Financial ecology without its predators

The recent short squeeze endangered the hedge fund industry. Many of us are quite happy with the result. After all, they chased Tesla too strong. And we do not really like that particular branch of the financial sector. I argue that the situation is dangerous and we should not be happy about it… More ecological articles here, here, and here.

Kill the bad wolf

I have a friend who is a retired officer. He lives in the Blue Ridge Mountains and hunts recreationally.  He eats what he kills. I told my small daughter about him and she said “Tell your friend not to kill Bamby’s mother, but kill the gray wolf instead”. Now, this is cute and funny, but there is an interesting point she missed: the wolf has a very important role in ecology.

Decades ago there was a very successful project of the reintroduction of wolves to Yellowstone Park. People prefer safe natural wonders, and wolf packs are frightening. So about 100 years ago wolves were eradicated from the park. As a result, deers were overpopulated. There were huge outbreaks of deer disease as wolves did not hunt sick individuals, and between these outbreaks, there was overgrazing killing all grass. The park was sick for decades until the wolves returned. Within 10 years they restored the natural order. Now they are protected and beloved.

We may dislike certain creatures, but when we eradicate them entire ecological systems crumble.

Hedge funds are hunters and scavengers

We may dislike hedge funds, but they are a very important balancing force in modern markets. Hedge funds identify the sick and wounded entities and hunt them down until their stock price corresponds to their value.

Being a predator is dangerous. Placing a short order on a stock may require covering several times the value gambled. People who work in hedge funds are usually highly energetic, motivated, and fear-free. They risk quite a lot every day based on forensic evidence, mathematical analysis, and some intervention. And they win only when their prey loses.

Since the risks are high, hedge funds need to show revenues well above the market average. To do that, they often go into gray area activities like bad PR and ugly fights over the control of companies. All of us can place short orders (probably up to 30% of our portfolio).  Only the hedge funds have the resources to actually hunt down the overvalued companies.

Bubbles

Hedge funds have a very important role in financial ecology. They ensure that the market valuation is fair and there is no bubble. At least on a small scale.

To be honest, they cannot really stop a bubble: they are not as large as some institutional investors and the general public.  When there were a housing bubble and crisis in 2007 several hedge funds invested against the housing prices and got x6 multipliers on their investment. They did not stop the bubble and did not accelerate the crisis. They simply benefited from it.

On the other hand, there is no sufficiently powerful force guarding against cryptocurrency bubbles. We see x10 multiplies both up and down. Nobody wants that in Blue Chips companies. In 1999 there was a huge dot com bubble followed by a collapse of the entire sector.  Simply the enthusiasm of the general public was more powerful than the activity of well-informed investors. Without hedge funds, we could see this sort of bubble every year.

An alternative to hedge funds is heavy regulation, the kind of regulation we see in China. If an entrepreneur overplays his hand, the government steps in taking care of things quietly. This is effective, but we love our entrepreneurs and do not want them to see the bad side of the regulator.

Large and dangerous pray

Taking down a small stock is something a hedge fund can handle. But what happens when the overvalued stock is Tesla? In the year 2020 Tesla stock sored well above the reasonable valuation. Hedge funds used their tricks and spotted the company’s weakness. Once they placed the bet, they further issued bad PR and harassed a bit the CEO. All of this is standard practice. What followed was not standard.

Elon Musk, the CEO of Tesla Motors did not just sleep on the assembly line. He tweeted the stocks that hedge funds targeted and asked the general public to bet against the hedge funds. This is known as shorts squeeze. As the price goes up, the hedge fund that bet against the asset loses a lot of money, and become incapable of placing further large short orders.

It’s not like nobody used shorts squeeze before. Just not on a scale that eradicates a large number of hedge funds. Now what? Do we risk another bubble?

Diversity of thought

What the hedge funds represent beyond their direct function is the diversity of thought. People who work in hedge funds are very different from generic investors. After all, the most popular investment technique is dual momentum: following the strongest local and global trends and diversifying the investment. What the hedge funds require is something very different from happy grazing in the green fields of American dollars.

The people who work in hedge funds need to identify situations when everybody is wrong. This is hard and requires very different people. Some are pessimists, some are monsters and most are very smart. Genius-level smart. They could be successful teachers and doctors, scientists, and entrepreneurs, but their personalities made them hunt financial prey and compete with other successful predators.

