What do the Oscars have in common with hedge funds?

Answer: Film financing.

I just noticed the New York Times Dealbook's posting about how hedge funds have gotten involved in film financing. Although a nod from the Academy of Motion Picture Arts and Sciences will be a boost to the egos of these would be movie moguls, I suspect that they are much more interested in profits. It is from this perspective (the monetary one rather than the artistic one) that we see how financial and commercial randomness can prove more fickle than the whims of the Academy's voters.

According to empirical research done by economist Arthur De Vany, financial returns from investing in movies seems to be more uncertain than the prospects of winning an Oscar. This situation is caused by the fact that movie success (and, more often, failure) tends to be consistent with the power law -- specifically, a few movies account for most of the profits of the film industry during any given period. The power law is often associated with 'wild randomness' (a favorite topic of this blog) -- i.e, where the ability to pick winners & losers is hampered by bewildering layers of complex interactions and 'jumpiness' that occur when films are released in the marketplace.

Even if hedge fund managers and traders are disappointed by the results of the 79th Academy Awards or by the byzantine nature of Hollywood financial practices, they can take heart in the Bush administration's recent decision to not regulate the hedge fund industry. If there was an Academy award for acting surprised by this decision, then it would surely go to some lobbyist acting on behalf of the hedge fund industry.

Profile of David Swensen, Yale's legendary investor

This Sunday's New York Times had a fascinating profile of David Swensen, Yale's legendary chief investment officer and a faculty member of its business school: For Yale’s Money Man, a Higher Calling (Feb. 18,2007). In over two decades, Mr. Swensen "has generated an annual compound growth rate of 16.3 percent" for Yale's endowment "beating the performance of Harvard’s endowment and that of every other major school in the country over the same period." This amazing performance over the years has accounted for over $7.8 billion into Yale's coffers ... making him the largest financial contributor to the school over the last 20 years.

In the article, David Swensen mentions two contrarian maxims that have guided him both as an investor and as a man over the years. The first of these maxims is that he looks for "people who define success by generating great returns, not by making as much money as they can." This may sound odd coming from one of the greatest investors in recent memories but it makes a lot of sense in both a practical and a philosophical way.

From a practical perspective, it makes sense for an investor to entrust money to someone who is more focused on performance rather than on generating fees. As Mr. Swensen explains it:

“If you make money personally by gathering a huge pile of assets, it is great for the management company because they make bigger fees,” Mr. Swensen says. “But if the fund goes from $2 billion or $3 billion to $20 billion, they are inevitably going to reduce their ability to generate investment returns. Size is the enemy of performance."

From a philosophical perspective, Mr. Swensen's first maxim is consistent with a meritocratic view of life. In other words, it's performance and merit that should matter most rather than just having access to a pile of assets.

Mr. Swensen's second maxim is that the art and science of investing can be applied to things beyond making the wealthy wealthier. Investing can be used to support non-profit causes and other endeavors that can make contributions to sorting out the world's problems. This second maxim has led to Mr. Swensen spurning generous offers to become an investor in the private sector for substantially higher pay.

Besides his contributions to the practice and philosophy of investing, David Swensen is an author of two of the best books on finance ever written: Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, and Unconventional Success: A Fundamental Approach to Personal Investment. Anyone serious about learning the art and science of investing should read both of Mr. Swensen's books.

Partnoy's Non-Complaint for Hedge Fund Activism

This sunday's New York Times had a column by Mark Hulbert that describes research by a group of finance and law professors arguing that hedge fund activist interest is good for share values for up to a year: A Good Word for Hedge Fund Activism (Feb. 18, 2007). This would contradict the negative image held by some people that hedge funds are solely concerned about short-term profit and may not enhance shareholder value for relatively long periods.

The research -- consisting of a working paper, Hedge Fund Activism, Corporate Governance, and Firm Performance, by a cadre of finance and law professors -- does bolster some of of Mark Hulbert's points. However, a slightly closer perusal of the original research paper reveals that the Times article is being a bit too optimistic about the benefits of hedge fund activism.

