Taylor Ogan, Snow Bull Capital: China's tech frontier, the view from Shenzhen — Manifold #47

 

I really enjoyed this conversation. Taylor is a very unique investor who relocated his fund to Shenzhen in order to have direct access to information on Chinese tech companies.

Taylor Ogan is Chief Executive Officer of Snow Bull Capital, based in Shenzhen, China. 

Follow him on X @TaylorOgan. 

Steve and Taylor discuss: 

 

0:00 Introduction 

1:02 Taylor's background and why he moved his firm to China 

20:43 China post-pandemic and economic dynamism 

33:43 China dominance in electric vehicles; LIDAR 

56:55 Investment research: factory and site visits 

1:06:52 US-China competition - the future of innovation is in China

Audio-only version and transcript: 

https://www.manifold1.com/episodes/taylor-ogan-snow-bull-capital-chinas-tech-frontier-the-view-from-shenzhen-47 

Vineer Bhansali: Physics, Tail Risk Hedging, and 900% Coronavirus Returns - Manifold Episode #43

Steve and Corey talk with theoretical physicist turned hedge fund investor Vineer Bhansali. Bhansali describes his transition from physics to finance, his firm LongTail Alpha, and his recent outsize returns from the coronavirus financial crisis. Also discussed: derivatives pricing, random walks, helicopter money, and Modern Monetary Theory.

Transcript

LongTail Alpha

LongTail Alpha’s OneTail Hedgehog Fund II had 929% Return (Bloomberg)

A New Anomaly Matching Condition? (1992)
https://arxiv.org/abs/hep-ph/9211299

Added: Background on derivatives history here. AFAIK high energy physicist M.F.M. Osborne was the first to suggest the log-normal random walk model for securities prices, in the 1950s. Bachelier suggested an additive model which does not even make logical sense. See my articles in Physics World: 1 , 2


man·i·fold /ˈmanəˌfōld/ many and various.

In mathematics, a manifold is a topological space that locally resembles Euclidean space near each point.

Steve Hsu and Corey Washington have been friends for almost 30 years, and between them hold PhDs in Neuroscience, Philosophy, and Theoretical Physics. Join them for wide ranging and unfiltered conversations with leading writers, scientists, technologists, academics, entrepreneurs, investors, and more.

Steve Hsu is VP for Research and Professor of Theoretical Physics at Michigan State University. He is also a researcher in computational genomics and founder of several Silicon Valley startups, ranging from information security to biotech. Educated at Caltech and Berkeley, he was a Harvard Junior Fellow and held faculty positions at Yale and the University of Oregon before joining MSU.

Corey Washington is Director of Analytics in the Office of Research and Innovation at Michigan State University. He was educated at Amherst College and MIT before receiving a PhD in Philosophy from Stanford and a PhD in a Neuroscience from Columbia. He held faculty positions at the University Washington and the University of Maryland. Prior to MSU, Corey worked as a biotech consultant and is founder of a medical diagnostics startup.

Theory, Money, and Learning

After 25+ years in theoretical physics research, the pattern has become familiar to me. Talented postdoc has difficulty finding a permanent position (professorship), and ends up leaving the field for finance or Silicon Valley. The final phase of the physics career entails study of entirely new subjects, such as finance theory or machine learning, and developing new skills, such as coding.

My most recent postdoc interviewed with big hedge funds in Manhattan and also in the bay area. He has accepted a position in AI -- working on Deep Learning -- at the Silicon Valley research lab of a large technology company. His compensation is good (significantly higher than most full professors!) and future prospects in this area of research are exciting. With some luck, great things are possible.

He returned the books in the picture last week.

James Simons: Mathematics, Common Sense, and Good Luck

A great MIT colloquium by Jim Simons (intro by I. Singer). Interesting discussion @28 min about how Simons (after leaving mathematics at 38) became an investor. Initially, he relied both on fundamental / event-driven analysis (reading the newspaper ;-) as well as computer models. But Simons eventually decided on a completely model-driven approach, and the rest is history.

@38 min: on RenTech's secret, We start with first rate scientists ... Great infrastructure ... New ideas shared and discussed as soon as possible in an open environment ... Compensation based on overall firm performance ...

@44 min: Be guided by beauty ... Try to do it RIGHT ... Don't give up and hope for some good luck!

@48 min: a defense of HFT ... the cost of liquidity?

@55 min: world's greatest investor is a Keynesian :-)

@58 min: brief precis of financial crisis ... See also here.

See also Jim Simons is my hero.

Harvard as giant hedge fund

Ron Unz seems to be getting some traction on Twitter with his observation that Harvard looks like a giant hedge fund ($30B AUM) attached to a smaller educational institution (annual budget about $1B?) for tax purposes ;-)

Paying Tuition to a Giant Hedge Fund: ... Harvard’s Division of Arts and Sciences—the central core of academic activity—contains approximately 450 full professors, whose annual salaries tend to average the highest at any university in America. Each year, these hundreds of great scholars and teachers receive aggregate total pay of around $85 million. But in fiscal 2004, just the five top managers of the Harvard endowment fund shared total compensation of $78 million, an amount which was also roughly 100 times the salary of Harvard’s own president.

... The typical private foundation is legally required to spend 5 percent of its assets on charitable activities, and with Harvard’s endowment now back over $30 billion, that sum would come to around $1.5 billion annually. This is many times the total amount of undergraduate tuition ...