Or maybe their PhD dealt with subjects that made them attractive for hedge funds, and the hedge fund compensation packages were significantly better than what anyone else could offer. In this case, their education made them different. (A disclaimer: my own PhD dealt with financial volatility).

Anyway, hedge funds are a diverse and colorful bunch.

Burn the witches

The complex and diverse tools used by hedge funds are often very creative, well beyond the tools used by traditional investors. Regular folks do not like that. If we lived in the middle ages, some of the hedge fund managers would be burned as warlocks and witches. In fact, this is exactly what happened in medieval Europe.

There was no reliable way of identifying a witch. Burning green twigs looked like a strange dragon. A familiar, like a cat, sounded like a demonic presence for drunken villagers in the middle of the night. Extraordinary financial success appeared as a contract for someone’s soul. Today high-stress jobs that leave no place for personal lives also often look like a dubious contract.

So for the greater good of medieval society, the witches were quite physically eradicated. And that included strange and deranged women, men suffering effects of syphilis and mercury, scientists and astrologists, and maybe some financial wizards.

Do not get eaten

The medieval society performed as well as the cutting-edge knowledge and technology of that time allowed. Fear is a very powerful motivator. And there were many reasons to fear. A disease carried by mice could kill 50% of the villager, but avoid the lonely lady with three cats in her house. A famine could exterminate poor families, while the speculators literally hold huge bags of food in their basement.

The fear is very natural. A rabbit in the woods is afraid of the gray wolf. We know that the wolf will probably make a lot of stupid mistakes and the rabbit is likely to escape, maybe four times out of five. But the rabbit does not know if today is his lucky day, or else…

I quote:

With the majority of predator attacks unsuccessful, many animals have literally escaped the jaws of death. Near-death experiences give prey an opportunity to sharpen their survival skills for next time. That includes staying vigilant, which creates a starvation-predation trade-off – the dilemma facing the dunlins burning fuel in flight to avoid getting eaten by the peregrine. Prey cannot simultaneously search for food while keeping a watchful eye out for predatory danger.

And moreover, there is healthy competition between predators. Every family wants more food on its own table. Sometimes this means eradicated competition. Lions definitely do that in African savannahs. As the most successful predators, we eradicate predators wherever we go.

Keystone predator

We do not necessarily need all of our predators. Owls, cats, and ferrets eat mice. If one of the species suffers, more food for the others. However… Some prey is simply too tough for anyone except an apex keystone predator. Like a family of grey wolves. If there is no such predator, the tough species overpopulate the environment and generate an ecological crisis.

In the financial environment, hedge funds are keystone predators. Only they have enough creativity and critical thinking to go beyond the factors that cloud our judgment. They see weaknesses everybody else misses and make our financial markets healthy and efficient.

They harness mathematical skills to predict trends better than the rest of us. (Around Y2000 I did it using multimodal distributions, now AI is very effective.) And they use old-fashion detective to understand when the companies lie in their report. For example, they used quadcopters to examine cars successfully manufactured by Tesla. And they rely on diversity and fierce competition to come up with crazy ideas.

The keystone predators are fierce and magnificent. They are crucial for ecology. But they are also great trophies.

Trophy hunting

Humans are the most powerful predators. The general public has enough power to kill any predator: sniping tigers from elephants, or hedge funds from curated investment accounts.

There are easier targets to hunt, but they are not as satisfying on the walls of our study rooms. Probably the most discussed case of trophy hunting was the killing of a mature and friendly lion called Cecil who was left to bleed to death from arrow wounds in Zimbabwe. The guy who killed the lion thought that everything was legal, but his local guy tricked him. Trophy hunters think they help ecology, providing money to breed magnificent species. Is that really so? Do they have all the facts?

Elon Musk bought a lot of cryptocurrencies. We do not really know how this currency was used. We do know that under his guidance, the general public killed several magnificently monstrous hedge funds. What troubles me is not this particular trophy hunt, but its meaning for our ecology. And it is also troubling to understand that a single person has enough power to organize a trophy hunt of the keystone predators of modern financial markets.