The excerpt below is taken from Satyajit Das‘ entertaining new book Extreme Money: Masters of the Universe and the Cult of Risk which was named to the longlist for the 2011 FT and Goldman Sachs Business Book of the Year award.  We hope you enjoy this provocative take on the new world of hedge fund as much as we did.

————————–

“Minsky machines” – an edited excerpt from Extreme Money: Masters of the Universe and the Cult of Risk by Satyajit Das.  © 2011 Satyajit Das All Rights reserved.

Hedge funds do not consistently deliver alpha, and returns were disappointing – in some periods lower than the broader equity market. Average returns dropped from 18.3 per cent per annum in the 1990s to 7.5 per cent in the 2000s.

Investment genius was always little more than a short memory and a rising market. Edwardian novelist Max Beerbohm was vindicated: ‘The dullard’s envy of brilliant men is always assuaged by the suspicion that they will come to a bad end.’

Clever people can make money if there are few clever people and lots of opportunities. Steve Cohen, owner of The Physical Impossibility of Death in the Mind of Someone Living, sounded a cautionary note: ‘It’s hard to find ideas that aren’t picked over and harder to get real returns and differentiate yourself. We’re entering a new environment. The days of big returns are gone.’

There is also the problem of scalability – what works on a small scale may not work on a larger scale. Some strategies need liquid markets. If you exploit inefficiency, then other investors must supply it. To be alternative, there must be a majority, the alternative cannot be the majority.

Inflow of money into successful hedge funds erodes returns. Louis Bacon (of Moore Capital) observed: ‘Size matters. It is the bane of the successful money manager.’ Size forces style drift. LTCM drifted from its métier, relative value trading in fixed income, into volatility trading, credit spread trading and merger arbitrage. In 2006, when market neutral hedge funds losses mirrored the fall in the market, hedge fund managers explained: ‘Everything in the market was a compelling buy. We could find nothing to short.’

The market has also changed. Banks cloned hedge funds, replicating returns by using simple instruments, with lower fees and less risk of an Amaranth or LTCM. Investors were looking for grand masters at knock-off prices.

Smart money focuses on incubators, identifying traders and seeding start-ups. Once established with a track record, the hedge fund raises third-party funding. The original investors exit, retaining the real investment crown jewel, the interest in the fund manager.

The economist Hyman Minsky theorised that in the early stages of a business cycle money is only available to creditworthy borrowers, known ironically as hedge finance. As the cycle develops, financial conditions look rosy and competing lenders extend money to marginal borrowers, a phase known as speculative finance and ultimately Ponzi finance. The cycle ends in a Minsky moment when the supply of money slows or shuts off. Borrowers unable to meet financial obligations try to sell assets, leading to a collapse in prices that triggers a spiral of economic decline.

Hedge funds are Minsky machines. They borrow to purchase assets, a strategy that works in moderation. Increased borrowing to buy assets artificially boosts asset values, generating profits that allow further leverage until the supply of money ceases. When the asset price bubble eventually bursts, the pressure to liquidate assets triggers losses, triggering a run on the funds, leading to larger losses and failure. Minsky machines are creatures of stable, benign environments that through their actions create the conditions for instability and their own demise. Ian Macfarlane, the former governor of the Australian Central Bank, observed: ‘Hedge funds have become the privileged children of the international financial scene, being entitled to the benefits of free markets without any of the responsibilities.’

Hedge fund managers themselves take few risks. As Alan Howard, co-founder of Brevan Howard, a large London-based hedge fund, put it: ‘I have no interest in getting excited or upset.’ After an accident, Howard, known in London’s trading community as ‘Mr Bond’, gave up skiing. He does not even drive, to avoid the dangers of London traffic: ‘I see all these nutty drivers.’ In a ‘heads I win tails you lose world’, only investors and lenders are at risk.

© 2011 Satyajit Das All Rights reserved.

This content, which contains security-related opinions and/or information, is provided for informational purposes only and should not be relied upon in any manner as professional advice, or an endorsement of any practices, products or services. There can be no guarantees or assurances that the views expressed here will be applicable for any particular facts or circumstances, and should not be relied upon in any manner. You should consult your own advisers as to legal, business, tax, and other related matters concerning any investment.

The commentary in this “post” (including any related blog, podcasts, videos, and social media) reflects the personal opinions, viewpoints, and analyses of the Ritholtz Wealth Management employees providing such comments, and should not be regarded the views of Ritholtz Wealth Management LLC. or its respective affiliates or as a description of advisory services provided by Ritholtz Wealth Management or performance returns of any Ritholtz Wealth Management Investments client.

References to any securities or digital assets, or performance data, are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services. Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others.

Please see disclosures here.

Please see the Terms & Conditions page for a full disclaimer.