Monday, January 01, 2007

Money talks

The anonymous commenter who inspired my post on the benevolence of financiers has identified himself as David Kane, Harvard PhD and former US Marine Corps officer (!), who runs Kane Capital Management, a quantitative, market-neutral, global equity hedge fund. David takes me to task in further comments here (copied below).

In his remarks he says "There are many confusions here, so it is tough to know where to start", "D'uh!", and "Unconvincing!"

David, I respect your opinions, and if you ever want to guest blog here, send me an email and I'll post it for my readers :-) Since I'm a truth-seeking idealist, I'm displaying your comments where they can be seen.

A couple of thoughts:

1) No disagreement that the market works through the self-interested actions of participants. But I don't see how this contradicts my original comment that "not all financial games that make money for a hedge fund necessarily lead to more efficient resource allocation in the overall economy." Although selfishness is crucial to the operation of markets, let us not mistake selfishness for altruism :-)

2) Of course it's based on an unscientific sample (i.e., people I know), but yes, I would say that people who join startups tend to be more idealistic than people who join hedge funds. Would anyone differ if I replaced the word "startups" with "the Peace Corps" or something similar (like "academic science" ;-)? There are generalizations about groups that are statistically true.

A lot of people are in startups as much for the chance to "do something cool" or improve the world, as for the stock option lottery ticket. I can't think of a single person I know who is in finance primarily because of the good it does in the world. Perhaps, as David mentions, they are looking ahead to their future days as a philanthropist, but I think that consideration is dominated by near term remuneration.

Comment 1: I was the original commentator but forgot to sign. There are many confusions here, so it is tough to know where to start.

1) You write:

"For example, many people in startups are idealistic, and part of the attraction of their work is that they are changing the world for the better. The same goes for academic scientists."

Do you have any, you know, evidence that the average person in a start-up is more idealistic than the average person in a hedge fund? (By the way, is it useful to compare hedge funds as a class, including big ones and small ones, against start-ups? You think everyone at Cisco and Microsoft is an idealist? A more fair comparison would be tech start ups (like the firm you started) with hedge fund start ups (like the firm that I started). What makes you think that you (and your buddies) are more idealistic than me and my buddy?

2) The purpose of a hedge fund is not to allocate capital more efficiently. D'uh. But that is the effect of a hedge fund's activities. We can go into specific examples, if you like, but every time I short a stock it is because I think it's price will go down. But, by shorting it, I drive the price down a bit and therefore bring closer the day when it is accurately valued.

3) "Although financial activities play an important role in the economy, as I have emphasized, I suspect the prime motivation for finance as a career choice is maximization of remuneration, not altruism :-)"

And you start a tech company because, what, you are an altruist? I assume that this is a joke. All of us make career decisions for a variety of reasons. Salary, security, people, intrinsic interest all play a part. How much time would you spend on your current start up if you were certain that the financial reward to you would be zero?

Comment 2: I asked you for a specific example and the best that you can do is some ramble about the tech bubble? Unimpressive!

1) What should a hedge fund have done in 1998 with Yahoo at $4 (split-adjusted)? Is this a "bubble," so you should short it? Or is it too low, so you should buy it?

That was a really hard question in 1998 and --- guess what? --- it is an equally hard question today with YHOO at $25. It is a fantasy to think that you (or anyone) knew in 1998 or 2006 or any other specific time what a fair price of YHOO should be, or what the price of YHOO will be in 6 months.

You mention some hedgies or traders who "knew" that it was a bubble (YHOO goes lower in 6 months) or "knew" that the bubble was going on (YHOO goes higher in 6 months) without any sense of how this identifies a class of strategies widely used by hedge funds that fails in increase economic efficiency.

The economy is more efficient of capital is better allocated, relative not to some utopian ideal of perfect allocation, but compared to some other plausible world. All the equity trading done by hedge funds as a class makes the price of YHOO go more quickly to its real stable value, relative to what the price would have done in the absence of that hedge fund activity.

Can you imagine what the bubble would have looked like were it not for the billions of dollars of shorts done by hedge funds?

Comment 3: You write:

"I know from personal contacts that hedge funds actually behaved this way, and it is supported by subsequent academic studies."

Baloney! If you can site these "studies" then please do so! The one you do (in the linked post) is not worth more than the 5 minutes I spent with it. The authors have no information on short positions, so how can they know what was going on?

