Drobny, The Invisible Hands

Often a financial writer’s second book is merely a warmed-up version of the first. This is decidedly not the case with Steven Drobny’s The Invisible Hands: Hedge Funds Off the Record—Rethinking Real Money (Wiley, 2010). This is a terrific book, even better to my mind than Inside the House of Money, about which I wrote favorably, if belatedly, last summer.

The Invisible Hands is a series of interviews with two identified contributors from Drobny’s first book and ten anonymous global macro hedge fund managers whose funds collectively have over $100 billion under management and who performed well in 2008. The book’s stated goal is “to provide an understanding of how successful global macro hedge fund managers navigated the most significant financial crisis of our lifetimes and to offer suggestions for how real money managers and all investors can incorporate certain elements of the macro approach into their own investment process.” (pp. xviii-xix) With the endowment model failing during the crisis (Yale’s endowment assets, for instance, fell from almost $23 billion to $16.3 billion for fiscal year 2008-2009, a decline of nearly 30%) and global macro hedge funds returning 4.83% in 2008 and 4.03% in 2009, there’s something to be said for taking a closer look at global macro strategies.

Many of these strategies are difficult if not impossible for the individual investor to implement. But the thinking behind them and the way their risk is managed are often so compelling that everyone who is active in the markets can learn a tremendous amount from these interviews. Moreover, even though most of the contributors are anonymous their life stories are fascinating, sometimes even inspiring.

Here are just a few snippets. They are not representative of the book as a whole because it doesn’t lend itself to such piecemeal extraction.

Should a real money manager (such as a pension fund manager) who is long only and whose portfolio is primarily equities worry about long-term inflation? No. Equity indices are denominated in nominal terms, so in the long term equities and inflation are highly correlated. If a hedge fund manager wants to protect himself against the possibility of hyperinflation he can buy 10-year, 10,000 strike S&P calls for 14 basis points. (Leitner, “The Family Office Manager,” pp. 71-73)

Another contributor, “The Philosopher,” finds opportunities in our flawed attempts to understand an uncertain economic future. “The human brain,” he notes, “is not wired to understand probability very well. We are particularly bad at understanding low probability events, which we tend to think of as either inevitable or impossible. Therefore, a very small change in the underlying fundamental probability can sometimes cause wild swings in sentiment because the potential outcome went from impossible to inevitable, whereas the underlying fundamentals did not move substantially. Shifts in sentiment cause markets to move much more frequently and violently than shifts in fundamentals do.” (pp. 118-19)

“The Predator” always wants to know what kinds of people are on the other side of his trades. “You need buyers to short against at the top of the market and sellers to buy from at the bottom. You have to identify the type of person who shorts at the bottom or the one who leverages on the way up and use the liquidity they provide to do your trades. You need to understand where other people get it wrong in order to see if their errors create an opportunity for you.” (p. 335)

And, finally, “The Plasticine Macro Trader” opines that “even a true contrarian is only really contrarian about 20 percent of the time; it’s all about choosing the right moment to fight convention. The rest of the time is spent trend following.” (p. 364)