Most people know about the dot-com bubble that developed in the late 1990s. However, those with more than a passing interest in what makes markets tick are also aware of many other, equally extraordinary speculative episodes of days gone by. These include the 17th century Dutch Tulipmania and the 18th century South Sea Bubble, which have been chronicled in Charles Mackay's 1841 classic, Extraordinary Popular Delusions & the Madness of Crowds, as well as Edward Chancellor's equally fascinating, though more recent overview, Devil Take the Hindmost: A History of Financial Speculation. In "South Sea Hedge Funds," a Breakingviews commentary from today's Wall Street Journal, Chancellor and Lauren Silva explore a few interesting historical parallels.
Hedge funds now manage $2 trillion in assets, according to a recent estimate by Hedge Fund Intelligence. But they'd attract even more wealthy investors if they did a better job explaining themselves, says Spectrem Group, a Chicago-based research firm.
That looks like wishful thinking. The activities of contemporary hedge funds are so murky and complex, no one really knows what's going on inside of them.
This poor understanding derives partly from the fact that hedge-fund managers don't want to show their hands to competitors. The bigger problem is that hedge-fund strategies have gotten so complex. When they started out 50 years ago, the original fund simply took offsetting positions in stocks, a strategy known as "equity market neutral."
Today, few hedge funds are hedged, and many no longer trade stocks. Instead they're playing in the debt market, trading risky slices of collateralized debt obligations -- bonds secured by other bonds or loans -- and credit derivatives. And they typically use debt to help finance their positions. The trading gets even more complex than that. Some hedge funds also make bets on how different slices of a CDO will behave, something known as "capital structure arbitrage."
At the heart of many hedge-fund strategies is often a black box, driven by complex computer-run algorithms. Many engage in such complex trades that they can't be explained in English. Those that dabble in options describe their strategies in a bewildering Greek alphabet of gamma, delta, theta, and vega (the last was not known in Homeric times, but it sounds right).
If their activities are beyond the understanding of mere mortals, how can hedge funds market themselves to a baffled public? Perhaps they should imitate the sales tactics of a legendary company promoter during the South Sea Bubble who issued a prospectus for "an undertaking of great advantage but no one to know what it is."
Hmm, I thought some were already doing that?
(Disclosure: Edward Chancellor has endorsed Financial Armageddon, calling it "a breathtaking and coherent vision of financial disaster.")