Who do you think made all that money shorting stocks in 2000-2003? Some old lady in Des Moines?

There is no evidence that the bubble would have been less severe in the absence of hedge funds. Indeed, since the S&P is at about the same level that it was in 1999, just how much of a bubble was there?

15 comments:

Shakespeare's Fool said...

And how often is "idealism" — by being a rhetorical cover for the lust for power — an evil added to the lust for power?

Anonymous said...

Perhaps they are equally idealistic but just have different ideals.

I envision a world in which I am extremely wealthy...

steve said...

[This comment re-posted from the Benevolence... thread]

Nicole said...

David, do you think you are making the world a better place through hedge funds? Is that one of your motivations for pursuing the line of work you are in? I'm serious about my questions. I think many people who start tech companies do think the world is just waiting for their gadget/service. They want to make money too, we all have similar motivations, but the proportions are different. Financial gain may not be very important to many of them. And no, I don't have a study to quote, nor do you, or you would have cited it.

And I have to comment on this, in my experience academic scientists are not idealists that think they are making the world a better place. They are smart people who are used to being smart and are constantly pursuing the reputation of being smart. They are reputation-driven, but definitely not financially-driven. And not all are reputation-driven, but enough are. At least 50% in my humble opinion.

I wish I knew more about hedge funds so I could argue about the rampant greed that is destroying our society! Alas.

2:52 PM


steve said...
Nicole,

I am re-posting your interesting comment up above under "Money talks" so more people will see it.

I agree with you that academic scientists are not nearly as idealistic or altruistic as I would have expected.

A small subset are not at all ego or reputation-driven, and among these are often the undiscovered gems!

STS said...

I tend to agree with David Kane's perspective on this. Hedge funds aren't good or bad intrinsically. The issue (to the extent there is one) is the bubble in the talent invested.

The appropriate comparison is to the dotcom craze. Internet companies are a fine addition to our economy and do wonderful stuff on a daily basis. But there was a degree of me-too-ism going on in the late 90s which attracted people who were at best marginally suited to the problem space. They figured, hey, I wanna get me some of that!

Same deal with hedge funds these days. Sooner or later there will be a nasty collision with reality, a lot of SEC "accredited" investors lose a pile of money, new regs make hedge funds less amusing a playground, and the Shiftless MBA's of America will rotate into some other sector. "Problem" solved ;)

Now if you'd like to talk about globalization and how the American workforce avoids losing out big time, that's an interesting issue. But hedge funds are just drunken frat boys at a wake: they may deserve some of the dirty looks they're getting, but they aren't actually the cause of others' misfortune.

steve said...

STS: perhaps I was unclear. I'm not anti-hedge fund at all (see the post In defense of hedge funds).

My point is the following: The market allocates capital (reasonably) effectively due to the selfishness of individual actors, but let us not mistake selfishness for altruism!

STS said...

Steve, I understand you aren't "against" hedge funds. But the idea that they are less altruistic an activity is to make money the measure of self interest.

I was an academic at one time and felt selfish for not contributing to human progress in a more tangible way. While I believe research in math (or physics, chem, bio, etc.) have huge long-range benefits, I don't think my work was particularly valuable on its own.

I certainly wasn't being selfish about the share of wealth I was being accorded, but the activity did have a certain measure of self-absorption, if you will. I got relatively few dollars, but a lot of time to think and a certain amount of "privilege".

The academic folks I most respected seemed to be in it for creative satisfaction, the excitement of discovery, some prestige, etc. Very little to do with "human betterment" per se. Very self-centered as far as the proximate causes of their motivation was concerned. And I'm not even talking about people with disagreeable temperaments. Your average well-adjusted academic is not dramatically more concerned for the poor or social progress, etc. than people in other (more/less remunerative) lines of work.

Both Peter Thiel and George Soros have run hedge funds. Hard to find two more different political actors, though! And I don't think either of those guys is in it primarily for "the bling". Smart/wise people do what excites them. Shallow/immature people do what they hear other people find exciting. Hence the dotcom/hf excesses.

Anonymous said...

Steve,

Thanks for this thoughtful summary, and apologies for my occasional curtness. Perhaps I just expect a lot from someone who DB speaks highly of!

