As always, my opinion in financial matters is my own and does not necessarily reflect the views of my employers
The other day on a particularly boring flight between Bangkok and Taipei, I rewatched a TV series from a few years ago that I remembered a couple of days before in a discussion about the financial services industry and investing. The series in question is called Million Dollar Traders which originally aired in 2009 on BBC Two. Over the course of three episodes covering a period of eight weeks, plus a few that were not shown, eight ordinary people were given the chance to become hedge fund traders. Million Dollar Traders, or just Traders as it was shortened to documents the experiment created by the hedge fund manager Lex van Dam and confirmed the findings of the 1980’s “Turtle Traders” experiment by the investor Richard Dennis.
I was thinking about what the experiment at the TV series tells us about the financial industry and what hedge funds do and whether they do “good” in the wider context.
What the TV Series says about the financial services industry
In the first episode we saw Lex deciding who would get to trader with a million dollars of his own money. What was interesting was that he wasn’t looking for financial experience, or a degree. Rather, all he wanted was passion, the ability to cope with pressure, and to be good at maths. As it turned out, this is still a big ask. The maths aspect of the show also demonstrates something (that I will cover in a separate article) – that the maths education that we receive isn’t really fit for purpose. In the interview the candidates were asked to (mentally) calculate 32 x 32 (Hint: It’s 1024 – although base 2 mathematics becomes quite easy for a computer scientist!) During the course of the show, the traders had to deal with the complex application of simple arithmetic rather than the use of fundamentally complex mathematics.
As the show moves from the interview state to the start of actually trading, we meet the successful applicants. Because there is real money involved in the experiment, we should be safe to assume the traders aren’t there for their TV personality. In which case the traders covered a wide range of ages (20’s through to 60’s) and former careers (Student, Vet, Soldier, Entrepreneur…) Of the eight traders 75% were White British and (a different) 75% were men. Obviously eight people does not form a statistically significant group, and if the was to be expanded ten or twenty times, the results may be different. What it seemed to show is that when assessed against a set of criteria that look to capability rather than the person, there was not a more balanced split of people. There seems to be lots of research on the topic and it suggests that access to STEM education (Science, Technology, Engineering, and Mathematics) and different attitudes to risk by women and ethnic minorities seems to be part of the problem.
One of the big aspects of the experiment was the human factor. One of the traders wanted to see if it was possible to trade ethically and still make money. He frequently found himself at odds with the other traders. Their morning meetings were signed off with “Right, let’s go make some money.” Something he found distasteful. Other traders were more focused on making money from their trading, looking to profit from world events. This was reinforced by the traders’ manager Anton Kreil who retired from trading, as a millionaire, in his late 20’s. Anton perpetuated the ‘city’ culture, taking no nonsense and expecting high standards from the traders throughout, even at the expense of being ‘nice’. This clashed with the attitudes of some of the traders, although those that adapted to this style of working and communicating were also the highest performers. Perhaps then, to be successful in the finance industry there is a need to be outcome focused, almost to the exclusion of all else.
Over the course of the eight weeks, five of the traders left the group. One was fired and the other four left of their own accord. The first person to leave made losses early on, and was unable to recoup them. These losses seemed to prevent him getting into a rhythm and made him one of the weakest traders in the group, losing them money. Realising this, he volunteered to go. The next trader to leave was a woman who was recruited for her potential. During her time in the experiment however, she found herself unable to trade because of her fear, at times ending up in tears. At best, because she took so few positions, she lost only a small amount of money. At worst, she was a big distraction in the office, preventing other traders from performing to their best. Ultimately, six weeks in, she was fired by Lex. This prompted a walkout by the remaining three weak traders who said they had got fed up with how they were being treated. As Lex remarked however, those that were doing well remained sat at the desk, yet the weakest found it to be an excuse to leave. This prompted one of the scenes I found to be the most telling from the experiment. After the four people had left, the remaining three sat with Anton, picking through the bones of the others’ books. This was done without any emotion, merely an opinion on the position and whether it was worth keeping.