As the paper makes clear, a lot of the abnormal returns from hedge funds taking substantial positions -- by 'substantial,' I mean the 5% or more of company's outstanding shares that need to be acquired to trigger securities law requirements to file with the the Securities and Exchange Commission (SEC) -- in targeted companies come from the actual or implied hostility of the acquisition (e.g., disagreement with management about business strategy or sale of the company). Hedge fund activities that targeted more mundane corporate governance issues did not generate much in the way of abnormal returns.

Furthermore, the data set that the researchers looked at seem to me to be somewhat limited. This limitation is due to the fact that hedge funds have limited reporting requirements with the SEC and other financial regulatory authorities (hence their appeal to some investors). The data that the research looks at is limited to acquisitions of publicly traded shares that are substantial enough to trigger reporting requirements. By no means does this data set represent the bulk of hedge fund activities.

One final bit of info worth noting is that one of the authors of the working paper is Frank Partnoy, a law professor in San Diego. What he is best known for, however, was his stint as a derivatives salesman/trader at Morgan Stanley. He wrote up his experiences at Morgan Stanley in the highly informative and entertaining (but not particularly flattering for Morgan Stanley or his previous employer, CS First Boston) book, FIASCO: The Inside Story of a Wall Street Trader ... a book that has been favorably compared to the Michael Lewis classic, Liar's Poker. While Frank Partnoy is no Philip Roth, Prof. Partnoy is an excellent writer/story-teller by the standards of financial traders or lawyers.

The Shock of Uncertainty

Nick Bloom, an economist at the London School of Economics and Stanford, has done some fascinating research modelling the effects of uncertainty shocks on the investment decisions of firms and other macroeconomic actors. The gist of his research is that -- rather than focusing on the effects of macroeconomic shocks on the expected value (i.e., the first statistical moment of a probability distribution) of macroeconomic variables -- Prof. Bloom focuses on estimating the effects that volatility (i.e., the second moment of a probability distribution) shocks may have on firm level decisions in the macroeconomy.

Using numerical simulations with MATLAB (a computational mathematics software package), Dr. Bloom makes some interesting conclusions regarding what uncertainty shocks (i.e., second moment shocks) can do to economic decisionmaking. One of the many conclusions of the research is to confirm Ben Bernake's (formerly, a Princeton economist, but now the head of the Federal Reserve) previous research concluding that there is a 'real option' for firms to wait-and-see before making major decisions (such as making capital or labor investments). Another interesting conclusion is that second moment shocks tend (with the exception of the Great Depression period) to be transitory -- spikes in volatility lasts for a few months before settling back down.


Perhaps the most interesting finding by Prof. Bloom is that his model seems to fit well with what happened during the period on and following the 9-11 terrorist attack: a sharp spike in stock market volatility, many businesses taking a holding pattern before making major investment decisions, and, eventually, a return to relative normalcy (although it should be noted that the scandals involving Enron and Worldcom added further spikes in volatility that had a sort of knock-on effect that made the transition back to a lower volatility environment more uncomfortable than it otherwise could have been).

There are other findings that should be of interest to readers of this blog. You can download Nick Bloom's paper, The Impact of Uncertainty Shocks: Firm Level Estimation and a 9/11 Simulation, by clicking the link. A layman's overview of the research can be found in the Economics Focus section (Feb. 1, 2007) of The Economist: Momentous modelling: When terrorists strike, what happens to investment and jobs?

Uncertainty About Financial Risk

The Economist has an interesting article (Feb 1, 2007) on uncertainty regarding financial risk. The article briefly explores whether financial risk is being properly mitigated or whether people are simply paying lip service to risk management and that, in reality, hidden risks are poised to send shock waves throughout the markets.

As The Economist points out the 'great-and-good' at Davos and elsewhere seem to be mindful of risk, yet:

[A]s the Bible says, “by their fruits ye shall know them”. Banks are still financing leveraged buy-outs, junk bonds are offering their lowest spreads since March 2005, and the cost of insuring against a share-price fall, as measured by the Chicago Board Options Exchange Volatility Index (Vix), is low (see chart below). Financiers may be worrying about risk, but they do not seem to be doing much about it.

Perhaps the most succinctly wise way of thinking about financial risk is what Warren Buffet had to say about it: “It's only when the tide goes out that you learn who's been swimming naked.” In other words, we won't know whether the optimists or the pessimists are right about risk until the proverbial "tide goes out."