Anyway, let my tackle one point first:

----
"not all financial games that make money for a hedge fund necessarily lead to more efficient resource allocation in the overall economy."
----

Again, please provide at least one example of a widely used hedge fun strategy which fails to make the economy more efficient. I can't think of one. After all, any widely used strategy must, on average, be successful. It must, therefore, be profitable. Any profitable strategy involves some aspect of buying low and selling high. And, whenever you do that, you push prices in the correct direction. You move prices to where they "should" be, and will be, by your trading.

This point does not depend on altruism. Even if every hedgefund manager is motivated purely by greed, what they do (when successful) moves prices closer to where they will eventually be.

Dave Kane

Anonymous said...

You write:

----
Of course it's based on an unscientific sample (i.e., people I know), but yes, I would say that people who join startups tend to be more idealistic than people who join hedge funds.
----

I agree that the people who join the Peace Corps are more idealistic, on average, then the people who join hedgefunds or tech start ups. But, since I am a data hound, perhaps you could provide more detail on your observations.

How many people do you know at hedge funds? (I am guessing that this is not a big number.)

How many people do you know at tech start ups? (I assume that this is lots, but we should probably try to make the samples comparable by focusing on, say, people with Ph.D.'s)

What is the average idealism (on a N(0,1) scale normalized to some background population) of each group?

To give away the punchline, I suspect that you do not know enough Ph.D.'s well enough to estimate with enough accuracy the true mean idealism of this type of person in order to distinguish them from start up people.

Dave Kane

Anonymous said...

You write:

----
A lot of people are in startups as much for the chance to "do something cool" or improve the world, as for the stock option lottery ticket. I can't think of a single person I know who is in finance primarily because of the good it does in the world.
----

1) I agree with your assessment of start up people, especially 'the chance to "do something cool."' And, this sentiment is common in hedgefunds. Look at all the cool stuff that DB does (e.g., his g.data R package). But doing something cool != idealism.

2) You may need to meet a better class of hedgefund portfolio managers. (By the way, how many of the people you know are actually PMs, people with bottom line P&L responsibility for a model of their own design and construction?) A central part of what I do is to act as the whip hand of global capitalism, shorting the heck out of stocks which do not "deserve" to have such high prices. IIG is one such example.

We can go into more detail, if you like. But many, many portfolio managers see their mission in these sorts of terms. This doesn't make them as idealistic as a Peace Corps (or Marine Corps!) volunteer, but it does make them as idealistic as, say, you.

At least I like to think so!

:-)

Dave Kane

quickshield said...

You think that there is any motivation for a Start Up, that does not rest on the axiomatic principle of Missing Economy?

By Indentification Missing economy means a Market Opportunity or gap to be exploited by the creative capitalist mind. Forget PHD's they dont think well enoungh to perceive what I am talking about.

Next Mr Kane; instead of the pompous approach to hedge fund authentication by shorting the bubble....just thank greenspam for the hint....and the subsequent destruction of market cap without respect for valuation.....might very well have been conducted by interests using Illeagal naked short shares, so before you get too full of yourself, think about this.....did you or your fund use Naked shorts to adjudicate value of a business you may have known little or nothing about?

Please.....

steve said...

Hi David,

Thanks for your comments. Sorry it took me so long to respond - I'm traveling at the moment (typing this while waiting for a flight). I'll try to comment succinctly here - if I have more time perhaps I'll try to do an actual post on this topic.

1) regarding profitable strategies increasing market efficiency: yes, your logic is impeccable if I accept the assumption "Any profitable strategy involves some aspect of buying low and selling high. And, whenever you do that, you push prices in the correct direction. You move prices to where they "should" be..." But I think that is the essence of a strong efficient market assumption. If I think a lot of price fluctuations are noise, and the market only gets things right in the long run (and perhaps only most of the time), then trading against that noise may or may not improve resource allocation. So, imagine that, either by gut instinct, or by using some quantitative algorithms, I can guess the next market tick or fluctuation. By getting ahead of that fluctuation, I can make money. But, it's not obvious that improves the overall efficiency of the economy unless I make a rather strong assumption. Not sure if what I wrote is clear; we can revisit!

