Cockroach strategy for hedge funds

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A Demon of Our Own Design
By Richard Bookstaber
Wiley, $27.95

Financial markets are too complex for their own good. That creates the risk of a financial disaster. This is the central message of Richard Bookstaber’s A Demon of Our Own Design, published to considerable interest in the financial community earlier this year. In the past few weeks, the message has become relevant to far more people.

The global credit market has plummeted. Many believe it had become over-inflated due to the rapid growth of credit derivative contracts in recent years, which were designed to make it easier to spread risk but can be used for pure speculation. Now, the collapse of various hedge funds has raised fears that the credit market conflagration could become a true economic crisis.

Bookstaber is a former academic who went on to head risk management for Morgan Stanley and now runs a large hedge fund. He knows the subject and has written a lucid and readable book. To his aid he calls mathematics (from Bertrand Russell to Godel’s theorem); physics (particularly Heisenberg’s uncertainty principle); and even ­meteorology.

But his central arguments come from operations management and biology. He gives blow-by-blow accounts of the missteps that led to the ValuJet air crash over the Everglades and the nuclear accident at Chernobyl. Both involved complicated processes and both stemmed from safety precautions.

The point: when a system is already dangerously complicated, extra safety procedures only make it more dangerous and complicated. When systems are “tightly coupled”, with numerous indispensable links, the risk that one error can start a chain reaction leading to disaster becomes greater. The same argument applies to convoluted risk-management processes using Byzantine derivative contracts. It applies also to any attempt to regulate the market more closely.

Drawing from biology, Bookstaber says the species most likely to survive in the long-term, avoiding catastrophic changes in their environment, are “coarse” organisms, with a simple survival strategy. Animals that have become more complex, adapting better to their environments, enjoy greater success for a while, but are less likely to withstand a catastrophe.

The cockroach is the perfect example of the former. Its safety system is based on nothing more than the ability to react to puffs of air and yet it could survive a nuclear war. For a more complex species, Bookstaber names the furu, a fish that lived only in Africa’s Lake Victoria and evolved into hundreds of sub-species, adapted for ­different tasks and habitats within the lake. All were annihilated within years after the Nile perch, a bigger, aggressive predator, was introduced to the lake.

Applied to the market, the implication is that a crude strategy (like being guided by a few benchmarks, or sticking to stocks, bonds and cash) is more likely to survive a change in the environment, even if today’s far more complex strategies might work better in the current one. These insights look ominously relevant to the credit crunch now under way.

What would Bookstaber do to save the situation? He rules out extra regulation, which might, Chernobyl-style, heighten the risk of an accident. Transparency will also not work. The nature of the markets would change profoundly if everyone knew their counterparties’ holdings. He even cites Heisenberg’s uncertainty principle, which holds that the act of measuring something will change it.

So, unsurprisingly for a hedge fund manager, he is suggesting that hedge funds be left alone. But he does suggest that they should, in effect, sign a self-denying ordinance. They need to use simpler financial instruments, not invent ever more complicated new investments. To relax the “coupling” between different links in the chain, they need to take out less leverage. If a fund has not borrowed heavily, its collapse will not necessarily lead to losses elsewhere. Hence there is less risk of a systemic crash. In other words, hedge funds should behave like cockroaches, to avoid ending up like furus.

This might be too much to ask. After all, there is money to be made from designing new financial instruments and from levering up a strategy that makes money. But the latest upheaval in the credit market might help. Bookstaber’s book may not have done the trick on its own, but a serious loss of money might just persuade the investment industry to stop being too clever for its own good.

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