… as long as you don’t mind losing everything every once in a while. The thought occurred to me as I read the profile of hedge fund manager Victor Niederhoffer in the New Yorker this week. As the profile was being written, Niederhoffer’s flagship hedge fund blew up. And this wasn’t the first time. Niederhoffer, a man who is probably not one of the great money managers of all time but might be one of the great self promoters, has had this happen before.
It may surprise you to know that there are well known investment strategies that in most years can create gains that will beat the stock market by miles. These strategies are not obscure. The problem is that when they fail, they leave you subject to catastrophic losses. You can find one such strategy described in this paper. The paper uses an example developed by one of its authors, economics professor Andrew W. Lo of MIT, of a fund called (I love this) Capital Decimation Partners.
For those interested in the details, Capital Decimation Partners’ strategy relies on shorting certain stock options on the last day of the month, just before they’re about to expire; you can find out more from the paper. This strategy yields returns of close to four percent a month. That sounds awesome, and indeed would be awesome, except for one little detail: every once in a while–and there’s no way of predicting when, it can be after ten years or after one month–the strategy will go wrong, and results in a huge loss.
One natural assumption when you look at a hedge fund manager who loses a ton of money is to say, “Well, he blew up now, but he made a lot of money earlier.” But that doesn’t really work so well.
If you make 100 percent in a year and lose 50 percent you might think you’ve made an average of 25 percent. Actually, you’ve made zero percent. Not convinced? Start with one dollar. Add 100 percent. Now you’ve got two dollars. Now take away 50 percent. You’re back to one dollar. Or, worse: take that 100 percent gain. Now imagine you lose 100 percent of your money. Now you get it. No matter how much money you’ve made before, after a 100 percent loss you’re left with zero dollars.
Really sophisticated hedge fund investors understand that big losses are very hard to recover from (and if you’ve lost all your money, there’s no percentage gain big enough to get you back from zero). This is why they look not just at how much a fund makes, but insist on seeing how much capital it has at risk. And they still often get things wrong.
Do I know if Niederhoffer was pursuing a strategy that, like Capital Decimation Partners’, would impress investors only if they didn’t understand the risks? I have absolutely no idea. He doesn’t really tell the New Yorker’s John Cassidy enough about his approach to know. I do know from the story that a guy who worked for Niederhoffer had some odd thoughts about how to evaluate Thailand’s economic prospects:
Keeley believed that assessing a developing country’s economic prospects involved not only meeting with the C.E.O.s of leading companies but studying the lengths of discarded cigarettes—the theory being that the wealthier people are, the longer their butts—and the state of the brothels. After a couple of months in Asia, he reported to Niederhoffer that the brothels in Bangkok had recently become much cleaner and safer, and that Thailand was an excellent place to invest.
But that’s neither here, nor there. It’s also icky (that’s not a term of art in economic analysis, it’s just really the only word that comes to mind). I wish I knew more about how Niederhoffer’s analysis of the markets worked. But hedge fund managers are notoriously secretive about this. Sometimes that’s because their quantitative tools contain really valuable insights. But sometimes it’s because letting folks see how they come up with big returns can also reveal the scary risks they’re taking. Sometimes it’s a mix of both.
Like I said, I’ve got no idea of the quantitative aspects of Niederhoffer’s particular approach. But whatever it is, it’s worth noting that the key to running a hedge fund is not just getting outsized returns. It’s to do it without blowing up every few years.
Victor Niederhoffer Bonus Round: A friend, journalist Ilan Greenberg, points out that Niederhoffer seems to leave the implication that his child with his girlfriend (not to be confused with his wife) was unplanned. Says Niederhoffer:
We didn’t have in mind the ultimate outcome, but we created a fantastic legacy—the baby, the books, and the articles.
Niederhoffer’s son is one and a half, and his girlfriend 53. I’m not really sure if by not having in mind the ultimate outcome Niederhoffer actually means that he hadn’t expected the pregnancy. Greenberg asks if an unplanned pregnancy is even possible at that age. In a word, no. You don’t even need to be a hedge fund wizard to do that bit of quantitative analysis.