However, there has been very little media attention to his analysis of meritocracy in elite higher education. The humorous hedge fund observation is merely a sidebar to the meritocracy article.

Buffett's secret

Low beta + leverage. The leverage is obtained cheaply via Berkshire's insurance and reinsurance business. But I wonder whether low beta investing practiced algorithmically (i.e., without Buffet's stock picking skill, just taking a representative sample of low beta companies, or using some simple selection method) would work. I haven't yet read the AQR paper below and wonder how they adjust for "quality factors". Can I do that too?

Buffet's Alpha

Berkshire Hathaway has a higher Sharpe ratio than any stock or mutual fund with a history of more than 30 years and Berkshire has a significant alpha to traditional risk factors. However, we find that the alpha become statistically insignificant when controlling for exposures to Betting-Against-Beta and quality factors. We estimate that Berkshire’s average leverage is about 1.6-to-1 and that it relies on unusually low-cost and stable sources of financing. Berkshire’s returns can thus largely be explained by the use of leverage combined with a focus on cheap, safe, quality stocks. We find that Berkshire’s portfolio of publicly-traded stocks outperform private companies, suggesting that Buffett’s returns are more due to stock selection than to a direct effect on management.

More from the Economist.

Economist: ... Yet the underappreciated element of Berkshire’s leverage are its insurance and reinsurance operations, which provide more than a third of its funding. An insurance company takes in premiums upfront and pays out claims later on; it is, in effect, borrowing from its policyholders. This would be an expensive strategy if the company undercharged for the risks it was taking. But thanks to the profitability of its insurance operations, Berkshire’s borrowing costs from this source have averaged 2.2%, more than three percentage points below the average short-term financing cost of the American government over the same period.

A further advantage has been the stability of Berkshire’s funding. As many property developers have discovered in the past, relying on borrowed money to enhance returns can be fatal when lenders lose confidence. But the long-term nature of the insurance funding has protected Mr Buffett during periods (such as the late 1990s) when Berkshire shares have underperformed the market.

These two factors—the low-beta nature of the portfolio and leverage—pretty much explain all of Mr Buffett’s superior returns, the authors find. Of course, that is quite a different thing from saying that such a long-term performance could be easily replicated. As the authors admit, Mr Buffett recognised these principles, and started applying them, half a century before they wrote their paper.

See also If you're so smart, why aren't you rich?

"... the good things just don’t get shown to Western investors"

Via Maoxian.

Financial Review: ... “The trade over the past two years has been to be short China and go long Chinese corruption,” he says.

The trade has been a winner, with commodity prices weakening and Chinese stocks cooling. “But Macau casinos, and companies that sell $500,000 watches and $3000 a bottle cognac have been very strong. These are straight derivatives of Chinese corruption,” Hempton says.

Bronte has a strong track record picking Chinese frauds on global exchanges in sectors including cement, travel, medical products and education. By its estimates, it has successfully shorted more than 40 Chinese stocks.

“We really do have a hard time finding one that is honest, and we sincerely want to so we can hedge our short positions. There are a lot of good things going on in China. But the good things just don’t get shown to Western investors.”

The Hedge Fund Mirage

Bounded rationality even for the most "sophisticated" capital allocators of all: pension funds, wealthy individuals, private wealth managers. Financial services are incorrectly priced, both by sophisticated investors, and by society.

See also The truth about venture capital.

If you are interested in a sick story, search on Alphonse Fletcher or on Alphonse Fletcher chair gates west pao  :-(

Economist: “The Hedge Fund Mirage” attacks the Wall Street worshippers’ blind adulation. Simon Lack, who spent 23 years at JPMorgan, an investment bank, selecting hedge funds to invest in, grew tired of the free hand that investors all too often gave managers. He has written a provocative book questioning a central tenet of the hedge-fund industry: its performance is always worth paying for. The promise of superior performance is wrong, he says. Of course some investors make a killing, but on average hedge funds have underperformed even risk-free Treasury bills. This is because the bulk of investors’ capital has flooded in over the past ten years, whereas hedge funds performed best when the industry was smaller than it is now. What is more, it is hard to know how hedge funds actually fare, since indices that track industry performance tend to overstate the returns. Funds that do badly or implode are not usually included in the indices at all.  

Why would any client continue to pay for such mediocre returns? One reason is that hedge-fund managers are incredibly good salesmen. In addition, industry insiders who are all too aware of hedge funds’ shortcomings choose not to expose them, Mr Lack argues. Moreover, the common fee structure, in which hedge-fund managers keep 2% of assets as a “management” fee to cover expenses and 20% of profits generated by performance, has made many managers rich, but not their clients. Mr Lack calculates that hedge-fund managers have kept around 84% of profits generated, with investors only getting 16% since 1998. “Where are the customers’ yachts?” is the title of one chapter. What is worse, the disastrous dive of equity markets in 2008 may have wiped out all the profits that hedge funds have ever generated for investors.  

Mr Lack places a good deal of the blame for this on investors who fail to ask tough enough questions and have not grasped that they “want yesterday’s returns without yesterday’s risk”. They invest money with the biggest, best-known funds “that look nothing like those whose aggregate performance” they want to emulate. Instead investors should stand up to managers, negotiate more favourable terms and put their money into smaller funds, which tend to perform better.

