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Hedge Fund Losses Prompt Calls for Regulation

October 23, 2006 at 6:30 PM EST
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JIM LEHRER: Hedge funds. They are back in the news, with calls for greater regulation and a Securities and Exchange Commission investigation of some alleged insider trading. Our economics correspondent, Paul Solman, chronicles the rise and the risks of this particular kind of investment.

PAUL SOLMAN, NewsHour Economics Correspondent: The natural gas pit at the New York Mercantile Exchange went crazier than usual in September, when the Amaranth hedge fund bet on a short-term rise in natural gas prices, while, in fact, prices fell.

Amaranth’s investors lost their pants, the already troubled Pension Fund of San Diego alone more than $100 million. The State University of New York at Stony Brook had nearly 7 percent of its entire portfolio invested. And other hedge funds are reported to be on the rocks or folding, as well.

The losses again raised the specter of market contagion and financial panic, last seen in headlines back in 1998, when a hedge fund named Long-Term Capital Management lost $2 billion. And Senator Charles Grassley is now warning that the next hedge fund to go belly-up could leave America’s pension-holders in the ditch.

As for Amaranth, it’s going out of business, ironic since it’s named, like this amaranth plant here, for the Greek word meaning “immortal.” Now, the Amaranth affair caused no panic. But for years, people have warned that hedge funds are too big, unregulated, a disaster waiting to happen. And they’re now a $1.2 trillion industry.

So Amaranth’s demise seemed a good excuse to try to explain what hedge funds are and how they can lose so much, so fast. Since Amaranth itself is keeping mum, we’ll try to explain, by concocting a pretend hedge fund of our own, the Over the Hedge Fund. And it seems I actually could have started such a fund, even from my own house, which is in real life just over the hedge.

Even someone like me could start one, it seems, because, after the stock market swoon of 2000 — depicted here with the usual stock footage — investors, including managers of pension funds like yours, were looking for higher returns. Hedge funds promised to deliver them.

Unregulated investment funds

Nassim Taleb
Author, "The Black Swan"
The difference between hedge funds and mutual funds is that mutual funds take your money, and they have a lot of constraints on what they can do for you, OK? A hedge fund has usually more freedom to invest, to make bets, to take gambles.

PAUL SOLMAN: And what's a hedge fund? Law professor and former SEC Commissioner Harvey Goldschmid.

HARVEY GOLDSCHMID, Columbia University Law School: Well, a hedge fund is a misnomer. It sounds like you're hedging bets and covering them on both sides. Reality today is they're investment funds.

PAUL SOLMAN: Unregulated investment funds that, unlike mutual funds, say, can take any manner of risk, says hedge fund owner Nassim Taleb.

NASSIM TALEB, Hedge Fund Owner: The difference between hedge funds and mutual funds is that mutual funds take your money, and they have a lot of constraints on what they can do for you, OK? A hedge fund has usually more freedom to invest, to make bets, to take gambles, to do whatever you want.

PAUL SOLMAN: Hedge funds don't have constraints. That's because they can take money only from supposedly sophisticated, so-called accredited investors, those with $5 million or more, who can presumably afford to take risks; $5 million, however, automatically includes just about any pension fund.

So I put the question to Nassim Taleb, who as you'll see soon enough will provide the swan song to this story.

Higher rewards and more risks

Stan Jonas
Hedge fund owner
The path to success in the hedge fund is don't rock the boat

PAUL SOLMAN: OK, let's take it back to 2000. I have a lot of finance professor friends, some of whom would presumably go on my board. People know me from television as a financial something or other. Do you think I could have actually started a hedge fund?

NASSIM TALEB: You would have had billions under management currently.

PAUL SOLMAN: I would have billions?

NASSIM TALEB: Yes, because...

PAUL SOLMAN: Billions?

NASSIM TALEB: Yes, all you had to do is just go to university and pick up a couple of professors, OK, hire a couple of risk managers. Usually they have a foreign accent and, you know, they're quants, OK?

PAUL SOLMAN: Quants?

NASSIM TALEB: Quants, like me, like my background is a quant.

PAUL SOLMAN: "Quants," as in quantitative types, so-called financial engineers, like Taleb, himself a mathematician, a hedge fund owner, and author of a steeply skeptical book on investing, "Fooled by Randomness."

