Tuesday, September 05, 2006

Personalities: Maynard Keynes 0 comments

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Those who have studied Economics would know John Maynard Keynes; his magnum opus, the General Theory of Employment, Interest and Money, set the foundations for modern macroeconomics, otherwise known as Keynesian economics. At the same time, a less-known fact is that he was an accomplished hedge-fund manager.... at least, the scope of his operations, which involved long and short various asset classes spanning currencies, stocks, bonds, commodities qualified him for this term, although the phrase hedge fund would be invented only decades later.

People love underdog stories, such as Albert Einstein who rose from a clerk to pioneer the theory of relativity; however Keynes was never an underdog. Born with a silver spoon, he was consistently brilliant throughout his academic years in Eton, then Cambridge, where he was also invited to join the then fashionable and highly exclusive secret societies within these academic institutions which admitted the greatest intellectuals within them. It was there that Keynes entered into homosexual relationships; it was fashionable among intellectuals then to believe that women were inferior in mind and body and hence love of young men was ethically better and more enriching. Later in his life Keynes turned straight and married a woman.

A brief description of Keynes' mainstream career as an economist. He was adviser to the British finance department during World War 1, where he argued against forcing Germany, the eventual loser, to pay excessive war reparations .... which was ultimately ignored and which eventually led to German disillusionment and the rise of Hitler. His greatest work, the General Theory of Employment, Interest and Money challenged the economic paradigm when published in 1936, introducing the previously unthinkable idea of running government budget deficits to jump-start a depression economy ---- which eventually, when adopted, arguably ended the Great Depression of the 1930s (though some argue World War 2 did it). As a key negotiator post-World War 2, he was instrumental in creating a new currency order (fixed exchange rates, gold standard) and also in setting up of the World Bank and the International Monetary Fund --- legacies which have lasted till today.

As a fund manager Keynes' record branched along two avenues. Firstly, he oversaw an endowment fund for Cambridge which showed a brilliant record over ~20 years --- from 1928 to 1945, despite taking a massive hit during the Depression, the fund produced a very strong average increase of 13% compared with the general market in the United Kingdom declining by an annual average of 0.5%. The approach generally adopted by Keynes with his investments can be described succinctly as

1. A careful selection of a few investments ie. concentration, not diversification;
2. Buy-and-hold (for several years if need be) until either they have fulfilled their promise or it is evident that they were purchases on a mistake;
3. A balanced investment position, i.e. a variety of risks in spite of individual holdings being large, and if possible opposed risks --- an understanding of minimising portfolio risk even before Harry Markowitz's portfolio theory in the 1960s.

These principles may be a result of experience and distilled thought processes from his earlier speculatory experiences in his hedge fund and personal portfolio (described below), because his supervision of the endowment fund started long after his first forays into the markets.

Keynes had created what was essentially a hedge fund in 1919 with his broker in 1919 comprising of fund contributions from various friends, after speculating in stocks and currencies for ~4-5 years (let's see... he started speculating only around the age of 30!); he managed the hedge fund while also speculating separately with his personal portfolio. Given his training and career as an economist, it was natural that he adopted top-down macro positions in his asset allocations in both his hedge fund and his personal portfolio, dabbling in various asset classes --- European and US currencies, commodities, equities. It appeared that his earnings were quite cyclical, being wiped out to the brink three times --- at the start of his hedge fund (in a currency bet that turned sour), during the Great Depression (mainly commodities whose prices dived), and in an abrupt bear market in 1937-38 (in stocks); however he made big money in between. In his hedge fund and personal portfolio he used leverage aggressively to magnify bets; even the greatest economist cannot predict market turns consistently, and Keynes might have been too confident of his intellectual prowess in his liberal use of leverage.

Yet Keynes recognised the impreciseness of the stock market. He compared the stock market to a newspaper-sponsored beauty contest in which the prize was to be awarded to the participant who guessed which of the photographed faces would be judged to be the most beautiful. Essentially, to quote him: "It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which opinion genuinely thinks the prettiest. We have reached the third degree, where we devote our intelligences to anticipating what average opinions expect the average opinion to be. And there are some who practise the fourth, fifth and higher degrees." This leads to the "castle-in-the-air" theory of stock-picking as described in Burton Malkiel's "A Random Walk Down Wall Street", where one estimates what investment themes/situations are most likely to capture the attention of the investing public. This was Keynes' most famous insight on the stock market.

(1) Wikipedia article: John Maynard Keynes
(2) Hedge Hogging (by Barton Biggs)




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