The Magnetar trade, part 2

Janet Tavakoli pointed me to this WSJ article which covered the Magnetar strategy already in 2008. Tavakoli, and another correspondent (anonymous) who works in MBS, both believe Magnetar's claim that their strategy was market neutral (in a sense; see below). It was actually a common correlation trade at the time: assuming a certain correlation between the fate of the risky equity tranche and the AAA senior tranches, one could guarantee a positive return by investing in the former and shorting the latter using a CDS contract. The strategy would make money regardless of the default rate (assuming the correlation), but it seems the upside was larger from the CDS contracts. So there may yet have been motivation for Magnetar to pressure the underwriters to include particularly toxic mortgages in the CDOs they sponsored (as alleged).

Tavakoli and my other correspondent both believe that ProPublica and This American Life have the story wrong. It may be appealing to think that a single hedge fund was capable of exacerbating the credit crisis through its participation in the creation of $30-$40 billion in CDOs, but the real story is probably more complex.

WSJ: ... CDOs are sliced based on risk, with the riskiest pieces having the highest yield but the greatest chance of losing value. Less-risky pieces have lower yields and some pieces were once considered so safe that they paid only a bit more than a U.S. Treasury bond.

Magnetar helped to spawn CDOs by buying the riskiest slices of the instruments, which paid returns of around 20% during good times, according to people familiar with its strategy. Back in 2006, when Magnetar began investing, these were the slices Wall Street found hardest to sell because they would be the first to lose money if subprime defaults rose.

For the Wall Street firms underwriting the deals, selling the riskiest pieces was "critical to getting the deals done because they were designed to act as a cushion for other investors," says Eileen Murphy, principal at Excelsior CDO Advisors LLC, a structured-finance consultancy.

Magnetar then hedged its holdings by betting against the less-risky slices of some of these same securities as well as other CDOs, according to people familiar with its strategy. While it lost money on many of the risky slices it bought, it made far more when its hedges paid off as the market collapsed in the second half of last year.

Here is Tavakoli's comment on the ProPublica story -- she was actually asked for advice by Magnetar on how to put on the trade.

Tavakoli on the missed opportunity to grill Prince and Rubin under oath on Citi's CDO activities. Was senior management negligent (understood the risks, and approved them) or incompetent (didn't understand their own CDO business)?


The Magnetar trade part one, two, three.

The Magnetar trade

Just when I thought I was out, they pull me back in...

I thought I was done discussing all of this horrible CDS, CDO, credit crisis stuff, but here we go again. Yesterday I listened to this podcast from This American Life, which details the activities of a large hedge fund called Magnetar. See here for the original reporting done by ProPublica.

The Magnetar team ("Smart. Very smart"), it is claimed, put on a very clever trade in 2006, after spending 2005 surveying the MBS market and realizing that subprime was an irrational bubble. Magnetar actually created demand for CDO structures by agreeing to fund the riskiest equity tranches. By putting up $10 million (according to the reporting) they could help initiate the construction of a $1 billion dollar security. (If the models show that the expected loss is small, and someone is willing to expose themselves to it, other investors can come in later and take the senior tranches, which could have AAA ratings.) Magnetar apparently lobbied the banks assembling the CDOs to include the riskiest subprime mortgages in the structure, because they intended to bet against the more senior tranches using CDS contracts. The underwriters and asset managers went along with this in order to book fees (also in the tens of millions of dollars) collected at completion of the transation. These transactions generated fake alpha -- short term profits for the banks, at the cost of taking on hidden tail risk. The guys who did these deals made huge bonuses. When the CDOs tanked, Magnetar made huge profits through its CDS contracts. The senior tranches were typically sold to other banks, pension funds, investors, but a large portion were actually kept on the books of the banks that underwrote them. The CEOs of these banks were often unaware of the tremendous risks (potential losses of tens of billions of dollars, hidden in the AAA senior tranches) they were taking on in order to book hundreds of millions of dollars in fees during the bubble.

Comments:

1. Cognition is bounded. Magnetar understood what it was doing. Some of the structurers at the banks understood what was going on, but their incentives were to take the short term fees and do the transaction (who cares? IBG YBG = "I'll be gone, You'll be gone"). The counterparties who bought the senior tranches didn't know what was going on, and neither (I'll bet) did the CEOs of the banks that did the structuring. Certainly the shareholders of these firms didn't understand the risks. Mr. Market priced all these deals terribly.

2. Nobody in 2006 said "Paulson / Bernanke / Obama / Geithner / ... will definitely bail us out if this gets too hairy. We're too big to fail!" Most of the MBS guys lost their jobs in the crash. But they made plenty of money while the getting was good.

3. Some people violated their fiducial responsibilities in this game. But it appears they're going to get away with it.

For more, see Naked Capitalism and Yves Smith's book Econned.

Small correction for the NPR guys: a magnetar is a neutron star (pulsar) with very high magnetic field. It's not a black hole.


Note added: In letters to ProPublica Magnetar claims it was employing a market neutral stat arb strategy, and that the CDOs they sponsored were not built to fail. See here and here. My interest in this story is not Magnetar, per se, but rather what it reveals about the MBS industry in general, leading up to the credit crisis.