2) I guess I know about 25 guys at hedge funds, derivatives desks, or in quant jobs. Probably about equally distributed over the three. I've had some big hedge funds as investors in my startups, and the people I meet that way tend not to be quant-types; more the HBS MBA type. Otherwise most of the guys I know have academic backgrounds (like DB). I would say that all but one or two of them are more cynical about the markets than you are - for example, I think only one or two would embrace the strong efficient market assumption I described above in (1). Many, if not most, of them are *very* cynical about the markets, and only acknowledge the positive capital allocation aspects in a long-run, abstract sense (they can't see it in their day to day activities). Some of the guys are quite senior, like founding partner at a big (> few $B) fund, and most have their own P/L sub-portfolio.

3) Your idealism is refreshing, but at least in my experience I'm much more likely to hear the "what I do is cool; I might even do it if it weren't for the money" sentiment from startup guys than from finance guys. And much more so from academics!

Cheers!

Anonymous said...

"What I do is cool" does not man "idealistic." I accept that more start-up guys than hedge fund guys say this. Perhaps we can now agree1

This part is confused:

--------
But I think that is the essence of a strong efficient market assumption. If I think a lot of price fluctuations are noise, and the market only gets things right in the long run (and perhaps only most of the time), then trading against that noise may or may not improve resource allocation. So, imagine that, either by gut instinct, or by using some quantitative algorithms, I can guess the next market tick or fluctuation. By getting ahead of that fluctuation, I can make money. But, it's not obvious that improves the overall efficiency of the economy unless I make a rather strong assumption.
--------

First, it is not obvious to me that you understand what the assumption of market efficiency means. Start here. As you can read, "strong" form efficiency means "no one can earn excess returns." So, your example makes no sense.

Second, try this reasoning. 1) The more accurate prices are, the more efficient capital is allocated in the economy. If GOOG is accurately priced at $500, then the market is (correctly) making it easier for them to hire lots of people and invest in lots of projects. 2) To make money as a hedge fund, you must buy low and sell high, thereby driving prices back toward where they should be. The more that you do this, the more "accurate" (tending toward a longterm stable average representing real underlying economic fundamentals) prices will become. 3) Therefore, successful hedge funds increase economic efficiency. Unsuccessful hedge funds go out of business.

You write "I would say that all but one or two of them are more cynical about the markets than you are." Says who! I am incredibly cynical! Ask DB. I think that many companies (IIG, INPC, HSOA, OSTK) are run by very shady characters. I think that these companies do all sorts of nasty stuff and that their stock prices are way to high. I am amazed (and depressed) that the market hasn't caught up with them yet. But I have faith that one day it will. And I am doing my part.

Or by "cynical" do you mean hedgies that don't honestly believe that they have an edge, that their investors are getting a bad deal? I am not cynical in that way, but neither are most hedgies. (And plenty of start up guys have cynicism like that.) If you don't really believe that you can buy low and sell high, the last thing that you want is bottom line P&L responsibility.

I suspect that most of your hedge fund friends do not realize (or articulate) why what they do is so important. They serve the cause of efficient capital allocation without realizing it.

David Kane

steve said...

David,

You're right - I was not using the standard terminology about market efficiency. By "strongly efficient" I meant strongly efficient for resource allocation. That the price at any moment is what it should be to optimize resource allocation in the economy. Some might say this isn't so different from the usual definition, but I specifically meant economic efficiency, not no-arbitrage or no excess returns.

By cynical I meant that they don't claim that their individual trades actually push the economy toward greater efficiency. I would guess that most feel that people can make money without actually improving efficiency, because a lot of market movements are just noise and things can be mispriced for long periods of time. Mispriced means relative to the ideal price that would have optimized economic efficiency.

Sorry if ths is unclear. All the other forms of cynicism abound as well, of course :-)

Ray said...

Thanks for pointing out the article, Steve.

Funny to hear the perspective on money of those still in college. $150K a year will make you "rich" and give you financial freedom! A few years of this and you can retire at age 30! No way that can happen, especially if you live in Manhattan and develop a taste for the $3000 suits and expensive lap-dances that those interviewed were gushing about.

Anonymous said...

You write "By cynical I meant that they don't claim that their individual trades actually push the economy toward greater efficiency."

Well, if that is your definition of "cynical," then we have no dispute. More importantly, what you claim is try of most people at hedge funds. They don't realize how their actions make the economy more efficient, just as the baker does not realize that his raising the price for muffins or ordering more flour creates a cascade of price signals which make the economy more efficient.

But the actions of a portfolio manager have this effect, whether or not he realizes it (and tells you).

Dave Kane

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