Are Financialistas Over Hedge Fund Chic?

You can blame George Soros for making hedge funds the dark horse of the irrationally exuberant 1990s.

As the public face of the Quantum Group of Funds, Soros gained notoriety for short selling the English pound in September 1992 and allegedly making $1 billion in profits.  Adam Curtis observes in his riveting documentary The Mayfair Set (BBC, 1999) that Soros’ victory signalled the first time that market speculators had beaten a country’s central bank.  In the aftermath Soros cultivated a master trader persona based on his personal ‘theory of reflexivity’ or how ‘participant’s bias’ can shape our actions in and perceptions of market events.  Hedge fund chic arose in Wall Street as investment banks rushed to found hedge funds, which use leverage and pooled capital to manage assets, derivatives and securities for an investor group.

Financialistas however are showing signs of buyers’ remorse as subprime turbulence brings an end to Soros-inspired hedge fund chic.  The high-profile collapse of Bear Stearns‘ two hedge funds in mid 2007 was only a precursor, Hedge Fund Research notes, of 170 liquidated in early 2008.  The survivors have adopted Soros’ global macro strategy which relies on computational finance and dynamical models of currencies, interest rates and other macroeconomic factors to achieve returns.

Global macro is a risky strategy for several reasons: it requires forecasting models of complex interactions, computing power and fund mangers with impeccable judgment for asset allocation.  In fact global macro deals with a specific risk class known as systemic risk that results from business cycles and macroeconomic movements, thus it cannot be diversified away.  Add funds’ massive leverage of pooled securities, industry secrecy, little government regulation and hypercompetition between different funds and managers, and an accurate calculation of risk-return is difficult.  These challenges overshadow the potential of applied research solutions, such as Fritz Zwicky‘s morphological analysis, a problem-solving method which deals with ‘multi-dimensional, non-quantifiable problems’ – relevant to the macroeconomic factors and systemic risk in global macro strategies.

Hedge fund chic faces several other problems.  As an investment category hedge funds have matured and their combination of high leverage and high management fees are unsuitable for many non-institutional investors.  Subprime fallout is triggering change in US financial and regulatory institutions which will inevitably lead to more rules and regulatory oversight of edge funds and managers.  Internally, hedge funds also need to separate managerial processes (principal management, portfolio execution) from financial reporting (mark to market book) and governance (board, corporate and policies & procedures).

Which means despite Soros’ alchemical touch hedge fund chic may now be a fad.