Here is what Yves Smith has to say about the stat arb strategy:

... While Magnetar paid roughly 5% of the total deal value for its equity stake, it took a much bigger short position by acting as a protection buyer on some of the credit default swaps created by these same CDOs. This insurance in turn was artificially cheap because over 80% of the deal was rated AAA. Most investors did not understand what Magnetar recognized: this concentrated exposure to the very riskiest type of bond associated with risky mortgage borrowers, each of these CDOs was a binary bet. It would either work out (in which case Magnetar would still show a thin profit) or it would fail completely, giving Magnetar an enormous profit and wiping out even the AAA investors who mistakenly believed they were protected by having other investors sit below them and take losses first. Thus the AAA investors were only earning AAA returns for BBB risk.

The Magnetar trade part one, two, three.

The view from Clarium

Some interesting graphs from Clarium's August 2009 commentary. Clarium is the hedge fund run by Peter Thiel, of PayPal fame. (Click for larger images.)

Americans paying more to live longer. Per capita annual health care costs in 1960 were $1000 (real dollars) and life expectancy 70 years. Today per capita annual health care costs are $7000 and life expectancy 79 years. Many (most?) Americans are rich enough to willingly pay an extra $6000 each year (a total of over $400k!) for an additional decade of life expectancy, but it's not exactly an impressive result for 50 years of health care innovation.



The real cost of primary + secondary education has risen 3x in the last 30 years, but has this resulted in improved human capital? Not if judged by average (real) wages. (Or, perhaps the fruits of productivity gains have been stolen by the rich? The top 1% of wage earners have done extremely well over the same period :-)



Who is shaping the future? Global venture capital investment is dominated by the US, with China almost equal to Europe ex-UK. Israel is tied with the UK and leads on a per-capita basis.

Money men congressional testimony

Five big hedgies testified today before Congress, including Paulson, Griffin, Soros and Simons. Simons gave a very succinct and accurate summary of the causes of the current crisis.

Mr. Simons, the founder of Renaissance Technologies and a former mathematics professor who devises complex computer models to predict market moves, says there is plenty of blame to go around for the current financial crisis.

“In my view, the crisis has many causes: The regulators who took a hands-off position on investment bank leverage and credit default swaps; everyone along the mortgage-backed securities chain who should have blown a whistle rather than passing the problem on; and, in my opinion the most culpable, the rating agencies, which allowed sows’ ears to be sold as silk purses,” Mr. Simons says.

See my talk for related comments.

Before the money men testified, four finance professors had their say. From Andy Lo's (MIT Sloan School) testimony:

...[Government funding for training quants!]

6. All technology-focused industries run the risk of technological innovations temporarily exceeding our ability to use those technologies wisely. In the same way that government grants currently support the majority of Ph.D. programs in science and engineering, new funding should be allocated to major universities to greatly expand degree programs in financial technology.

...[Behavioral finance!]

Economists do not naturally gravitate toward behavioral explanations of economic phenomena, preferring, instead, the framework of rational deliberation by optimizing agents in a free-market context. And the ineluctable logic of neoclassical economics is difficult to challenge. However, recent research in the cognitive neurosciences has provided equally compelling experimental evidence that human decisionmaking consists of a complex blend of logical calculation and emotional response (see, for example, Damaso, 1994, Lo and Repin, 2002, and Lo, Repin, and Steenbarger, 2005). Under normal circumstances, that blend typically leads to decisions that work well in free markets. However, under extreme conditions, the balance between logic and emotion can shift, leading to extreme behavior such as the recent gyrations in stock markets around the world in September and October 2008.

This new perspective implies that preferences may not be stable through time or over circumstances, but are likely to be shaped by a number of factors, both internal and external to the individual, i.e., factors related to the individual's personality, and factors related to specific environmental conditions in which the individual is currently situated. When environmental conditions shift, we should expect behavior to change in response, both through learning and, over time, through changes in preferences via the forces of natural selection. These evolutionary underpinnings are more than simple speculation in the context of financial market participants. The extraordinary degree of competitiveness of global financial markets and the outsize rewards that accrue to the “fittest” traders suggest that Darwinian selection is at work in determining the typical profile of the successful investor. After all, unsuccessful market participants are eventually eliminated from the population after suffering a certain level of losses. For this reason, the hedge-fund industry is the Galapagos Islands of the financial system in that the forces of competition, innovation, natural selection are so clearly discernible in that industry.

This new perspective also yields a broader interpretation of free-market economics (see, for example, Lo, 2004, 2005), and presents a new rationale for regulatory oversight. Left to their own devices, market forces generally yield economically efficient outcomes under normal market conditions, and regulatory intervention is not only unnecessary but often counter-productive. However, under atypical market conditions—prolonged periods of prosperity, or episodes of great uncertainty—market forces cannot be trusted to yield the most desirable outcomes, which motivates the need for regulation. Of course, the traditional motivation for regulation—market failures due to externalities, natural monopolies, and public-goods characteristics—is no less compelling, and the desire to prevent sub-optimal behavior under these conditions provides yet another role for government intervention.

