BOOK REVIEW: Sebastian Mallaby's More Money Than God

Testifying before Congress in 1967, Nobel Laureate Paul Samuelson proclaimed that "Most portfolio decision makers should go out of business - take up plumbing, teach Greek, or help produce the annual GNP by serving as corporate executives." Though he later became a major investor in one of the world's most prominent hedge funds, Samuelson was merely spouting settled logic among academicians that markets were too efficient to be outperformed by individuals.

Importantly, Samuelson left himself some wiggle room in his denigration of portfolio managers. As he put it, "People differ in their heights, pulchritude, and acidity", so "Why not in their P.Q. or performance quotient." Samuelson was referring to the skilled outliers in the world of hedge funds, and the amazing exploits of these financial wizards are chronicled by Council on Foreign Relations senior fellow Sebastian Mallaby in his masterful new history of hedge funds, More Money Than God.

More Money Than God is a must read that will doubtless appeal to a wide range of readers, from hedge fund managers and finance professors to the average individual interested in markets, economics and finance. Mallaby notes in the acknowledgements that the book took three years to complete, and his painstaking research shows up throughout as he recreates financial history through the eyes and ears of some the world's greatest financial minds.

The story begins with Alfred Winslow Jones, an eccentric who at different times in his life worked on a tramp steamer, studied at the Marxist Workers School in Berlin, and who wrote about finance for Fortune. Unlike many of today's top hedge fund managers, Mallaby notes that Jones didn't learn the ropes at Goldman Sachs or Morgan Stanley, did not go to business school, nor did he have a PhD in quantitative finance.

Jones launched the first "hedged fund" meant to use leverage to enhance equity exposure alongside short sales to protect one's downside, and it was Jones who conceived the performance fee whereby his fund would keep for itself 20% of the profits. That his fund's returns were 5,000% likely speaks to investors who were quite happy to give him back a fifth. Modern commentary sometimes suggests that performance fees point to greed within the hedge fund world, but Jones instituted the fee given his belief that it would concentrate the minds of his portfolio managers. But in fairness to the greed faction, performance fees also served as a neat tax dodge, which Mallaby points out.

No doubt to this day the modern hedge fund managers who stand on his giant shoulders are thanking him for his performance-fee innovation. Indeed, while Goldman Sachs head Lloyd Blankfein's pay of $54 million in 2006 raised a lot of eyebrows, his compensation would not have gotten him anywhere near Alpha's list of the highest compensated hedge-fund managers in 2006.

And with Jones as the introduction, thus begins an unputdownable history of investment vehicles started by what Mallaby terms the "loners and contrarians", the very "individualists whose ambitions are too big to fit into established financial institutions", and yes, individuals eager to work free of the regulatory red tape that has long described much of what we might call traditional finance. Hedge fund entrepreneurs then and now seek to defy conventional wisdom about efficient markets, and as such, Mallaby writes that they would more properly be called "edge funds" for their managers offering investors "alpha", or returns uncorrelated with the markets.

Through the often mercurial Michael Steinhardt, Mallaby explains that while markets are generally efficient, they are that way only if liquidity is perfect. Steinhardt's genius had to do with offering liquidity where it didn't exist; specifically when it came to large blocks of shares. Able to negotiate discounts in return for liquidity, Steinhardt ultimately returned to his original investors 480 times their initial investment.

Of the 1970s hedge fund giants, Mallaby also introduces readers to Commodities Corporation, and colorful investing genius Michael Marcus who, among other eccentricities, was known to buy houses some of which he never spent the night in. As Mallaby so correctly points out, prior to President Nixon's decision to sever the dollar's link to gold, commodities themselves were quite sleepy, but with the floating dollar naturally leading to chaotic volatility among commodities priced in dollars, traders like those within Commodities Corp. were able to make a fortune essentially through speculation on the undefined dollar's direction. In that sense, it would have been interesting to read the author's thoughts on how much our economy has lost over the last 40 years thanks to so many brilliant minds gravitating to Wall Street over innovative production in order to profit from dollar-driven volatility.

Mallaby's story of Hungarian immigrant George Soros is inspiring considering that he got started in London as a busboy, and was once told by the head waiter at the restaurant he worked for that if he continued to work hard, he would someday be his assistant. Soros eventually made it into the London School of Economics, left with mediocre grades, but happened on the fascinating, anti-efficient market insight that people are incapable of properly perceiving reality, and that there was money to be made trading on faulty human reasoning.

Easily the most impressive aspect of Mallaby's brilliant book is his remarkable reconstruction of trades, and the thinking behind them. With Soros alone, and then later with Soros and his lieutenant Stanley Druckenmiller (when Soros later handed over the Quantum Fund to him, his comment was we'll now find out "if you really are inept), the reader is taken inside their minds as they short the dollar ahead of the 1985 Plaza Accord, and then later "break" the British pound. It is with the pound that Soros's impressive nerve becomes most apparent; his telling Druckenmiller to "go for the jugular" somewhat chilling.

