Masters or Trend-Followers of the Universe?

By James Kwak

There is an image that underlies the theory of efficient markets. The image is of a pack of hyper-intelligent, hyper-competitive, voracious traders (working at hedge funds, at bank prop trading desks, in their basements, whatever), relentless scouring the markets for pricing inefficiencies and pouncing on them, trading them out of existence before moving on to the next one. The archetype is the quantitative trading desk at Salomon Brothers in the late 1980s, led by John Meriweather, exploiting arbitrage opportunities between on-the-run and off-the-run Treasury bonds. In finance theory, these sharks are contrasted with the “noise traders” who don’t know what they’re doing, and the question is whether the noise traders are enough to upset market efficiency.

But how good are the sharks anyway? That’s the question that came to my mind on reading the Economist‘s summary of a paper by Lauren Cohen, Christopher Malloy, and Karl Diether on stock market responses to legislation affecting specific industries. They found that you could make money by buying stocks of companies likely to be helped by new bills, and you could identify those companies from the voting records of senators and the incidence of keywords in the bill text.

“The mystery,” according to the Economist, “is why the broader market is so slow to recognise the effect of legislation.” That’s the classic way of thinking about the problem. Shouldn’t the hedges have figured this out already? But this isn’t the only case. A recent column by Lucian Bebchuk reminded me of another example: Up until the 1990s, you could have made money by buying stocks of companies with good corporate governance practices and shorting those of companies with poor practices.

These are patterns that were discovered by academics, who have limited research budgets and little financial incentive involved. (Academic prestige counts for something, but, according to theory at least, not as much as the billions of dollars in fees brought in by top hedge funds.) How come they were discovered by Bridgewater and Renaissance and all of those guys who have huge piles of money to invest in research?

One possibility is that Renaissance has discovered this and other trading strategies and has figured out a way to milk them without making the arbitrage opportunity go away entirely. The other possibility is that the sharks really aren’t so terrifying and ruthless as popularly believed, and instead they just stumble around copying each other to try to reduce their variance from the competition.

Or more likely it’s some combination of the two. A handful of firms come up with their own superior trading strategies, but most simply copy whatever they hear other people are doing. That’s why the corporate governance anomaly seems to have been traded away, and why everyone is doing high-frequency trading these days. The problem is that most investors’ money is going to the followers, which is why they are getting low returns and high costs. But it’s good for the entire industry that laypeople are in such undeserved awe of hedge fund managers as a class.

5 responses to “Masters or Trend-Followers of the Universe?

  1. The entire concept of thinking of “hedge funds” as a class is kind of silly. It’s a unique legal fund structure (and I suppose fee structure). There is literally nothing else that is shared between long/short manager A, HFT manager B, CTA manager C, and Activist manager D. This isn’t even like comparing a large cap equity mutual fund to a high yield mutual fund. It’s like comparing large cap equity to Tilapia farms in Brazil — in some cases. One should be suspect of any insight claimed when the premise is that there’s some kind of hegemony in a group that doesn’t have much.

    Investing in “hedge funds” as an asset class is going to fail miserably for the institutional allocator. Just like everything else based on some quasi-optimized asset allocation model has. It’s just bound to fail even more spectacularly given that it’s an even more idiosyncratic group.

  2. edward ericson

    John Meriwether…hmmm… Meriwether. Where have I heard that name before?

    Oh, yeah! He was founder of the biggest hedge fund collapse in history–at the time.
    http://en.wikipedia.org/wiki/When_Genius_Failed:_The_Rise_and_Fall_of_Long-Term_Capital_Management

    Very fearsome, as I recall. Had laser beams attached to his fricken head.

  3. This is what still plagues us today. The housing boom was created for the high frequency trader, just tell us your total monthly income and we will find a house and mortgage that suits your needs. Once the trade went bad you either bailed out, or sold out, or possibly went to jail, depending on why the trade went bad, or how much monthly money came up short. It still occurs, and new and old ponzis alike go to bed at night thinking what Madoff would have done if his physical or gold etf plunged into the vapor assets of electronic money. So roll your dice or take your risks and hope that your health is greater than your perceived wealth.

  4. The belief that hedge funds perform better than the market is a canard, largely created by the business media (CNBC, and even to a lesser degree Bloomberg) who benefit from the advertisement revenue they get from these different funds and from the glamorization of these HF managers as demigods. A large segment of hedge funds in fact underperform the market, and I would not be surprised if over half of them lag behind the market indices (such as the S&P 500).

    If you want the real story I highly recommend you buy Simon Lack’s book on reality of hedge funds. More truth telling on things like this need to be told to the average investor (often disdainfully referred to by the “experts” as “retail investors”). The only way the truth on these things is going to get past the filtered propaganda of CNBC is if books like Simon Lack’s sell enough where they can try to, you might say, “yell above the awful CNBC din”.