A simple example of this dynamic is the existence of fire codes enacted by federal, state, and local governments requiring all public buildings to have a minimum number of exits, well-lit exit signs, a maximum occupancy, and certain types of sprinklers, smoke detectors, and fire alarms. Why are fire codes necessary? In particular, given the costs associated with compliance, why not let markets determine the appropriate level of fire protection demanded by the public? Those seeking safer buildings should be willing to pay more to occupy them, and those willing to take the risk need not pay for what they deem to be unnecessary fire protection. A perfectly satisfactory outcome of this free-market approach should be a world with two types of buildings, one with fire protection and another without, leaving the public free to choose between the two according to their risk preferences.

But this is not the outcome that society has chosen. Instead, we require all new buildings to have extensive fire protection, and the simplest explanation for this state of affairs is the recognition— after years of experience and many lost lives—that we systematically under-estimate the likelihood of a fire.5 In fact, assuming that improbable events are impossible is a universal human trait (see, for example, Plous, 1993, and Slovic, 2000), hence the typical builder will not voluntarily spend significant sums to prepare for an event that most individuals will not value because they judge the likelihood of such an event to be nil. Of course, experience has shown that fires do occur, and when they do, it is too late to add fire protection. What free-market economists interpret as interference with Adam Smith’s invisible hand may, instead, be a mechanism for protecting ourselves from our own behavioral blind spots.

Catastrophe bonds and the investor's choice problem

Consider the following proposition. You put up an amount of capital X for one year. There is a small probability p (e.g., p = .01) that you will lose the entire amount. With probability (1-p) you get the entire amount back. What interest rate (fee) should you charge to participate?

What I've just described is a catastrophe bond. A catastrophe bond allows an insurer to transfer the tail risk from a natural disaster (hurricane, earthquake, fire, etc.) to an investor who is paid appropriately. How can we decide the appropriate fee for taking on this risk? It's an example of the fundamental investor's choice problem. That is, what is the value of a gamble specified by a given probability distribution over a set of payoffs? (Which of two distributions do you prefer?) One would think that the answer depends on individual risk preferences or utility functions.

Our colloquium speaker last week was John Seo of Fermat Capital, a hedge fund that trades catastrophe bonds. Actually, John pioneered the business at Lehman Brothers before starting Fermat. He's yet another deep thinking physicist who ended up in finance. Indeed, he claims to have made some fundamental progress on the investor's choice problem. His approach involves a kind of discounting in probability space, as opposed to the now familiar discounting of cash flows in time. I won't discuss the details further, since they are slightly proprietary.

I can discuss aspects of the cat bond market. Apparently the global insurance industry cannot self-insure against 1 in 100 year risks. That is, disasters which have occurred historically with that frequency are capable of taking down the whole industry (e.g., huge earthquakes in Japan or California). Therefore, it is sensible for insurers to sell some of that risk. Who wants to buy a cat bond? Well, pension funds, which manage the largest pools of capital on the planet, are always on the lookout for sources of return whose risks are uncorrelated with those of stocks, bonds and other existing financial instruments. Portfolio theory suggests that a pension fund should put a few percent of its capital into cat bonds, and that's how John has raised the $2 billion he currently has under management. The market answer to the question I posed in the first paragraph is roughly LIBOR plus (4-6) times the expected loss. For a once in a century disaster, this return is LIBOR plus (4-6) percent or so. Sounds like a good trade for the pension fund as long as the event risk is realistically evaluated.

Note there is no leverage or counterparty risk in these transactions. An independent vehicle is created which holds the capital X, invested in AAA securities (no CDOs, please :-). If the conditions of the contract are triggered, this entity turns the capital over to the insurance company. Otherwise, the assets are returned at the end of the term.

In the colloquium, John reviewed the origins of present value analysis, going back to Fibonacci, Fermat and Pascal. See Mark Thoma, who also attended, for more discussion.

Catastrophe bonds

Next week's physics colloquium speaker is physicist turned hedge fund manager John Seo. John was profiled in the NYTimes magazine by Michael Lewis.

Fibonacci, Fermat, and Finance: How a Biophysicist
Built a Multi-Billion Dollar Catastrophe Bond Fund after
Re-Reading the Foundations of Modern Finance

John Seo

Fermat Capital Management, LLC

Dr. John Seo is Co-Founder and Managing Principal at
Fermat Capital Management, LLC. Based in Westport,
Connecticut, Fermat Capital manages over $2 billion in
catastrophe bond investments, making it one of the
leading catastrophe bond investors in the world. Prior to
forming Fermat Capital with his brother Nelson in August
of 2001, John was Senior Trader in the Insurance Products
Group at Lehman Brothers, an officer of Lehman Re, and
a state-appointed advisor to the Florida Hurricane
Catastrophe Fund. John received a B.S. in physics from
M.I.T. in 1988 and a Ph.D. in biophysics from Harvard
University in 1991.

Asset-backed oversold? Paulson ready to get back in!

John Paulson made $15 billion for his fund ($3.7 billion for himself!) betting against subprime securities last year. Now Bloomberg reports that he's ready to get back in on the upside!

I'm as dismayed as anyone else about taxpayer dollars going to bail out mortgage holders, commercial banks and the GSE's (Fannie, Freddie). I complained about Fannie back in 2004 when Franklin Raines was still CEO and the story first got out about their smoothing of earnings and use of derivatives accounting.

