Monday 16 June 2014

The morals and ethics of finance - why (most) hedge funds aren't that evil

I used to work for an investment bank. Frankly I did things that I didn't think were 'right' although they were legal. Some of my colleagues were doing stuff that as it turns out was perhaps just a little illegal. So I left. After a brief hiatus in the real world I joined a hedge fund. You may be surprised to know that I considered this a step up in terms of re orientating my moral compass in the right direction. Bluntly I felt like I could look at myself in the mirror again.

Partly this was due to moving from a rather brutal trading floor to a more abstract ivory tower environment in which it was easy to forget that there was anything as vulgar as actual money involved. But there is far more to it than that.

I am certainly not a theologian (I would have even struggled to spell it without the aid of technology), ethicist or moralist. However my judgement is that the average hedge fund is much less likely to be involved in behaviour which I personally would find morally repugnant, compared to the average investment bank.

Let us put aside for the moment any issues of the absolute morality of the various actors on the financial stage. You may be sufficiently purist in your beliefs that you think the entire concept of the capitalist system is a big pile of dung, and the bankers and hedge funds are just the cockroaches on the top. I respect your belief, although I would respect it more if you could come up with a workable alternative. I'm a big fan of misquoting Churchill on this subject.

Democracy Capitalism is the worst form of government economic system , except for all those other forms that have been tried from time to time”
Personally I'm going to stick to a more realistic goal of trying to make capitalism a bit more warm and fuzzy. For example I think the fees banks get for doing IPO's are excessive; but I think IPO's are necessary otherwise it cuts out a range of capital raising options for businesses that may well be of use to society.

This is all besides the point as what I am interested in here is relative morals.  Perhaps we all belong in a particular circle of hell, but my argument is the average investment banker would be in a more nefarious circle than the average hedgie.

Seven Deadly sins

Its probably worth reviewing what are the main shortcomings of the average banker using an old, but still useful, classification system.

- they get paid too much (greed)
- they want to get as much or more than the next guy (envy)
- they are arrogant showoffs (pride)

(Lust, gluttony and wrath also come into the mix for many bankers, but most work pretty long hours so I don't think we can pin sloth on them as well.)

Now its probably fair to say that these are labels which you might also associate with hedge fund managers. However in my experience at least hedge fund managers tend to be much lower profile than bankers. Partly this is out of choice, but as people running high profile public companies top bankers have to have a certain amount of exposure - although many certainly go out of their way to court more. I am pretty sure that most people in the UK now know what Bob Diamond and Sir Fred Goodwin look like. At the other extreme there are probably some members of John Paulson's own extended family who wouldn't recognise him in the street, though he is arguably responsible for the biggest single gain in hedge fund history.

However I accept that you really only have my word to take for it, and this claim somehow lacks sufficient weight to be the complete defence of the hedge industry.

Actually the fundamental reason why an investment banker is more likely to do bad things than the average hedge fund manager is that they have more opportunity to do so- its just much easier for a banker to be bad.

The menu of financial immorality

Let us consider the options for someone in the financial sector wishing to do 'bad' things. Some of these are illegal as well as immoral.

Insider information

Its true that hedge fund employees have been charged with dealing on insider tips. Its also true that pretty much all that information was supplied by people working for investment banks, without whom the crime couldn't have happened, and whom were undoubtedly getting a fair cut of the proceeds. There is no natural way for someone outside a bank to get access to confidential information. However people in banks advise companies and governments on transactions as a matter of their normal business. So they have to set up processes and barriers to deal with this very potential risk. It is much easier for an investment banker to trade on inside information, because they see so much more of it.

On the legal, but perhaps not ethical, side banks also see 'order flow'. They sit as conduits for transactions from other parts of the financial system where they effectively make markets or introduce corporate funds/loans into the system and then hedge exposure; to put it another way in many places banks are the 'market makers'. Its mostly legal to take advantage of seeing that flow. Even the very largest hedge funds don't have that kind of information, at least not first hand.

Market manipulation (real price)

Market manipulation is basically trading in such a way to move prices to your benefit. Some flavours of this are legal, some aren't; and it depends on the market.  So for example you might 'spoof' by submitting a large sell order, force the market down, and then buy in at the lower price. A more complex example would be if you had a binary option (an option that only pays off a fixed amount if a price is above or below a particular point, otherwise is completely worthless) then it would be worth making loss making trades in the underlying to give the option value.

To manipulate markets you either need a very small market  or lots of money.

You might assume that hedge funds have huge amounts of money. They don't, at least not in a relative sense. A lot of hedge funds are tiny. The largest hedge fund is around $80 billion. Where do you think an $80 billion dollar fund registers in the ranking of the worlds largest fund managers (i.e. 'long only' as well as hedge funds)? In the top 10? Top 20? Top 50? In fact an $80 billion dollar fund would barely scrape into the top 150 of the worlds largest funds. That 'huge' $80 billion fund is 98% smaller than the worlds largest asset manager. Many large asset managers are owned by banks. Even this excludes the amount of assets banks hold directly, which is probably an even bigger pool of money again.

