"The whole world admits unhesitatingly; and there can be no doubt about this, that Gutenberg's invention is the incomparably greatest event in the history of the world”
—Mark Twain
During the Middle-Ages, Europe was made-up of a series of squabbling fiefdoms. The biggest single landowner was the Roman Catholic Church, and most of Europe's wealth was concentrated in the hands of the church. Together with the feudal aristocracy, the church monopolized knowledge and influenced all the Political, Economic, Social and Technological events that precipitated in not only Europe, but the whole world.
European society was hierarchically stratified: with the church and the monarchs at the upper-echelons, the aristocrats occupying the second-tier (in terms of influence), the merchant-class occupying the mid-strata and the peasants occupying the lowest-strata. However towards the end of the Middle-Ages, the rigid class boundaries and the church's monopoly on power collapsed because of one thing: Johannes Gutenberg's movable printing press.
It helped to break the church's monopoly over access to knowledge, and, empowered the masses with knowledge that undermined, albeit indirectly, the status quo.
It helped to break the church's monopoly over access to knowledge, and, empowered the masses with knowledge that undermined, albeit indirectly, the status quo.
...Media Communications Technology
From the historical account above, one can see that communications media technology has the potential to improve the welfare of the masses: an upside. But it also has a downside: the potential to harm.
Technology is in itself neutral, it is neither negative nor positive. It is like a surgical knife that is a life-saving tool in the hands of a seasoned surgeon; in the hands of a psychopath, the same life-saving knife becomes a life-threatening tool. By the same token, communications media technology is in itself neutral; neither negative nor positive. Its usage is shaped by prominent social values and 'in-season' societal trends.
Currently, society has an insatiable hunger for information on hedge funds; people are conscious of the enormous fortunes being made by alpha-hedgies (e.g Paulson, Cohen, Griffin, Soros, Simmons e.t.c), and naturally, the general populace (and beta-hedgies) want(s) to know exactly how those fortunes are made. This leads them on a search for 'position-level' details on the activities of alpha-hedgies; which is where communications media technology comes in.
Communications media technologies are integrated into every facet of our daily lives. They are also interconnected amongst themselves. Which means that every facet of our lives is potentially, within the reach of the entire spectrum of communications technologies. To put this into perspective: a confidential email can, within a matter of seconds, find its way onto a(n) blog/online forum; readers of that forum/blog can quote 'interesting bits' of the email and send them off to their buddies via email/instant messenger/text message e.t.c, and, their buddies will in turn send the quotes to their friends and so on. Within a matter of minutes, references to the 'confidential email', would have circumnavigated the globe!
Has this happened within the context of hedge funds? Yes! The obvious example is of Daniel Loeb's emails, although they had nothing to do with position-level data. One recent example of a widespread leak of confidential position-level information, concerns the email exchange between Hohn and Degorce of The Children's Investment Fund. However, this leak didn't have any adverse effects.
Side Note/Food for thought: Have you wondered why Petroleo Brasileiro SA is the most popular stock (according to Goldman Sachs VIP list of 50 common stocks in hedge-fund holdings) among hedgies? (Hint: Soros Fund Management has an $811million stake in PetroBras, as of July 2008).
...Why should the average person be concerned about the exposure of proprietary hedge-fund strategies?
Let us postulate the Fingale's-Law-Scenario, where anything that can go wrong, goes wrong: In this scenario, position-level data seeps from an alpha hedge-fund to other market participants, including beta-funds that have an operational focus that is similar to alpha-fund's investment focus. When the beta-funds receive this information, they replicate the alpha-fund's proprietary trading strategies and build a portfolio that (structurally) resembles the alpha fund's portfolio. This pattern of imitation results in the formation of a super-portfolio, that is administered by fund managers with a diverse range of skill sets; who are also subject to varying investment circumstances.
The consequential super-structure, made-up of large overlapping portfolios, will be fragile and prone to collapsing when a minor perturbation occurs. In business cycles there are upturns and downturns, and when downturns occur, the 'super-portfolio' unravels and takes the hedge funds (both alpha and beta funds) down with it. When this happens, the globalized world economy goes into distress! In this cataclysmic scenario, return-to-risk ratios of securities held by the funds hover around negative infinity: the securities begin to have asymmetrical relationships between risk and return.
The 1998 debacle of Longterm Capital Management is the closest empirical parallel to the aforementioned Lingale's-Law-Scenario. According to Donald MacKenzie's research paper titled Risk, Financial Crises, and Globalization: Longterm Capital Management (LTCM) and the Sociology of Arbitrage, LTCM experienced outstanding success practising convergence arbitrage in the following markets; US government bonds, bond derivatives, mortgage backed securities (CDOs and CLOs), international stock markets and the equity derivatives markets. When the success of LTCM became well-known, other market-players that operated within LTCM's investment space, started imitating LTCM's investment strategies.
This worked in LTCM's favor during the initial stages of imitation; as pay-off periods of arbitrage positions, that would normally take longer periods of time to become profitable, became accelerated. However, this all changed on Monday the 17th of August 1998, when the Russian government defaulted a scheduled interest payment (coupon) on Ruble-denominated debt, and, devalued the Ruble: a black swan event. This triggered a chain of losses in the Ruble-denominated bond market, where LTCM and its 'replicas' held positions, and, market players began dumping Ruble-denominated bonds to mitigate losses.
When yield-curves inverted and unanticipated losses occurred, value-at-risk models (that marked-to-market) told LTCM and its 'replicas' to enhance liquidity and limit exposure. This triggered a selling spree of securities, including shares, non-bond derivatives e.t.c, held by LTCM and its 'replicas': there was a fire-sale. Eventually, markets were full of buyers and not enough sellers, and securities became unsellable.
Capital was eroded, hedge fund investors withdrew their assets, and, a crisis that seemed minor, now threatened the entire global financial system. Everyone was in panic! What initially appeared to be an idiosyncratic risk factor, now become systematic!
And so on, and so on, etc, etc
The example above illustrates why hedge-funds should be concerned about imitation risk, especially in this era of heightened societal interest in hedge fund strategies; where new communication media technology aids rapid dissemination of proprietary strategies (if they happen to leak out).