But, on the other hand, maybe Uncle Sam can actually generate positive return by buying oversold securities! Rumor says that current prices of subprime mortgage backed securities suggest implied default rates which are unrealistically high (e.g., like 50% !). Barring a complete economic meltdown these assets are underpriced and will generate a handsome return for an intelligent investor willing to take some risk. Is Uncle Sam smart? Let's hope that the other Paulson negotiates some upside for us taxpayers in any bailout organized by the Treasury.

Bloomberg: John Paulson, the money manager whose wagers against the U.S. housing market helped him earn an estimated $3.7 billion last year, is now seeking to profit from Wall Street's search for capital to offset mortgage writedowns.

Paulson plans to open a hedge fund by December that will provide capital to the world's biggest banks and brokers as they add to the $345 billion they've raised in the past year, according to two people with knowledge of the matter. His Paulson & Co., which oversees $33 billion, hasn't set a size target for the fund, said the people, who declined to be identified because the plans aren't final.

The New York-based firm's credit funds rose as much as sixfold last year, helped by bets that rising defaults on subprime home loans would pummel the value of mortgage-backed securities. The meltdown has forced the world's biggest banks and securities firms to take $467 billion in asset write-offs and credit losses and led to the collapse of Bear Stearns Cos.

``Investors who are able to make money in a declining market and then rapidly turn around and profit from a rising market is highly unusual,'' said Thomas Whelan, president of Greenwich, Connecticut-based Greenwich Alternative Investments, which advises clients on investing in hedge funds.

Paulson declined to comment. His 2007 earnings made him the highest-paid hedge-fund manager, according to Institutional Investor's Alpha magazine.

The New Math

Alpha magazine has a long article on the current state of quant finance. It may be sample bias, but former theoretical physicists predominate among the fund managers profiled.

I've always thought theoretical physics was the best training for applying mathematical techniques to real world problems. Mathematicians seldom look at data, so are less likely to have the all-important intuition for developing simple models of messy systems, and for testing models empirically. Computer scientists generally don't study the broad variety of phenomena that physicists do, and although certain sub-specialties (e.g., machine learning) look at data, many do not. Some places where physics training can be somewhat weak (or at least uneven) include statistics, computation, optimization and information theory, but I've never known a theorist who couldn't pick those things up quickly.

Physicists have a long record of success in invading other disciplines (biology, computer science, economics, engineering, etc. -- I can easily find important contributions in those fields from people trained in physics, but seldom the converse). Part of the advantage might be pure horsepower -- the threshold for completing a PhD in theoretical physics is pretty high. However, a colleague once pointed out that the standard curriculum of theoretical physics is basically a collection of the most practically useful mathematical techniques developed by man -- the high points and greatest hits! Someone trained in that tradition can't help but have an advantage over others when asked to confront a new problem.

Having dabbled in fields like finance, computer science and even biology, I've come to consider myself as a kind of applied mathematician (someone who applies mathematical ideas to the real world) who happens to have had most of his training from working on physical systems. I suspect that physicists who have left the field, as well as practitioners of biophysics, econophysics, etc. might feel the same way.

Readers of this blog sometimes accuse me of a negative perspective towards physics. Quite the contrary. Although I might not be optimistic about career prospects within physics, or the current state of the field, I can't think of any education which gives a richer understanding of the world, or a greater chance of contributing to it.

...Finkelstein, who also grew up in Kharkov, has a Ph.D. in theoretical physics from New York University and a master’s degree in the same discipline from the Moscow Institute of Physics and Technology. Before joining Horton Point as chief science officer, he was head of quantitative credit research at Citadel Investment Group in Chicago.

Most of the 12 Ph.D.s at Horton Point’s Manhattan office are researching investment strategies and ways to apply scientific principles to finance. The firm runs what Finkelstein, 54, describes as a factory of strategies, with new models coming on line all the time. “It’s not like we plan to build ten strategies and sit on them,” he says. “The challenge is to keep it going, to keep this factory functioning.”

Along with his reservations about statistical arbitrage, Sogoloff is wary of quants who believe the real world is obliged to conform to a mathematical model. He acknowledges the difficulty of applying scientific disciplines like genetics or chaos theory — which purports to find patterns in seemingly random data — to finance. “Quantitative work will be much more rewarding to the scientist if one concentrates on those theories or areas that attempt to describe nonstable relationships,” he says.

Sogoloff sees promise in disciplines that deal with causal relationships rather than historical ones — like mathematical linguistics, which uses models to analyze the structure of language. “These sciences did not exist five or ten years ago,” he says. “They became possible because of humongous computational improvements.”

However, most quant shops aren’t exploring such fields because it means throwing considerable resources at uncertain results, Sogoloff says. Horton Point has found a solution by assembling a global network of academics whose research could be useful to the firm. So far the group includes specialists in everything from psychology to data mining, at such schools as the Beijing Institute of Technology, the California Institute of Technology and Technion, the Israel Institute of Technology.

Sogoloff tells the academics that the goal is to create the Bell Labs of finance. To align both parties’ interests, Horton Point offers them a share of the profits should their work lead to an investment strategy. Scientists like collaborating with Horton Point because it combines intellectual freedom with the opportunity to test their theories using real data, Sogoloff says. “You have experiments that can be set up in a matter of seconds because it’s a live market, and you have the potential for an amazing economic benefit.” ...

And the winner is...

