Monday, July 18, 2011

The social utility of hedge funds

There is an article in the New Yorker magazine profiling Bridgewater Associates, the world's biggest global macro hedge fund. Inevitably, we come to the awkward question: "If hedge-fund managers are playing a zero-sum game, what is their social utility?"

I thought about this question a lot in the past, and I used to agree with many others that the social utility of hedge funds, or trading in general, is to provide liquidity to the markets. And a good economic case can be made that the more liquid a market is, the higher the utility it is to all participants. However, based on recent experience of flash crash and other unfortunate mishaps, we find out that traders typically do not provide liquidity when it is needed most! So this answer becomes quite unsatisfactory.

In trying to come up with a better reply, I though it is curious that few people asked "What is the purpose of having a Department of Defence?" since wars between nations are typically also zero-sum games, yet we greatly honour those who serve in the armed forces (in contrast to our feelings for hedge fund managers).

To me, clearly the answer with the best moral justification is that, in both cases, there is great social utility in defending either your clients' comfortable retirement from financial meltdown (e.g. due to governmental or corporate mismanagement), or in defending your country from foreign aggression. More specifically, the purpose of hedge funds is to reduce long-term volatility in your clients' net worth. (I would like to say "reduce risks to your clients' net worth", but that would be a bit too optimistic!) 

I emphasize long-term volatility, because of course trading generates a lot of daily or hourly volatility in your clients' equity. But I do not believe that such short-term volatility affects ones' life goals. On the other hand, a 3-or-more-year drawdown in a typical buy-and-hold portfolio can wreck havoc with many lives.

If one day, the markets become so quiescent that few hedge funds can generate higher Sharpe ratio than a buy-and-hold portfolio (as indeed seems to be the case with the US equities markets these days), then yes, most hedge fund managers should just quit, instead of hogging intellectual resources from our best universities.


Fuzhi Cheng said...

In the commodity market, speculators provide liquidity and more importantly play a key role in price discovery. They identify disequilibrium and buy/sell to dampen down natural volatility. Of course many people argue that they are the creator of excess volatility!


Justin said...

isn't perhaps a better metric by which to measure a hedge fund's performance is its Sharpe Ratio's stability? (and similarly, its Sharpe Ratio's stability as compared to a benchmark index over say a rolling 2-year window). The S&P500 is a benchmark for many funds, but as we all know the rolling 2-year Sharpe Ratio of the S&P500 over its 50+ year history is almost as volatile as its daily returns. Typically I compute a rolling 2-year sharpe ratio of my backtested strategies and then computer standard deviations of this Sharpe Ratio timeseries (in the same way I would compute the volatility of my equity curve). If my Sharpe Ratio is on average >2.0 over the entire period, and the minimum rolling 2-year Sharpe is 1.75 and max of 2.25, I feel much better than a strategy that might make have a total sharpe ratio of 2.75, but its lower 2-yr Sharpe is 0.25 and max of 4.0.

Ernie Chan said...

Yes, I think a rolling Sharpe ratio plot is a good idea, certainly more informative than one single number.

My point in the article is that the drawdown duration may be more relevant to an individual investor than the Sharpe ratio.


Anonymous said...

Hey Ernie,

I'm reading over your book and had a question on the GLD vs GDX pairtrade using regression (ex 3.6). It seems like you use the hedge ratio to determine the spread and trades, but not to adjust the size of the respective positions. For example, 3 shares of GLD to 1 share of GDX. Is this intentional? I expected to see some sort of hedged position to take out some market risk.

Please excuse me if this is not the correct forum to post this material.


Ernie Chan said...

Yes, strictly speaking you should use the hedge ratio to adjust the number of shares of GLD vs. GDX as well. I fix the dollar capital to be 1 on both sides for simplicity only.

ZK said...

I've really enjoyed your book and blog and want to thank you for all the effort. This is off topic from the article, but I was wondering what toolboxes do you use in Matlab and how much is the total cost of your package (including the basic Matlab software)?

wanderer said...

Except the problem is that hedge funds increase long term volatility, and engage in zero sum games such as Stat Arb, Convertible Arb and the like.

Hedge Funds lead to a massive increase in trading volume, and a increase in trading volume inevitably leads to a increase in volatility.
Remember that more often than not, a speculator lies on the opposite end of the trade with a hedger.
There is little economic justification for many of the strategies used by hedge funds, and hence very close to being worthless to society.

just my opinion


Ernie Chan said...

I am not using any Matlab toolbox at the moment, but I have used Matlab Datafeed toolbox in the past when I needed Bloomberg and/or Yahoo Realtime data.

The basic platform is about $2K, and the toolbox is about $1-$2K each.


Ernie Chan said...


When I said hedge funds decrease long term volatility, I am referring to the long term volatility of their clients' net worth. I am not interested in whether they increase long-term volatility of the market as a whole.

As hedge fund managers, our primary mission is to protect our client's comfortable retirement, and not to act as guardian of some abstract "market". I view the protection of my clients' comfortable retirement to be of very high social utility.

As I mentioned in my blog post, whether this results in a zero-sum game or not is irrelevant. We do not dismantle our national defence because war is a zero-sum game. Similarly, we should not abandon financial defence of our clients' net worth simply because it might decrease the net worth of some unrelated parties.


Art said...

I think there is an unspoken assumption in the question of the article: there are people smart enough to decide if hedge funds are necessary. If these geniuses deemed hedge funds as unnecessary, then they have the right to eliminate them.

If the market did not need hedge funds, they would not exist – period. The fact that they do exist means they have a utility.

There are a lot people out there who think they are smart when in reality they are extremely stupid.


Ernie Chan said...

Yes, I agree with you. Let the market decides whether hedge funds are useful to someone. If they aren't useful to anyone, surely they will become extinct soon enough.

Anonymous said...


I think you're confusing two discussions. Undoubtably, an investment fund that provides excess risk-adjusted returns to its clients (net of fees) is useful *to its particular clients*. Note: that's true both for funds that manage volatility (i.e hedge funds) and long-only funds. But there's no denying the fact that active investment management is a zero sum game, so in the aggregate the overall industry destroys value after fees are taken into account.

Here's something similar to think about. Besides my stock and bond investments, I also have a "poker investment". A friend of mine is an excellent professional poker player. He plays live at a casino in Atlantic City. I provide the capital he uses to play the game, so it's my money that's at risk, but he does all the work and I get 20% of the profits. He's a good enough player that it's a very good deal for me; my long-term rate of return is over 100% per year, and it's statistically independent of any other conceivable investment. So clearly his poker playing is good for *me*, but can one say that it's useful to society overall? No, of course not. It is, quite literally, a game that adds nothing to society when the profit/loss is added up among all players. But that doesn't change the fact that it's a great investment for those that can find an expert poker player in need of an investor.

- aagold

Ernie Chan said...

I emphasize that I am not interested in the notion of an abstract utility to humanity. I am only interested in the utility I provide to my clients. Hopefully those clients will include doctors, educators, farmers, etc. that can go on to generate more direct value. However, I am not about to become a farmer myself.

If you are really concerned about utility to humanity as a whole, there are lots of institutions you need to dismantle before we even get to hedge funds. I would start with every department of defence in the world, and then on to casinos and lotteries, video games, spectator sports, beer-drinking, ... I would include Halloween somewhere in the list too.