What is “complexity” and is it really to blame?

North Americans woke up Saturday morning to two major newspaper stories that blame recent financial upheaval on the sheer complexity of hedge fund strategies.  The Wall Street Journal proclaimed that “Hedge Funds Feel New Heat” and Canada’s Globe and Mail announced that “Statistical geniuses of finance at the banks and hedge funds got it wrong.”  Both articles rely heavily on anecdotal evidence.  But unlike the mutual fund industry, the hedge fund industry does not lend itself to such extrapolation.  This is because manager dispersion within each hedge fund category is relatively large.  As a result, such anecdotes – the bread and butter for mainstream hedge fund coverage – are a poor indicator at best and misleading at worst.

For example, the Journal article argued that,

“The past decade has been the era of the hedge fund, as investors snapped them up for their track record of beating the market with often highly complex trades.  But now, as the credit crunch upends financial markets, that very complexity is coming back to bite some of them.”

This is a fair hypothesis (and one that we have also made in the past).  But the anecdotal examples held up as proof would likely be branded as “curve-fitting” by statisticians.  One hedge fund cited in the article faced problems with its real estate holdings, one had “improper accounting”, and one “got burned dabbling in debt”.  None of these drawdowns were blamed explicitly on excessive complexity.  In fact, the only drawdown explicitly blamed on excessive complexity was actually run by a bank.

For every -15% hedge fund, there is a +15% hedge fund and for every Global Alpha, there is a Paulson.  Hedge fund returns are all over the board every month – making cherry-picking a fruitful endeavor for those arguing on either side.

Nonetheless, the article says that hedge fund complexity and “opacity” are being met with a “flight to simplicity” as investors opt out of complex hedge funds and into “simple” hedge funds and (even simpler) commodities.  Again, this is a viable hypothesis.  But faced with an overwhelming lack of empirical evidence on this issue, the paper is forced to arbitrarily divide the hedge fund world into “simple” and “complex” strategies to prove the point (chart, right).

The article goes on to suggest that investors are shunning hedge funds in favour of commodities.

“The recent exodus from the most sophisticated hedge-fund variants represents a flight to simplicity as investors snap up easier-to-understand assets instead. As a result, gold, silver, oil and other commodities are soaring. Even agricultural commodities, once the most boring part of the market, are on a tear. Soybeans and wheat are up more than 75% in the past year.”

Want complexity?  Try forecasting the price of wheat, oil and soybeans a year from now.  Want opacity?  Try asking a value manager how exactly they employ their gut and intuition to beat their benchmark.

The growth of 130/30 and recent outperformance of plain vanilla “long/short” funds is also weak evidence of a flight to simplicity.  130/30 funds are attracting dollars that, in most cases, were previously earmarked for long-only equities.  So the growth of 130/30 can actually be viewed as a flight to complexity, not the reverse.  And the out-performance of long/short funds in January tells us little about changing investor tastes.

In the end, the article seems to suggest the real culprit is the death-spiral of leverage and illiquidity in credit markets, not “complexity” in general.  In fact, a lot of hedge funds stood by and watched as others got burned by credit (see earlier article in the FT, “Hedge funds shrug off credit crunch“)

Complexity exists all around us in many well-managed forms.  Blaming hedge fund drawdowns on complexity is like blaming the complexity of your laptop when it crashes.  Sure, all computer crashes result from some kind of complexity, but not all complexity leads computer crashes.

North of the border, Canadian hedge fund managers must have been choking on their back-bacon and eggs Saturday morning when they read in the Globe and Mail how the “statistical geniuses at the banks and hedge funds got it wrong” during the recent market upheaval.  The article is well written, but like the Wall Street Journal piece, it draws easy-to-make conclusions from limited anecdotal information – particularly when it comes to the “geniuses” at the country’s hedge funds.

The story only contains one (1) reference to hedge funds:

“For winners like Fairfax and U.S. hedge fund manager Bill Ackman, the windfalls are tremendous, but for the losers, the costs are staggering.”

Sounds like the “geniuses” at the hedge fund actually got it right after all.

Apparently, the geniuses at the banks weren’t so lucky.  The article cites several large financial institutions that lost many billions of dollars on “fancy new products” developed by PhDs

“As markets flourished, financial institutions poured vast intellectual and electronic resources into creating fancy new products such as collateralized debt obligations (CDOs). At the same time, in a parallel universe also populated by PhDs and supercomputers, risk managers used statistical models in hopes of simulating what sudden market moves would do to the value of those securities and derivatives.”

[Ed: Never has having a PhD seemed so…unsavory.]

Taken together, these two weekend articles issue an indictment of “PhDs”, “computers”, and “statistics” in favour of “wheat”, “soybeans” and “gold”.  Have we gone a little far in our drive to find a scapegoat for our financial ills?

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