We all know who the losers are in the subprime meltdown: shareholders of Citi, Merrill, Countrywide Financial, etc. One of the winners is profiled below, a hedge fund manager who made $15B (keeping $3-4B himself!) from the bursting subprime housing bubble.

WSJ: Trader Made Billions on Subprime
John Paulson Bet Big on Drop in Housing Values

By GREGORY ZUCKERMAN
January 15, 2008

On Wall Street, the losers in the collapse of the housing market are legion. The biggest winner looks to be John Paulson, a little-known hedge fund manager who smelled trouble two years ago.

Funds he runs were up $15 billion in 2007 on a spectacularly successful bet against the housing market. Mr. Paulson has reaped an estimated $3 billion to $4 billion for himself -- believed to be the largest one-year payday in Wall Street history.

Now, in another twist in financial history, Mr. Paulson is retaining as an adviser a man some blame for helping feed the housing-market bubble by keeping interest rates so low: former Federal Reserve Chairman Alan Greenspan. (See article.)

On the way to his big score, Mr. Paulson did battle with a Wall Street firm he accused of trying to manipulate the market. He faced skepticism from other big investors. At the same time, fearing imitators, he used software that blocked fund investors from forwarding his emails.

One thing he didn't count on: A friend in whom he had confided tried the strategy on his own -- racking up huge gains himself, and straining their friendship. (See article.)

Like many legendary market killings, from Warren Buffett's takeovers of small companies in the '70s to Wilbur Ross's steelmaker consolidation earlier this decade, Mr. Paulson's sprang from defying conventional wisdom. In early 2006, the wisdom was that while loose lending standards might be of some concern, deep trouble in the housing and mortgage markets was unlikely. A lot of big Wall Street players were in this camp, as seen by the giant mortgage-market losses they're disclosing.

"Most people told us house prices never go down on a national level, and that there had never been a default of an investment-grade-rated mortgage bond," Mr. Paulson says. "Mortgage experts were too caught up" in the housing boom.

In several interviews, Mr. Paulson made his first comments on how he made his historic coup. Merely holding a different opinion from the blundering herd wasn't enough to produce huge profits. He also had to think up a technical way to bet against the housing and mortgage markets, given that, as he notes, "you can't short houses."

Also key: Mr. Paulson didn't turn bearish too early. Some close students of the housing market did just that, investing for a downturn years ago -- only to suffer such painful losses waiting for a collapse that they finally unwound their bearish bets. Mr. Paulson, whose investment specialty lay elsewhere, turned his attention to the housing market more recently, and got bearish at just about the right time. ...

How to run a hedge fund

Via Mark Thoma, this nice summary of how to run a hedge fund, taking advantage of the fee structure and the asymmetry of compensation and risk. If the fund goes up, the manager gets paid. If the fund goes down, the manager still gets paid the management fee, if not the performance component. This means he is incentivized to take asymmetric bets like selling insurance policies, which have a high probability of a decent return from the premium, but a small chance of blowing up due to a rare event. In the latter case the investors lose their money but not the manager. What looks like a decent return by the fund might in fact reflect crazy risk taking -- it's hard for investors to know.

But don't be too critical. These people are making our economy more efficient ;-)

Most managers don't behave this way, although it's an example of the more general agency problem, which arises whenever the incentives and interests of a principal differ from those of an agent (e.g., hired to manage a company or financial portfolio owned by the principal).

Washington Post: ...It is extremely difficult to tell, based on past performance, whether a fund is being run by true financial wizards, by no-talent managers who happen to get lucky or by outright scam artists.

To illustrate how easy it is to set up a hedge fund scam, consider the following example. An enterprising man named Oz sets up a new fund with the stated aim of earning 10 percent in excess of some benchmark rate of return, say 4 percent. The fund will run for five years, and investors can cash out at the end of each year if they wish. The fee is the standard '2 and 20': 2 percent annually for funds under management, and a 20 percent incentive fee for returns that exceed the benchmark.

Although he has no investment track record, Oz has a smooth manner, a doctorate in physics and many rich acquaintances. He raises $100 million and opens shop. He then studies the derivatives market and finds an event on which the market places fairly long odds, say 9:1. In other words, it costs $.10 to buy an option that pays $1 if the event occurs and $0 otherwise. The nature of the event is unimportant: it might be a large fall in the stock market, Florida getting hit by a Category 5 hurricane or Russian President Vladimir Putin dying before the end of the year.

Next Oz writes some covered options on this event and sells 110 million of them in the derivatives market. This obligates him to pay the option holders $110 million if the event does occur and nothing if it does not. He collects $11 million on the options. To cover his obligations in case the 'bad' event occurs, he uses the investors' money plus the proceeds from the options to buy $110 million in one-year Treasury bills yielding 4 percent, which he deposits in escrow. This leaves $1 million in "pocket money," which he uses to lease some computer terminals and hire a few geeks to sit in front of them, just in case his investors drop by.

The probability is ninety percent that the bad event does not occur and Oz owes nothing to the option holders. With a gross return (before expenses) of $15,400,000, the investors are thrilled, and so is Oz. He collects $2 million in management fees (of which he has only spent $1 million), plus a performance bonus equal to 20 percent of the 'excess return', namely, 20 percent of $11,400,000. All in all, Oz nets over $3 million for doing absolutely nothing.