I think that apart from the conclusion that, yes, ordinary people can become traders that can beat the professionals, is that teamwork only runs one way. The individuals are working towards a shared goal, for the fund to make a profit. When they do well individually, it looks good on them and the group. However when the individual does badly, their poor performance will only be supported by the group for a brief period before the hindrances to the group’s success are removed. The conclusion of the experiment does suggest however that the professionals who insist that they are something special may need to rethink their justification of why that is.
The role of hedge funds
A hedge fund is one of the things that many people have heard of, but few actually understand. First, what is a hedge fund not? It’s not a bank, you can only deposit and withdraw funds at certain times and the value of your investment can go down as well as up. Nor is it a casino, a (good) hedge fun isn’t gambling, instead it’s using its understanding of the markets and how external events impact upon share prices to determine what trades to make. Hedge funds don’t buy companies. Typically their investments are minute in comparison to the size of the company they are investing in. Finally a hedge fund doesn’t invest in the company directly. Instead they invest in companies shares on the open market.
What a hedge fund does is in its name. It is an investment vehicle that manages risk through hedging. Hedging itself is a process for reducing risk by investing both ways in the market. Let’s say for instance that a report is due to become public that will impact oil prices. As an investor you believe that the news will increase the price of oil. The obvious beneficiary of rising oil prices are the oil companies, so you buy long in an oil company. If the price of oil falls however, then the price of the oil companies will also fall. We therefore sell another oil company short, hopefully one that is more exposed to bad news. Now whether the market rises or falls, it should be possible to make a profit, or at least minimise losses, even in difficult trading conditions. The investment portfolio will also be diversified and well balanced such that no one single event should result in large losses.
When talking about hedge funds, short-selling, or selling short is another terms that is commonly used. This is the second of the two tools in the trader’s arsenal, and certainly the more complex. The other tool is buying long, which we’ll look at before moving onto selling short. If I think that the price of a company is going to rise then I want to own some shares now while I feel they’re undervalued. I will then hold them until I think they’ve reached the right price and will sell time. The other person in the trade is known as the counterparty, and generally (but not always) trading is done through a man in the middle called the broker. A share has two prices: The bid price, which is what you will pay to buy a share, and the ask price which you would receive for selling a share. The bid price is higher than the ask price. The difference between the two prices is known as the spread. When a share is heavily traded, the spread will be smaller (tighter.) The spread is how the broker makes money from facilitating the trading.
If I think however that the price of a share is going to shall, I don’t want to buy it, but I still want to make money from the price falling. Enter short-selling. In short-selling, if I think the value of the stock is going to fall then I “borrow” a share from my broker and sell it. This is possible because, generally, when buying and selling shares, the broker will hold them on the client’s behalf. The share sold has been borrowed from another client holding a long position. The broker assumes liability to the client holding the share long and passes this liability to the trader by way of a margin account which is effectively trading credit. Interest is payable on the margin held which the broker receives in return for lending shares. Note that the person whose share has been borrowed plays no actual part in this transaction (more on this in a bit.) The share that has been sold has to be bought back by a certain point. If the price of the share when it is bough is lower than the price it was sold at then, after fees, it is possible to make a profit.
One of the problems with short-selling is the potential for unlimited losses. If the value of a long position decreases to zero, then the value lost is limited to the purchase value of the shares. There is however no upper limit on the value of a share. If you was to sell a share for 100, but the price then rose to 500, the lost is now 400 and the shares must be repurchased. In order to reduce this risk (it can also be used on buying long) a “stop-loss” can be used which trades out of a position if a certain price threshold is passed. Another risk is if the people holding shares long wish to sell them outside of that broker. Remember they have no part in the short-selling transaction. If enough shares are sold that the broker no longer holds shares equal to those being borrowed then a margin-call can be made, and the shares on-loan repurchased regardless of whether a profit or loss is made.
Understanding what it is that a hedge fund does, the next question is whether they provide value to their markets. We’ll leave the question of value to society for others to answer. Having done a little reading, the answer seems to be yes, to an extent. They are one of the less transparent and well understood sections of the financial industry and the biggest hedge funds could present a systemic risk to the industry. On the other hand they can help to stabilize volatile markets and provide liquidity by making trades when others don’t. Also, the relatively small size of most funds means their potential impact on the market is limited. As for whether it’s worth investing via a hedge fund: If they’ll even take your money, that’s something you have to decide.