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Hedge fund blow up – fact or fiction (threat or menace?)

Date: Tuesday, February 7, 2006
Author: Hunt Taylor

Our industry has lost one of its most popular and well liked individuals. More than that, our industry has lost one its great thinkers. So many people that I have spoken to have commented on his vision not only as it related to emerging asset classes but more importantly to his vision as to our industry as a whole. So often Hunt would pen the article or give a speech that would have us all saying “but of course”. As was so often the case, he usually saw it well before most of us. The following speech which I describe below was just another example of his brilliance. We will all miss him.

In a much applauded analysis presented at the 8th Alternative Investment Roundup in Scottsdale, Taylor gave examples how throughout history the media was actually creating fear. And in most cases, “what we are afraid of is not what we will die from.” For example after Chernobyl, CNN said about 3.2m people will die. The latest number Taylor could get about the fatalities of this Russian nuclear disaster were 4000.

Looking at press archives and publicly available records, Taylor identified the following hedge fund frauds and blow ups.

  • In 2000: Manhattan $400m, Phoenix $100m (was actually a Canadian fund), Laser $71m
  • In 2001: Integral ($71m)
  • In 2002:: Lancer $571m, Lipper $357m, Beacon Hill $300m
  • In 2003: Eifuku
  • In 2005: Portus, Bayou, Wood River, KL etc.
Taylor mentioned his intention was to add up all hedge fund frauds and the actual investor losses. Taylor said the list may not be complete and if he left out any blow up (that caused real investor losses), he will be grateful for any hints or information.

Hunt then put the losses in relation to the total (hedge fund) industry assets:

Losses as % of industry assets:
2000: $500bln – 0.11%
2001: $563bln – 0.014$
2002: $650bln – 0.18%
2003: $817bln – 0.03%
2004: $950bln – 0%
2005: $1.1trln – 0.15%

Even if you add up all hedge fund blow ups since 2000, this would correspond to a 1% down day in GE, or -0.1% of the Dow Jones Industrial Average.

Hunt was next looking for reasons that could explain the massive media attention and fear factor the hedge fund industry is facing. He found some answers in the book “Freakonomics”, specifically where the authors analyse the way people assess risk. The book gives the hypothetical family that has a 10 year old daughter. The daughter has two friends. One family has a swimming pool, the other family has a gun in the house. So the parents decide to let the daughter go visit the family with the pool, but not the one with the gun in the house. The authors concluded, that the parents were extremely bad risk assessors, since the chances of a child drowning is a 100 bigger than by being killed by a gun (1:11,000 vs. over 1:1,000,000).

Hunt explained the key for the parents’ assessment may be the perception or associations to both pool and gun. Pools are fun and familiar, but just the (mental) picture of a child being shot with a gun is horrifying. Hunt concludes that the risks that scare people turn out to be very different from the risks that kill people. Similar misjudgements happen over other mundane questions like what is more frightened: flying in an airplane or driving in a car? What is more dangerous, mad cow disease or food bourne pathogens (e.g. salmonella) in the home?

The difference between the two would be control (or the hallucination of control). Control is negatively correlated to outrage. The higher the control we assume we have, the less the actual outrage.

In fact, risk experts state the following:
Risk = hazard + outrage
High hazard + low outrage = under reaction (for example heart disease – no outrage (“no marches against congress although 40% of us will die of heart disease”)
Low hazard + high outrage = over reaction (terrorist attack)

The risks that scare people turn out to be very different from the risks that kill people. And they are also different from the ones that cost us money. Emotion is the enemy of rational argument. And emotion is more potent that other emotions.

When it comes to hedge funds, outrage factors abound: Hedge funds are not liquid, not transparent, not regulated, leveraged, managers are overpaid, they “whip” the market by increasing volatility, driving up oil prices etc.

When it comes to investing, investors feel in control when making investment decisions like (buying stock) themselves, or even when selecting mutual funds. For an unseasoned investor, handing money over to a hedge fund manager may feel quite the opposite.

Drawing another analogy, Taylor said that hedge funds are at the forefront of financial technology. As in many other frontiers of human science and development, technology and the changes caused by technology are often opposed. German philosopher Schopenhauer said every truth comes through three distinct stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as self-evident.

Taylor finished saying that at the time where some “experts” and the media still try to whip the public into fear, the markets have already started the “process of adjustment”. Such corrective developments come with a lag time, as we “live in an echo chamber”. He is confident that “servomechanisms” of the markets (as a thermostat that starts the heater or the air condition depending on the needed reaction) will come up with the proper solutions.

Editor's Note: Hunt Taylor killed in tragic motorbike accident in Arizona

Some of you may have already heard that Hunt Taylor was killed in a motorbike accident in Arizona. According to HedgeWorld.com, the Arizona Highway Patrol said that Taylor, 54, died when the motorcycle he was riding on State Route 87 collided with another vehicle about two miles north of Strawberry, roughly halfway between Phoenix and Flagstaff. It was a great shock to learn this yesterday afternoon. I am mourning the loss of a friend. We spent precious hours just a few days back at the SRI conference in Scottsdale, before he took off for his trip. Together with a relative, Hunt wanted to spend one week cruising through Arizona and other neighbouring states. He was so much looking forward to this trip, and only a two days ago sent me from his Blackberry “just did 400 miles today in Death Valley and the Mojave Desert”.

I am at the MFA conference in Florida now and every person I speak to and who knew Hunt is deeply shocked about this devastating news. We have lost one of our best. My deepest sympathies and condolences to Hunt's family and friends. He was a great man with a great heart, and we will all miss him.

Hunt Taylor's career spanned twenty-five years on Wall Street during which he has acted in a range of industry capacities including trading, brokerage, management, new product development and marketing. Hunt was one of the founders of FINEX, the financial futures division of the New York Board of Trade and one of the developers of the US Dollar Index. He was the original Managing Director of Dublin based FINEX Europe and worked with the Irish Government to create that country's first open outcry exchange. Active in the alternative investment industry since 1987, Hunt Taylor was an early investor in TASS Investment Research, a hedge fund data and research organization, where he was instrumental in TASS's acquisition by Tremont Advisers and in the development of the CSFB/Tremont Hedge Fund Indices.

Hunt worked as Director of Investments of Stern Investment Holdings, the investment arm of the Hartz Group. Contrary to some press reports, Hunt Taylor left on friendly terms and Ed Stern mentioned in a phone call Hunt may continue to manage hedge fund assets for the Stern family. Hunt has recently written an online course on hedge funds for the New York Institute of Finance and was also Chairman of the Public Relations Committee of the Managed Funds Association.