Sunday, December 24, 2006

On the benevolence of financiers

An interesting comment on a previous post:

[Me:] "I guess the other thing to add is that not all financial games that make money for a hedge fund necessarily lead to more efficient resource allocation in the overall economy."

[Commenter:] Well, "all" is a high benchmark. But at least as high a percentage of the "financial games" that hedge funds use drives efficiency gains as whatever it is that start-ups do. In fact, because the winnowing process is more efficient (better measurement), I'd bet that the net increase in efficiency from hedge fund activities is greater than that generated by tech start-ups.

But, as always, specifics help. I can't think of a single major hedge fund strategy which does not improve efficiency for the economy as a whole.

I suspect the commenter, although anonymous, is a hedge fund manager, so we should take his opinion seriously :^)

Let me give a simple example of a case where financial activities that made hedge funds a lot of money did not in any way increase economic efficiency. At the end of the tech bubble, a lot of traders strongly believed that internet stocks were ridiculously overvalued. You might imagine that hedgies, with their ability to short, might play an important role in popping an obvious speculative bubble. But, the reality turned out to be the opposite: as long as they felt they could make a short term gain on riding the bubble, they were happy to do so, despite their strong belief that it was a bubble, with significant distortionary effects on the economy. I know from personal contacts that hedge funds actually behaved this way, and it is supported by subsequent academic studies. (See related discussion here; indeed, according to the famous Keynes observation about beauty contests, it matters not whether you think it's a bubble, but rather what you think others in the market believe!)

Of course, and this is the main point, a trader's job is not to "allocate resources most efficiently in the economy" but rather to make as much money for their investors as possible. Only an extreme interpretation of "efficient markets" would imply that these two goals are one and the same!

From the viewpoint of the old Adam Smith quip:

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest

we might conclude that there is no reason to differentiate between forms of economic activity. However, some people are genuinely altruistic and take part of their compensation in satisfaction that their work helps others. 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.

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 :-)


Anonymous said...

There's really nothing new here.

Take away fashionable terms like "alpha" and "efficient capital allocation" and you're left with the good old "greed is good" justification of Gordon Gekko.

Anonymous said...

I never heard of anyone working in Finance so that he/she could "allocate resources most efficiently in the Economy"! I know people who decided early on in their careers that they would work in Finance because they worship money above all, as if it were some sort of deity; I also know people who were trained as scientists for years and years, but then decided to work in Finance because doing Science didn't allow them to pay the bills. To state the obvious, not all people in Finance are alike. Generalizing: not all hedge funds are alike.

In my honest opinion, the benevolence of the financiers (when it exists) is when they give back to society (fortunately there are some good examples, though probably not enough), i.e., philantropy. For example, Jim Simons is famous for funding research projects. Stem cell research is moving forwards in the US due to philantropists (the Bush administration decided long ago that such an "immoral" research field should not have funding from the government), although it's true that not all philantropists are former financiers, nor all former financiers ventured into philantropy. Basically, since the governments are usually imcompetent, philantropy indeed allows a more "efficient" funding of projects and constructions. That's where financiers can truly be benevolent, I think... doing philantropy.

Regarding Finance itself, it's not allocating resources that matter, but to make money. It's always been like that, and everyone know it. Not there's anything wrong with it (greed is a human trait, after all) but to the financiers out there: please don't insult people's intelligence by stating that you strive to allocate resources more efficiently, ok!? :-p

Anonymous said...

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?

David Kane

Anonymous said...

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?

David Kane

Anonymous said...

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?

David Kane

Anonymous 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.

Steve Hsu said...


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, although some certainly are and not all are ego or reputation-driven.

Anonymous said...

Of some relevance: Joel Spolsky on why venture capital is a bad fit with entrepreneurship. The punchline: entrepreneurs want their company to succeed, venture funders want some number (not necessarily a lot) of the companies they invest in to pay off big-time.

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