Unregulated investment funds

PAUL SOLMAN: And what’s a hedge fund? Law professor and former SEC Commissioner Harvey Goldschmid.HARVEY GOLDSCHMID, Columbia University Law School: Well, a hedge fund is a misnomer. It sounds like you’re hedging bets and covering them on both sides. Reality today is they’re investment funds.

PAUL SOLMAN: Unregulated investment funds that, unlike mutual funds, say, can take any manner of risk, says hedge fund owner Nassim Taleb.

NASSIM TALEB, Hedge Fund Owner: The difference between hedge funds and mutual funds is that mutual funds take your money, and they have a lot of constraints on what they can do for you, OK? A hedge fund has usually more freedom to invest, to make bets, to take gambles, to do whatever you want.

PAUL SOLMAN: Hedge funds don’t have constraints. That’s because they can take money only from supposedly sophisticated, so-called accredited investors, those with $5 million or more, who can presumably afford to take risks; $5 million, however, automatically includes just about any pension fund.

So I put the question to Nassim Taleb, who as you’ll see soon enough will provide the swan song to this story.

Higher rewards and more risks

PAUL SOLMAN: OK, let’s take it back to 2000. I have a lot of finance professor friends, some of whom would presumably go on my board. People know me from television as a financial something or other. Do you think I could have actually started a hedge fund?NASSIM TALEB: You would have had billions under management currently.

PAUL SOLMAN: I would have billions?

NASSIM TALEB: Yes, because…

PAUL SOLMAN: Billions?

NASSIM TALEB: Yes, all you had to do is just go to university and pick up a couple of professors, OK, hire a couple of risk managers. Usually they have a foreign accent and, you know, they’re quants, OK?

PAUL SOLMAN: Quants?

NASSIM TALEB: Quants, like me, like my background is a quant.

PAUL SOLMAN: “Quants,” as in quantitative types, so-called financial engineers, like Taleb, himself a mathematician, a hedge fund owner, and author of a steeply skeptical book on investing, “Fooled by Randomness.”

So let’s say I hired a few quants, signed up some professors, and launched the pretend Over the Hedge Fund back in 2000, after the stock market swoon, from my backyard. Best promise to investors? High returns, of course, that wouldn’t be volatile, or so says Nassim Taleb.

NASSIM TALEB: All you had to do is provide these steady returns or the illusion of low-risk returns.

PAUL SOLMAN: Or, as Taleb’s friend Stan Jonas, also a hedge fund manager, puts it…

STAN JONAS, Hedge Fund Owner: The path to success in the hedge fund is don’t rock the boat.

PAUL SOLMAN: Don’t rock the boat. So we at the Over the Hedge Fund would have told investors — rich people, pension funds, everyone — that we were insuring low volatility, safe, stable returns, by investing in a lot of different markets, stocks, bonds, commodities, so we wouldn’t be over-exposed in any one of them.

Yes, our traders would have gambled, making bets in those sometimes-wacky markets. But genius quants, not unlike Taleb here, would have written computer programs to protect those bets. In fact, Long-Term Capital Management, the hedge fund that famously collapsed in 1998, was run by Nobel laureates who once called their strategy “vacuuming nickels that others couldn’t see,” making small bits of money, that is, on big, supposedly sure-thing bets.

So what’s not to like? Lots, says Stan Jonas, who operates his hedge fund from this townhouse in Manhattan. First of all, you can’t have higher-than-average rewards without taking higher-than-average risks.

STAN JONAS: Every trade is implicitly a bet on something. The more of the trade you do, the more risk you take on.

The ‘black swan’ event

PAUL SOLMAN: Indeed, like that of almost any major hedge fund, the former success of Amaranth came from taking big risks, in its case on natural gas after Hurricane Katrina last year. A 32-year-old trader made several billion dollars on huge, highly leveraged bets that natural gas prices would surge. This year, however, no rough weather, no big storms, but a similar big bet, and thus a Katrina-like outcome for Amaranth, despite its claims of low risk.And that’s because of a fundamental fallacy with the supposedly risk-free approach: the black swan event. The black swan event is a way of saying that, just because you’ve never seen something happen, it doesn’t mean it won’t.

For millennia, Europeans thought that all swans were white because, everywhere they looked, even when they got to North America and rivers like this one, swans always had been.

NASSIM TALEB: We saw a lot of white swans. Every white swan was confirming that, you know, “Hey, all swans are white.”

PAUL SOLMAN: Nassim Taleb’s next book, not yet out, is called “The Black Swan,” because, in 1697, Dutch explorers discovered Australia and black swans.

NASSIM TALEB: And, sure enough, they saw that black bird and said, “Hey, one single observation, OK, can destroy thousands of years of confirmation.” So likewise in the markets, all you need is one single bad month to destroy years of track record.

PAUL SOLMAN: In fact, the hedge fund that claimed to be vacuuming those nickels, Long-Term Capital, needed about one bad month to go under in 1998, even though its mathematical models, based on years of track records, said these were the odds — several billion times the life of the universe to one — of experiencing a major loss.