Ever wonder how hedge fund strategies are implemented? Interested in the thought process of one of the greatest investors (albeit, not a value investor) of all times? Confused by currency unions and exchange rate mechanisms? I have just the story for you!
The week before the Brexit referendum, I found the account of how George Soros “broke the Pound” in 1992 on a website whose stories I find good – Pricenomics. With the Brexit kerfuffle, however, I had plenty to write and think about, so am just getting around to posting this now.
The story about the breaking of the pound is interesting, but what I thought was particularly valuable from an educational standpoint was the clear-eyed way hedge fund strategies were explained in the piece. Put simply, if you can identify cases in which the market-perceived likelihood of an event or condition is substantially different from a more clear-eyed and reasonable assessment of likelihood, you have an opportunity to profit.
Mechanics of Hedge Fund Strategies
The first hedge fund was different from our typical image today – a secretive, exclusive fund that makes big, sometimes ill-advised bets on some financial outcome. The first fund, started in the 1950s by a fellow named Alfred Winslow Jones, was truly a hedged fund in that Jones paired bullish investments with bearish investments on a per industry basis to hedge out macro risk. Here’s the excellent explanation of long-short pairs trading offered by Pricenomics:
Say you’re a hedge fund that thinks AT&T’s cell phone network stinks and you want to bet against it. You could “short” the stock (make money when the stock goes down), but the whole cell phone market is going gangbusters, so AT&T might get new customers even though it stinks. If that happens, AT&T’s stock price could go up, and you’d lose a lot of money. To “hedge” against this risk, you buy some Verizon stock as well, because more precisely, you think that AT&T is crappy relative to Verizon.
Now, if cell phone carrier stocks increase in value, you still make money in the event that Verizon goes up more than AT&T does. Conversely, if cell phone stocks go down, you still make money if AT&T’s stock goes down faster than Verizon’s does. By creating a position like this, you’ve “hedged” a lot of the more general market and industry risks away and made a very specific bet: that AT&T stinks compared to Verizon.
And while a lot of people have heard about “shorting” for some, the mechanics of shorting are mysterious. Later in the article, Pricenomics has an explanation of the process of shorting as well:
…[Y]ou or your broker can go to someone that owns some Apple stock and ask to borrow a single Apple stock from them. You’ll give them back the share later and of course pay them interest for the loan. But for now, you sell that stock for $90 in cash. Two days later, the stock price is $88, so you buy one share with your $90 in cash. That leaves you with $2 in profit! (Well almost two dollars—you have to pay the person who loaned you the stock two days of interest.)
But what if you didn’t sell your Apple stock when it hit $88 and instead decided to hold onto it until the stock plummeted further? Well, you’d be screwed because the stock went up from $90 to around $600; you would lose $510 on a the trade, plus interest!
If you buy a stock, the worst you can do is lose all your money. If you short a stock, your downside is limitless because the stock can always keep going up. You can possibly lose more than all your money, and that’s a very bad thing. So if you take a short position, you want to make sure your downside risk is hedged.
Options make the process of shorting easier for the investor. You can gain exposure to the downside range of exposure for the stock and, conveniently, because you are not accepting upside price risk, you don’t have to worry about what Pricenomics describes as “a very bad thing” – losing more than 100% of your capital in an investment. Behind the scenes, a market maker that sells a put to a client is, in fact, shorting the stock – a process that I explain in our Options Master Class.
“Unlikely” Events
The other part of the Pricenomics account of this story that I find fascinating (and encouraging) is that Soros was able to make money on this investment at all. One of the main tenants of modern finance is that markets are “efficient”, which means that any information material to the valuation of an asset (whether that’s a currency, a stock, or a commodity) is assessed instantaneously by market participants, leading to the immediate convergence of the asset price with its true value.
The Efficient Market Hypothesis, as it is called, is one of the foundations of the Black-Scholes option pricing model, and was described by Nobel Prize winner Robert Shiller as “…one of the most remarkable errors in the history of economic thought.”
The fact that Soros was able to make a billion dollars on behalf of his investors in the bet against the pound illustrates the weakness in the Efficient Market Hypothesis. New information is not priced into markets immediately and market participants are not perfectly rational and these factors lead to mispricings of assets that are exploitable for investors.
The core of value investing is, in fact based on this principal that sometimes the price of a stock spectacularly fails to reflect the value that can and will be created by the company. It is occasions like these that offer opportunities to intelligent investors. In my mind, the disconnect between price and value boils down to the fact that markets often – whether due to behavioral biases or structural factors – do not accurately assess the likelihood of future scenarios accurately.
Soros understood that the likelihood that the British Pound was worth as much as it was trading versus the Deutsche Mark was very low. A few weeks ago, I realized that the prices of options on U.S. indices did not reflect the economic uncertainty tied to a Leave vote. Nearly two years ago, I realized that the likelihood that GE would create much more value for its owners was better than the market assumed by far. Even though the instruments are different – a currency, an index, and a stock – the principal behind them is the same. If you can identify cases in which the market-perceived likelihood of an event or condition is substantially different from a more clear-eyed and reasonable assessment of likelihood, you have an opportunity to profit.