It is through Tiger's Julian Robertson that readers learn how instinct itself comes into play for the best and brightest investors. Short-selling eminence James Chanos feels that in his day, Robertson knew stocks better than anyone, but instinct too played a role in his decisions. For one, Robertson wouldn't invest with CEOs who would change the lie of their golf shots, and after visiting German companies post-unification, and seeing how they were built to serve employees over shareholders, Robertson greatly reduced Tiger's exposure to Germany.

The market outperforming success of the myriad Tiger "cubs" who presently dot the hedge fund landscape is also used by Mallaby to show yet again that brilliant, well-trained minds can outperform the markets. And while Warren Buffett's policy musings frequently annoy the libertarians among us (including this one), Mallaby's retelling of his debate with efficient-market acolyte Michael Jensen might win him back some fans.

Perhaps because so many of the modern hedge fund managers Mallaby profiles are still in the news, it's his recount of the activities of 21st century managers that most interested this reader. While the giants of the ‘90s suffered from being too large, in the decade just passed if your fund didn't have at least a billion dollars, you were a nobody according to Mallaby.

Indeed, by mid-2000 there were over 8,000 hedge funds, and for those who use anecdote to predict market crack-ups, they might point to this figure as a signal that something was amiss. According to Mallaby the book Hedge Funds for Dummies hit the stores, former Secretary of State Madeleine Albright had jumped into the game, and as he sees it, "Too many people were making too much money too fast."

That said, he no doubt agrees that some of the individuals who entered the field in more modern times did the economy a lot of good. Indeed, with the housing boom in full force by 2003, so did the boom allow for a number of marginal characters to enter the mortgage-lending space.

Mallaby profiles Daniel Sadek, a former Mercedes salesman who ultimately founded Quick Loan, a firm that marketed its mortgages with "No income verification. Instant qualification!!" Perhaps the most entertaining passage in a very entertaining book was Dallas hedge fund manager Kyle Bass's remark about Sadek, a man who'd plowed his subprime mortgage millions into a movie vehicle for his starlet girlfriend, and that would feature smashups of his impressive foreign car collection. About Sadek, Bass said "That's the guy you want to bet against."

More well known among the mortgage deniers is John Paulson, and there too Mallaby takes the reader on a gripping ride as he recounts Paulson's growing certainty (amid sniping among some clients who felt he'd strayed from his investing competency) that mortgages were set to collapse, and in a very big way. Paulson was aided in this by lieutenant Paolo Pellegrini who deduced as a few other deniers did that housing needed only to stop rising for overextended homebuyers to turn in their keys.

The above remains important, because as opposed to a housing market that collapsed, in truth home prices simply stopped rising, and soon enough the game was over. Here Mallaby adds a fun story in which Paulson, in a meeting with potential clients, leaves briefly to confer with an employee only to return with a report that his fund had just made a billion dollars in one day.

Even now, the greed faction continues to decry the stupefying gains of Paulson, Bass, and others who "got rich betting against the little guy", and more laughable, that their gains "caused the crisis", but it says here that we should elevate their success. Indeed, the rush to housing this decade was the recession, and the money made by housing's deniers halted this classic form of Austrian malinvestment. In short, the success of Paulson et al was a sign that the economy was on the mend; that is, if the government had let markets heal.

Of course any history of hedge funds would be incomplete absent the tales of spectacular blowups, and there too, Mallaby doesn't disappoint. A great storyteller and a very talented analyst of all things financial, the author weaves an important theme throughout the book which reveals that despite the certain genius behind hedge funds, they're still run by fallible human beings unable to account in total for the fickle nature of markets.

The above in mind, Mallaby takes the reader on the LTCM rollercoaster. Though the fund's managers had conducted "stress tests" which revealed that at worst it could lose $116 million in a day, and $532 million over 21 days, bond spreads widened substantially in 1998, and LTCM was essentially dead. Amaranth, though a fund pursuing diversified strategies ultimately put much of its capital behind natural gas trader Brian Hunter, whose positions gradually accounted for much of the market. Though internal testing showed that his positions could at best lose the fund $300 million in a day, fickle markets yet again exposed him, and with his positions well known, the fund in its present form was essentially dead.

It is with the blowups that Mallaby exposes the absurd logic increasingly embraced by both the left and right that hedge funds should be forced to reveal all of their investment positions so that our allegedly skilled regulators can gauge "systemic risk." If we ignore that those positions are the property of their managers every bit as much as the ingredients in Coca-Cola are the property of Coke, Mallaby makes plain through difficult times experienced by Tiger, LTCM and Amaranth that increased market knowledge driven by expropriation of what is private property would lead to more, not less in the way of hedge fund blowups as vultures in competing funds would work against their positions.

As LTCM founder John Meriwether found out all too painfully when his fund was down by half, once that occurs you're dead due to the vultures circling. LTCM's story and others reveal that hedge fund holdings are already somewhat known, but if managers were essentially forced to make public their property, it would be more difficult for hedge funds to do their work.

This would be unfortunate because as Mallaby reminds the reader throughout, hedge funds perform an essential market function for making inefficient markets more efficient, damping excessive exuberance through their ability to sell securities short, plus given their relatively small size, they're small enough to fail. Considering failure, during the misery of 2008 hedge funds according to Mallaby were only down 19% compared to an S&P down twice that, plus they made it through all the carnage "without receiving any direct taxpayer assistance."

