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Avoiding the Self Destructive Hedge Fund Manager: the Gambling Addict One of the fund-of-funds managerís jobs is to identify and avoid self-destructive hedge fund managers. One of the worst of this species is the gambling addict.The first fund manager I realized was a gambling addict was Ian S., and I didnít realize that he was addicted until after he was dead. Ian was a talented trader with real insight into the market. Unfortunately, he wasted much of his potential by overtrading, trading too often and trading too large.
Ianís wife told me that while he was dying, she kept saying to him, ďGold is rallying, Ian! Gold is rallying!Ē She knew her husband. Ian wasnít particularly greedy as fund managers go. He wouldnít have gotten off of his deathbed just to make money. But I could almost see him getting up for the action.
Some gambling authorities estimate that 1Ė2% of the general population is addicted. Considering the cost of gambling addiction in terms of ruined marriages and lost property, that estimate seems high to me. But perhaps I donít get out enough.
On the other hand, if that estimate is correct, or, at least, reasonable, then the percentage of hedge fund managers who are addicted to the action might be, say, 10Ė20%. And if these estimates are even vaguely correct, the fund-of-funds manager who can identify the gambling addict could have a real and important advantage over those who cannot. Or perhaps not. Gambling addiction is almost certainly a medical problem as opposed to, say, a lack of understanding of probability theory. (An article in the American Journal of Psychiatry, some months ago showed preliminary evidence that the drug nalmefene can help control pathological gambling. Nalmefene is an impulse control drug used to treat alcoholism.)
Unfortunately, lacking a cerebral dipstick or, at least, a safe and polite way of getting a hedge fund managerís bodily fluids, there is no obvious way to use this insight. Worse, the difference between an addicted and a nonaddicted hedge fund manager is almost certainly only a matter of degree. Worse yet, it is not at all clear that a need for action, a need to take big risks, is a bad thing. After all, almost everyone in this industry is a risk-taker.
Consider, as a noninvestment example, Catholic priests. As I understand the issues (I am not Catholic), there is nothing to prevent a strongly sexed heterosexual man from becoming a priest. He is expected, however, to behave himself, to remain celibate. A similar argument can be made for gambling-addicted hedge fund managers. The only difference being that faith is a liability in our line of work. This means that the fund-of-funds manager must determine the extent to which the hedge fund manager needs action, how aware the manager is of his needs and to what extent he can control himself.
In vino veritas In my experience, people who seek risk rarely seek only one kind of risk. A gambling addict might take sports, marriage and health risks, for instance. Some of this information is available on the Internet, some of it is available only by employing a private detective, but some of it is available for the asking.
Asking a hedge fund manager how he got into this line of work, what he did before and what he does with his time off is often enough. On the other hand, the only time some hedge fund managers tell the truth is at two in the morning after the sixth or seventh drink. If a fund-of-funds managerís interviews and research indicate that the hedge fund manager has a need for action, he needs to look at the managerís trading approach and see where this need can compromise that approach. For obvious reasons, nonsystematic approaches are the most vulnerable.
But for many reasons, a mechanical trading system wonít stop a gambling addict from losing your money.Usually, this just means that overtrading is built into the system. Managers who have a need for action, for example, typically do not have the patience necessary to do research right. Or they may have money management systems that are far too aggressive for their trading methods.
If the fund-of-funds managerís research indicates the hedge fund manager needs action but he sees no weaknesses in the managerís technique, it may be that there are no weaknesses in the managerís technique. Much more likely, the fund-of-funds manager screwed up.
If a hedge fund manager has a destructive need for action, there are only two things he can do. He can try to manage his psychological needs, and he can set up systems to manage his work in a rational manner.
Unfortunately, unless the fund-of-funds manager is willing to place a relatively large amount of money, he will rarely be able to enforce rules or delve deeply into the hedge fund managerís psychology. This is a serious problem because it is part of the fund-of-funds managerís job to ensure that the hedge fund manager controls himself.
If the fund-of-funds manager thinks this is necessary and does not think he can do it, he must place his money with someone else. Gambling addiction leads to overtrading and overtrading turns a game that is, at best, difficult to win into a game that is almost impossible to win.
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