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Hedge Fund Insider: The Psychology of Making Markets

Byline Times’ hedge fund insider argues that hedge funds are not a conspiracy, but they do manipulate market psychology and have unpredictable feedback loops.

Byline Times‘ city insider sheds light on this inscrutable world and warns they can create unpredictable feedback loops.

Hedge funds are some of the most misunderstood institutions in the modern world. Not ‘teenager listening to the smiths in a darkened room’ misunderstood, but straightforwardly misconstrued by most economists, journalists and politicians. 

I’ve been dealing with them now for almost a decade and am beginning to get a handle on what they’re up to – so let me share something of what I’ve learnt, as it relates to the EU Referendum and how hedge funds muddied the waters of our national conversation around it for financial gain.

Firstly, the nuts and bolts. 

A hedge fund neither hedges risk nor invests most of its funds. It is a corporate artifice designed to gamble in financial markets without constraints. 

These days, that mostly involves a bunch of wealthy people wiring some money to an account in the Cayman Islands, which a few rich and privileged men in London, New York, Singapore, Hong Kong and Tokyo (roughly in that order) can then use as high stakes gambling chits in speculative bets in the financial markets. 

The ‘investors’ agree to lock up their money in the fund – and to pay a management fee (usually 1-3%) – in exchange for a proportion of the gains made using them for trading (normally 70-90%). 

The hedge fund managers keep the 1-3% fee, and the 10-30% leftover gains. 

Generally, 40-90% of the cash just sits in the Cayman Island accounts doing nothing – except backing up the bets which the managers make. They will promise a bank, say, that if the price of gold goes up by 1$ per ounce, they’ll pay 1mio USD, and if it goes down – they’ll make 1mio USD.

Some people might call that ‘short selling’ and bore you with the exact mechanics but – essentially – it’s a bet. Up, down, sideways in a particular range, up then down… Hedge funds bet on outcomes in financial markets. Banks are the croupiers.

The Psychology of Gambling

The thing about bets is that they affect people’s perceptions of reality. 

When your loudmouth friend in the pub starts declaiming that if Liverpool score next he’ll down his pint but if Arsenal score next you have to down yours , your refusal to take the bet because you need to cycle home might be interpreted as a lack of conviction in the merits of Liverpool’s attacking football. 

Having a big pool of money available to stake behind enormous gambles gives hedge funds the position of the loudmouth. Other investors need to cycle home. 

That said, no amount of bragging can prevent Arsenal being useless on the offensive. And, in the same way, your loudmouth friend’s delusion about a football team’s prowess might bring him into trouble – most hedge funds eventually go bust because they had some delusion about their ability to forecast financial market behaviour. 

In the meantime though, their views can shape our very perception of what is probable or possible. This is especially true of markets where everyone can understand what the price means.

If I tell you that hedge funds are currently keenly selling payer skew on US interest rates, you might not immediately understand that this means they are betting on a US economic slowdown (it does, they are). 

But, if I tell you that the bookies odds on are 4-1 on Elizabeth Warren becoming the next US President, and a month or two ago they were 14-1, you understand that there are people wagering that she will get the top job. 

Hedge fund managers know you know – and in the run-up to the EU Referendum, they were making large bets on various betting sites that Brexit wouldn’t happen. Meanwhile, in the market for pounds, they were making enormous bets that the pound would fall.

Because those responsible for determining the odds on those bets, the banks, had to take into account the odds on betting sites – because everyone else was doing so – the hedge funds got better odds than they would have otherwise. Can I prove to you this was deliberate? Of course not. Hedge fund managers aren’t stupid – they spoof the markets in this way only on trading venues with zero transparency. Did I hear it firsthand from those who had been involved in it? Yes.

Not a Conspiracy Theory

None of this is to say that hedge funds are engaged in a sinister conspiracy to make Brexit happen – they have no agenda except skewing odds in their favour. 

What this is to say is that the power they accidentally wielded over the EU Referendum by skewing the odds that we were all counting on to tell us what people thought the result would be is a matter of public interest – but we’ll never know the details. 

The managers who run these firms are human beings, or at least prepared to do an impression of one when I take them out for dinner on the expense account. But, it’s hard to see human agency in much of their behaviour. They are decision engines in service of the corporation that employs them – which is, in turn, designed to be as secretive, powerful and unconstrained as possible. 

By allowing these entities to influence our national conversations about politics, we are creating all manner of unpredictable and inscrutable feedback loops. Let’s hope we can manage the consequences.

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