More realistically, it's been other, healthy hedge funds that have for the most part stopped the bleeding within their competitors through market-driven bailouts. Had hedge funds been regulated as so many desire, Mallaby properly alludes to the inability of regulators over the years to see much of anything anyway, not to mention the seemingly greater point he alludes to that the lack of regulation in the hedge fund space precisely means that taxpayers are not on the hook for the inevitable failures. His somewhat contrarian conclusion is that if anything, "Governments must encourage hedge funds."

Of course it's Mallaby's acknowledgement that hedge funds should be largely left alone that brings up an area of disagreement. Properly skeptical of the ability of regulators, he is of the opinion that they should remain free of oversight with the caveat that when they "cease to be small enough to fail, regulation is warranted." He then says that if leveraged assets within a fund reach $120 billion that hedge funds "should undergo regulatory cross-examination", and if above $200 billion they should face "the second level of oversight, which would include scrutiny" of their leverage.

Not explained by Mallaby is who among the salary-men who toil within government might possess the skills necessary to pursue "cross-examination" of what he deems truly brilliant minds? Not answered either is that with money nothing if not fungible, couldn't hedge funds of the size that scare him easily get around such rules? Beyond that, as he points out throughout the book, one of the biggest problems hedge fund managers have faced over time is too much in the way of capital. Not only are regulators incapable of doing what he desires, hedge funds have been self-regulating in terms of size since their inception, plus as a taxpayer, regulated anything scares me to death because when the failures inevitably occur, I'm forced to pay. No thanks.

Considering the larger, heavily regulated banks and investment banks that are "too big to fail", Mallaby argues that there's no elegant laissez-faire solution there given that governments will never stand pat, plus to his thinking, failure among big institutions is an economy killer; Lehman Brothers his main example. Ignored here is what the size and leverage of banks would be absent the presumption of government protection, not to mention that Lehman Brothers' collapse was only a problem insofar as investors presumed it would not be allowed to fail. As evidenced by the frenzied calls among hedge fund managers to their lawyers on the day Lehman filed for bankruptcy, and about which Mallaby writes, it's very apparent that by virtue of many funds having kept assets with Lehman, they assumed a bailout would occur.

Assuming then a truly laissez faire approach it's fair to suggest that the initial collapse of Bear Stearns, if allowed, would have made Lehman's eventual demise much less of market event. Country economies have come back from the near total destruction of war, so for Mallaby or anyone else to suggest that they can't emerge from big bank failures that by virtue of their decline cleanse the economy of non-economic activity is to promote a dangerous and untrue falsehood.

Regarding the 1987 stock-market crash, Mallaby uses it as one example showing why markets aren't efficient. The problem with his thinking there is that eleven pages earlier he noted that a rumor circulating that Congress would raise taxes on transactions associated with mergers led to a 3.8% selloff in the Dow Jones Industrial Average.

So true, and far from October 19, 1987 disproving efficient markets (Mallaby's other examples were far more compelling), the crash then showed that investors were fearful of the merger tax, Rep. Dick Gephardt's Super 301 tariff bill, plus the day before Treasury Secretary James Baker talked down the dollar on national television. If anything, 1987 shows how very efficient markets are for pricing in potential economy-harming legislation. Thankfully, however, Mallaby disproves the absurd notion that "program trading" authored the crash, noting that on the day of, program trading only accounted for $6 billion of the $39 billion worth of shares sold.

More than once Mallaby references currency devaluation as a way for nations to restore their competitiveness, and there he ignores how both England and the U.S. became economic powers with strong, stable currencies, not to mention that Japanese exports to the U.S. skyrocketed in the decades after Bretton Woods despite a yen that crushed the dollar. China's exporting capacity doesn't seem to have been hurt either despite the yuan's 20%+ rise versus the dollar since 2005.

Devaluation is a popular cure among the financial commentariat, but just once it would be nice if its advocates could point to countries that have devalued their way to long-term prosperity. Concerning the Asian crisis in the late ‘90s, Mallaby suggested that the dollar pegs were unsustainable. Maybe so, but China has thrived with a dollar peg, plus the aforementioned pegs were only unsustainable due to an ever-rising dollar making them less credible. If the dollar is stable back in the late '90s, there's no Asian currency crisis.

At one point in the book Mallaby proclaimed that there was no inflation this decade, but if the ‘70s commodity boom was a function of a falling dollar as he acknowledges, what does he think happened this decade? Indeed, commodity booms and frothy housing markets have throughout history resulted from currency devaluation, and to the extent that there was no inflation this decade, that solely resulted from our minders in Washington stripping out the prices most sensitive to monetary error from their extremely faulty inflation measures.

Despite the disagreements, it can't be stressed enough what a triumphant book Mallaby has written. Meticulously researched and very interestingly written, More Money Than God is an essential read for anyone inside or outside of finance with an interest in the history of hedge funds. It was a great read, and one that I'll reference for years to come.