Oz can then repeat the same gambit next year. When the fund terminates after five years, the chances are nearly 60 percent that the unlucky event will never have occurred. Oz looks like a genius and gets paid like a genius. ...

The quants of August

Why the rough markets in August? Why the big losses for certain quant funds? This paper claims the following:

1) many funds are pursuing the same strategies, using significant leverage

2) problems in the credit markets forced some multi-strategy funds to sell liquid equity positions in order to meet margin calls

3) positions commonly held by quant funds deteriorated in a correlated manner

Conclusion: systemic risk galore!

More discussion in the Economist.

What Happened to the Quants in August 2007?

AMIR KHANDANI
ANDREW W. LO
Massachusetts Institute of Technology

September 20, 2007


Abstract:

During the week of August 6, 2007, a number of high-profile and highly successful quantitative long/short equity hedge funds experienced unprecedented losses. Based on empirical results from TASS hedge-fund data as well as the simulated performance of a specific long/short equity strategy, we hypothesize that the losses were initiated by the rapid unwinding of one or more sizable quantitative equity market-neutral portfolios. Given the speed and price impact with which this occurred, it was likely the result of a sudden liquidation by a multi-strategy fund or proprietary-trading desk, possibly due to margin calls or a risk reduction. These initial losses then put pressure on a broader set of long/short and long-only equity portfolios, causing further losses on August 9th by triggering stop-loss and de-leveraging policies. A significant rebound of these strategies occurred on August 10th, which is also consistent with the sudden liquidation hypothesis. This hypothesis suggests that the quantitative nature of the losing strategies was incidental, and the main driver of the losses in August 2007 was the firesale liquidation of similar portfolios that happened to be quantitatively constructed. The fact that the source of dislocation in long/short equity portfolios seems to lie elsewhere - apparently in a completely unrelated set of markets and instruments - suggests that systemic risk in the hedge-fund industry may have increased in recent years.

Masters of the Universe

The Times reports on a recent dinner hosted by Institutional Investor.

NYTimes: Not since Michael Milken’s Predators’ Ball in the 1980’s have so many of Wall Street’s bold-faced names dared to mingle together. Until last night.

Institutional Investor, the first trade magazine to cover Wall Street, celebrated its 40th birthday Monday by throwing itself a party at the American Museum of Natural History in Manhattan. Masters of the Universe from around the nation and the world flew in for the event. There was Henry Kravis, seated next to Jean-Claude Trichet, president of the European Central Bank. Across the way was Mr. Milken himself, whom Mr. Kravis praised in a brief speech for helping to create the modern private equity industry.

Mr. Milken didn’t make a speech to the crowd, but he circulated among them and seemed to take pleasure at being surrounded by so many of what he referred to DealBook as his “disciples.”

Also on hand was James D. Wolfensohn, former president of the World Bank. John C. Bogle, the founder of the Vanguard Group, mingled during the cocktail hour with other luminaries such as John Whitehead, the former chairman of Goldman Sachs, credited with creating the securities firm’s vaunted culture.

John Thornton, the former president of Goldman Sachs, who now splits his time between New York and Beijing, also attended, as did Joseph L. Rice III, co-founder of the private equity firm Clayton, Dubilier & Rice.

James Simons, founder of Renaissance Technologies, one of the most successful “quant” hedge funds in history, mixed with younger hedge fund managers such as William Ackman, the activist investor, and David Einhorn of Greenlight Capital.

Perhaps the highlight of the evening was when Mr. Kravis jokingly apologized to his peers in the audience for charging his investors 20 percent of profits in 1976, which became a benchmark for private equity and hedge funds. He said that, at the time, there was no going rate, so he and his partners decided 20 percent was fair. In retrospect, he said with a laugh, “You could have gotten 25 percent.”

The room burst out laughing.

Then Mr. Simons of Renaissance took the stage. He famously takes more than 40 percent of all profits from his fund investors. “We blissfully ignored” the benchmark Mr. Kravis created, he said.

Mr. Simons also explained how the summer’s credit crunch caused his fund briefly to lose 8.7 percent in only a few days ––”a remarkable amount of money,” he said nonchalantly — though it later rebounded. At the time, he wrote a note to his investors about the losses, observing with a laugh that it took a couple of “gin and tonics to get that letter out.”

He went on to jokingly taunt Mr. Kravis into buying his firm. “If he wants to buy my company for $30 billion, I’m going to make it damn easy for him,” Mr. Simons said.

From the comments:

This convention was made up of people who sacrificed their personal lives to use their extreme intellects and incredible work ethics to strive to be the best in their fields. This is exactly what America was built on and should be what keeps us going forward. We as a country should reward winners, but instead we encourage mediocrity with the whole “everyone is a winner, everyone is great” mentality. Congratulations to those invited to this great event and if you really don’t like it then work harder to change the system, but that does mean actually working which you may not be inclined to do.
— Posted by Eric


Why are people assuming these people make money by plundering society? Jim Simons makes money as fairly and squarely as anyone in the world. Anyone can do what he does…if they come up with the magic formula. There’s nothing unfair about that, and it does society a world of good. The huge creation of wealth around the world is largely due to capital being deployed to its most productive use. What are masters of the universe but the “central planners” of the free market — the better the job they do, the more money they make, and the richer we all become.
— Posted by James