Although hedge funds have more leverage and often trade more, magnifying their impact, in most markets (though not all) they are not big enough to manipulate the market by themselves. The 'market maker' advantage that banks have in many markets, as well as seeing order flows, makes it even easier to 'adjust' prices if desired. 

It is true that hedge funds are more likely to be involved in short selling. Some people think short selling is intrinsically bad, and is always market manipulation. I disagree, but you can read the well rehearsed arguments for and against elsewhere.

Market manipulation (not really a price)

Too hard to rig the market through spoofing transactions? Why not make it easier for yourself by creating a 'fix'. This is a 'price' set by a survey or some other method which doesn't have to rely on real transactions. The best known example of this was the LIBOR fix. LIBOR was set by asking a bunch of people (the 'panel') what they thought the price of money should be without actually meaning they had to borrow or lend at that rate. Pop quiz: What proportion of the LIBOR panel are banks? What proportion are hedge funds? If you answered 100% and 0% respectively, go to the top of the class. LIBOR is / was a club which hedge managers were not invited to join. I am not aware that any hedge fund benefitted from the manipulation, but even if they did as with insider trading they could not have done so without help from an insider, at a bank.

Dealing with uninformed counterparties

Although it says caveat emptor on the label in most markets we rely on regulation to prevent people buying stuff without understanding what they are getting themselves into. In financial regulation there is an awful lot of regulation around selling to 'normal' people, but its possible to completely avoid this if you are dealing with someone who falls outside that definition. Many of these are not sophisticated investors and still need protecting in my opinion. This could be a small business, a wealthy but by no means super rich investor, or even a large pension fund. There are countless historic examples of banks taking advantage of institutions and businesses and also more recent ones (eg swaps gate and LOBOgate). The main problem is the lack of a transparent market for these kinds of transactions; this means a lack of truly competitive comparable quotes and an open invitation to get taken advantage of. There is also the problem that the counterparties often have to do the deal with somebody (eg local authority treasurers under pressure to reduce funding costs).

Hedge funds overwhelmingly deal in liquid open markets with publicly posted prices. Some markets are less transparent (eg credit derivatives) but here they trade almost entirely with banks, or occasionally with other funds.

Hedge funds do have customers -investors - and perhaps some of them don't know what they are doing. The Madoff scandal hangs over the industry like a cloud, and we can't ignore it. But there is usually a large choice of hedge funds for those who can invest in them. Pricing isn't completely transparent, but fairly so. Finally nobody is forced to invest in hedge funds.

Charging excessive fees

Uninformed counterparties often get charged excessive fees. But this deserves a separate heading as even informed counterparties can pay too much in a monopoly situation. Again the 2 and 20 fees of hedge funds are much derided given the performance on offer and in many cases the derision is deserved as 'skill' is in shorter supply than the fees would suggest. I would argue that charging 1.5% for a simple skill-less long only tracker fund is far, far worse. This is what I am being charged in a child trust fund, merely because the product category is an 'orphan' (okay, bad choice of analogy). Its also the case that banks are far more likely to be involved in products in which the fees being made are even larger and hidden from the buyer; structured products and loans with embedded derivatives for example.

Aiding and abetting 'bad stuff'

The range of businesses that banks are involved with gives them a much wider intrinsic opportunity to do things that are unethical. So hedge funds generally don't lend money to businesses. So they can't lend money to arms or tobacco firms. They can buy shares in them of course, but so can banks, and as we've discussed banks have far more financial firepower. Hedge funds don't lend people money to buy houses (though they can invest in securities linked to mortgages). They don't lend people more than they can afford and then re posses their houses when they can't pat it back. Hedge funds can't lend people money, then make them buy useless insurance to 'protect their payments'.

Be assured I do have some qualms about the hedge fund business even the relatively abstract kind that I was involved in. For example is it right to trade palm oil futures? Or in the midst of a food crisis to trade any foodstuff? Or given the environmental problems, crude oil? These are not easy questions to answer, and there are huge grey areas, but at least in a relative sense these are relatively benign moral dilemmas compared with the LIBOR scandal, swaps gate and LOBOgate.


To summarise I do not personally think that the average hedge fund manager is any more morally flawed than anyone else whose main concern is profit, including such warm and cuddly people like Sir Richard Branson (also the less cuddly but still admired Lord [Alan] Sugar). Investment bankers on the other hand have many more opportunities to be bad people, and unfortunately quite a few of them exploit those.

Ironically investment bankers are probably in a position to do more good than the average fund manager. This more complete menu of moral choices is available because banks are an integral part of the economic system, whereas hedge funds are 'just' investment vehicles.

Really though this is a numbers game. If investment banks are the cockroaches on the dung pile of capitalism then hedge funds are a tiny speck of rubbish on the back of one cockroach. Encouraging bankers to behave in a more moral and ethical way will have far more effect on the general level of morality than similarly re-educating hedge fund managers. It is not worth wasting moral outrage on the hedge fund industry. Go and pick on some bankers instead.

1 comment:

  1. Good read. "Investment bankers on the other hand have many more opportunities to be bad people, and unfortunately quite a few of them exploit those." In my experience, it was hard to find those not willing to exploit. BB bank.


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