist that clouds those without the proper night vision goggles (which can only be obtained after appropriate study at the appropriate institutions and even then only by the appropriate people).  But is luck just an illusion?  A crutch for the masses?  And if it is, what does this mean for our judgement of Amaranth, hedge funds, financial life in general?

"The man who said 'I'd rather be lucky than good' saw deeply into life," quips successful murderer Chris Wilton.  He continues, "People are afraid to face how great a part of life is dependent on luck. It’s scary to think so much is out of one’s control."

The man who first said "I'd rather be lucky than good," near as I can tell, was Lefty Gomez, the Yankees Hall of Fame pitcher.  It shouldn't be surprising that wherever luck plays a large part, statistics are sure to follow.  That Gomez, well in tune with the practical meaning of luck, would be a baseball player should, therefore, come as little surprise either.  Neither, really, should the revelation that absent luck skill is unhelpful, turn heads.

The best and the brightest can be unmade quickly by the occurrence of an event with three standard deviation probability.  This is as true in baseball as it is in finance.  I suspect, however, statisticians in finance are better compensated than statisticians who cull baseball figures.  Should we be equally surprised then that the myth of inaccessibility is used to sell financial products.  What would we need experts for if not for this disparity?

The best that you can say about such things, I believe, is that while smart is required, it is a hygiene feature really.  It is luck that makes the difference.  All that remains therefore, is to compute the probabilities (read: understand the risks) and make "smart" bets.  We buy into the S&P 500 knowing full well that a terrorist attack might crush the market (and our returns) but we judge this risk as small, and therefore discount it sufficiently to invest regardless of the risk, or mindful of our ability to absorb the loss.  We cope with financial loss either through capital reserves (we can afford it) or future earnings potential (we have enough time to earn it back before our earnings ability is weakened).  The returns are worth the bet if either of these two cushions are in place.  Note that neither of these cushions would be important if our predictive ability were perfect.  (I will come back to this in a moment).  If we still find terrorist risk too distasteful, then what alternative deployments of capital can we find that minimize the downside of that risk and still have suitable returns?

The real question is not "will a terrorist event happen?"  That question is unanswerable without some interesting twisting of space-time.  The real question is how well do we judge risk and, having judged the risk how well have we discounted it.  In other words, how well are we prepared to be on the wrong side of luck?  How in tune with the unknowable, the uncontrollable are we?  That is, do you know what is unknowable and uncontrollable and have you prepared for it?  In a sense, I think you have to be an existentialist to invest well.  Either that or a Woody Allen fan.

So should we complain that Amaranths exist?  I don't believe so.  Providing a bit of pure risk (and giving liquidity to the market for risk so that the risk averse can sell it and the risk hungry can buy it) is absolutely essential and required to provide the tools to design well adjusted portfolios.  Pulling liquidity from natural-gas price risk markets (and thereby hampering the ability of those who have neither the capital reserve cushion nor the future earnings potential to cope with the price risk they are holding from selling it to willing parties) may suggest that somehow there is a difference between weather prediction and equity investing, but it does so at the expense of healthy markets.  We spend a lot of time trying to support this fiction that markets are "fair," (see, e.g., insider trading law) and it is becoming a recurring Going Private theme that these fictions are harmful.  Comfortable, but harmful.

This is why I believe Cramer is confused.  He believes both that you can be smart enough to beat the system, but at the same time admits that the capital reserve cushion is the only way to protect "the public."  “The only government regulation we need," he quips, "is a prophylactic one: If you aren’t rich or your clients aren’t rich, you shouldn’t be in hedge funds."  The fantasy that the market is more "knowable" than the weather serves Cramer, another expert for hire, though.  I just can't decide if he knows it, or if he just believes his own lie.

Thursday, October 05, 2006

Order, Order I Said

backdating graph? no, amaranth salvage. Late night procrastination bears fruit.  This morning that's a Wall Street Journal article on the mostly orderly wind-up of Amaranth's energy position.  The surprise is the speed and motivation for Citidel and J. P. Morgan to pick up the scraps of the wayward hedge fund.  Sayeth Gregory Zuckerman of the Journal (subscription required):

Citadel and J.P. Morgan employed their risk-management systems to estimate the investments' value. Their conclusion: Once transferred from Amaranth, the trades would be more valuable than the market assumed. The new owners would be able to hold them until they proved to be winners, in part because each was bigger than Amaranth and so could afford to wait. J.P. Morgan and Citadel also felt they could hedge, or reduce the risk of the trades, through other investments.

What entrances me about this passage (aside from the lateness of the hour, of course) is the exploration of investment horizon and valuation.  Unleveraged, unburdened by margin calls, Amaranth's bets might yet pan out, particularly now that they have been picked up for pennies on the dollar.

This is an important point that should be considered by the doom-sayers.  There are established players out there who can and will play salvage team for blown short term bets that, but for timing, could have proved winners.  The Journal continues:

To reduce some of their risk, the partners immediately moved to sell some of the investments after concluding that the energy market wasn't buckling, despite worries about ripple effects from Amaranth's woes. Willing buyers quickly emerged. Some were J.P. Morgan's investor clients. Others were traders on the other side of Amaranth's bets eager to cash out and pocket their winnings.

Within days, the firms had sold enough of the portfolio to shift more than 50% of its risk to others, according to someone close to the matter.

The article takes up a subject I will revisit in the belated second part of my long-winded discourse on private equity and hedge funds: timing and its effect on investment decisions.  Take note my fellow late-nighters:  There are risk hungry players in the market who can ride out the storm.  The last sentence of the Journal article is a real keeper.

Thursday, October 12, 2006

The Absurdity of Election Years

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