So let's say I hired a few quants, signed up some professors, and launched the pretend Over the Hedge Fund back in 2000, after the stock market swoon, from my backyard. Best promise to investors? High returns, of course, that wouldn't be volatile, or so says Nassim Taleb.

NASSIM TALEB: All you had to do is provide these steady returns or the illusion of low-risk returns.

PAUL SOLMAN: Or, as Taleb's friend Stan Jonas, also a hedge fund manager, puts it...

STAN JONAS, Hedge Fund Owner: The path to success in the hedge fund is don't rock the boat.

PAUL SOLMAN: Don't rock the boat. So we at the Over the Hedge Fund would have told investors -- rich people, pension funds, everyone -- that we were insuring low volatility, safe, stable returns, by investing in a lot of different markets, stocks, bonds, commodities, so we wouldn't be over-exposed in any one of them.

Yes, our traders would have gambled, making bets in those sometimes-wacky markets. But genius quants, not unlike Taleb here, would have written computer programs to protect those bets. In fact, Long-Term Capital Management, the hedge fund that famously collapsed in 1998, was run by Nobel laureates who once called their strategy "vacuuming nickels that others couldn't see," making small bits of money, that is, on big, supposedly sure-thing bets.

So what's not to like? Lots, says Stan Jonas, who operates his hedge fund from this townhouse in Manhattan. First of all, you can't have higher-than-average rewards without taking higher-than-average risks.

STAN JONAS: Every trade is implicitly a bet on something. The more of the trade you do, the more risk you take on.

The 'black swan' event

PAUL SOLMAN: Indeed, like that of almost any major hedge fund, the former success of Amaranth came from taking big risks, in its case on natural gas after Hurricane Katrina last year. A 32-year-old trader made several billion dollars on huge, highly leveraged bets that natural gas prices would surge. This year, however, no rough weather, no big storms, but a similar big bet, and thus a Katrina-like outcome for Amaranth, despite its claims of low risk.

And that's because of a fundamental fallacy with the supposedly risk-free approach: the black swan event. The black swan event is a way of saying that, just because you've never seen something happen, it doesn't mean it won't.

For millennia, Europeans thought that all swans were white because, everywhere they looked, even when they got to North America and rivers like this one, swans always had been.

NASSIM TALEB: We saw a lot of white swans. Every white swan was confirming that, you know, "Hey, all swans are white."

PAUL SOLMAN: Nassim Taleb's next book, not yet out, is called "The Black Swan," because, in 1697, Dutch explorers discovered Australia and black swans.

NASSIM TALEB: And, sure enough, they saw that black bird and said, "Hey, one single observation, OK, can destroy thousands of years of confirmation." So likewise in the markets, all you need is one single bad month to destroy years of track record.

PAUL SOLMAN: In fact, the hedge fund that claimed to be vacuuming those nickels, Long-Term Capital, needed about one bad month to go under in 1998, even though its mathematical models, based on years of track records, said these were the odds -- several billion times the life of the universe to one -- of experiencing a major loss.

Rare mistakes can be 'devastating'

PAUL SOLMAN: The head of Amaranth put it less precisely: "Sometimes," he said, "even the highly improbable happens."

As I understand it, your central insight is that people underestimate the likelihood of rare events.

NASSIM TALEB: Exactly. And my idea is twofold: number one, that rare events happen more often; and, two, that when they happen, they're far more devastating than we can imagine.

PAUL SOLMAN: In the end, then, I guess it's a good thing that I never started a hedge fund, even though, like Amaranth's owner, I might have done pretty well for myself, a fat salary, plus some 20 percent to 30 percent of the profits, while they lasted.

And had the Over the Hedge Fund gone under, well, the toppling of Amaranth hasn't hurt the world financial system because, it seems, it didn't borrow as much as it might have and thus averted the great peril: not being able to pay someone with whom it had bet.

But next time, says Harvey Goldschmid...

HARVEY GOLDSCHMID: That someone may then not be able to pay someone else. And if that bounces through the economy, you could have a crisis of confidence and failures to pay.

PAUL SOLMAN: A crisis of confidence because of an event that seemed impossible, until it happened.