An Uncritical Glorification of Hedge Funds
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Sebastian Mallaby’s 2010 book about the hedge fund industry, More Money Than God, is a disappointment. Mallaby worked on the book for three years, conducting hundreds of interviews. He credits his agent with steering him to “grapple harder with the rich variety of thought that explains the success of hedge funds.” As the director of the Maurice R. Greenberg Center for Geoeconomic Studies at the Council on Foreign Relations, he had plenty of support. He benefited from a series of dinners with investment experts, convened by Robert Rubin, to discuss portions of his manuscript. The book should have been an eye-opener.
But somewhere along the way Mallaby got captured by the industry, and in the end, he comes off as a hedge fund industry lobbyist. The book does shed some light on interesting events in hedge fund history and is strewn with a few valuable insights. Mostly, though, it is a work of serial hagiography. It seems designed to attract worshippers like those who drive by celebrity homes in Beverly Hills.
“Hedge funds” or “a few hedge funds”
A major criticism is that the book does not adequately distinguish between hedge funds in general and the very small number of hedge funds – about a dozen or so – that the book does cover. There are at least 8,000 hedge funds in existence. As Mallaby himself writes, 5,000 hedge funds went out of business between 2000 and 2009. So over the last 10 years, there have been at least 13,000 hedge funds. The small number of unusually large and successful ones – a disconcertingly large percentage of which actually crashed and burned – are certainly not representative of the entire population of hedge funds.
Mallaby does mention many of the doubts about hedge funds that have been raised. In almost every case he dismisses these doubts with weak or non-existent counterarguments. Toward the end of the book – in almost the only place where he addresses the distinction between prominent hedge funds and all hedge funds – he asks, “But in its focus on the pioneers who shaped the industry, a history of hedge funds is necessarily biased toward winners. Perhaps the average hedge fund that attempts these strategies loses money?”
He answers this by saying that the best evidence comes from a 2010 paper by Roger Ibbotson, Peng Chen and Kevin Zhu, which states that the average hedge fund earned 7.7% net return between 1995 and 2009, after correcting for survivorship and backfill bias – including 3 percentage points of alpha. Mallaby fails to mention that the 7.7% return trailed the S&P 500 return over the same period. Granted, the authors calculated that risk-adjusted, the hedge funds earned an alpha of 3%. But they also caveat in a footnote that many hedge funds hold hard-to-price illiquid securities, which are priced in a manner that makes their movements asynchronous with monthly S&P 500 returns. This leads to understated estimates of market exposure. While the authors attempt to take account of this in their calculations, these securities contaminate the data in a way that could reduce betas and increase alphas.
Yet in other places Mallaby trumpets the returns of successful hedge funds by comparing them directly with S&P 500 returns. Why doesn’t he mention that comparison here? Also, he does point out the problem of illiquid assets elsewhere in the book, explaining that they make hedge fund managers “smooth” their returns, artificially reducing their volatility. Why does he not mention this here?
The answer seems to be that Mallaby has become a salesman for hedge funds. Salesmen don’t go out of their way to mention negative things about their products.