conclusion, and programmed a computer
to trade on it.
Meanwhile, other researchers acknowledged that markets were not perfectly
liquid, as Steinhardt had discovered long
before, and that investors were not perfectly rational, a truism to hedge-fund
traders. The Crash of 1987 underlined these
doubts: When the market’s valuation of
corporate America changed by a fifth in
a single trading day, it was hard to believe
that the valuation deserved much deference. “If the efficient markets hypothesis
was a publicly-traded security, its price
would be enormously volatile,” the Harvard economists Andrei Shleifer and Lawrence Summers wrote mockingly in 1990.
“But the stock in the efficient markets
hypothesis — at least as it has traditionally
been formulated — crashed along with the
rest of the market on October 19, 1987.”
The acknowledgment of the limits to
market efficiency had a profound effect
on hedge funds. Before, the prevailing line
from the academy had been that hedge
funds would fail. After, lines of academics
were queuing up to join them. If markets
were inefficient, there was money to be
made, and the finance professors saw no
reason why they should not be the ones
to profit. Asness was fairly typical of the
new wave. At the University of Chicago’s
Graduate School of Business, his thesis
adviser was Eugene Fama, one of the
fathers of the efficient-market hypothesis. But by 1988, when Asness arrived in
Chicago, Fama was leading the revisionist
charge: Along with a younger colleague,
Kenneth French, Fama discovered nonrandom patterns in markets that could be
lucrative for traders. After contributing to
this literature, Asness headed off to Wall
Street and soon opened his hedge fund.
In similar fashion, the Nobel laureates
Myron Scholes and Robert Merton, whose
formula for pricing options grew out of
the efficient-markets school, signed up
with the hedge fund Long-Term Capital Management. Andrei Shleifer, the
Harvard economist who had compared
the efficient-market theory to a crashing stock, helped to create an investment company called LSV with two fellow
finance professors.
Yet the biggest effect of the new inefficient-market consensus was not that academics flocked to hedge funds. It was
that institutional investors acquired a
license to entrust vast amounts of capital
to them. Again, the years after the 1987
crash were an inflection point. Before,
most money in hedge funds had come
from rich individuals, who presumably
had not heard academia’s message that it
was impossible to beat the market. After,
most money in hedge funds came from
endowments, which had been told by their
learned consultants that the market could
be beaten — and which wanted in on the
action.
If markets were
inefficient, there
was money to
be made, and
the finance
professors saw
no reason why
they should not
be the ones
to profit.
The new wave was led by David
Swensen, the boss of the Yale endowment,
who focused on two things. If there were
systematic patterns in markets of the sort
that Fama, French and Asness had identified, then hedge funds could milk these
in a systematic way: There were strategies
that could be expected to do well, and
they could be identified prospectively.
Further, the profits from these strategies
would be more than just good on their
own terms. They would reduce an endowment’s overall risk through the magic
of diversification. Following Swensen’s
example, endowments poured money into
22 Financial History | Spring/Summer 2011 | www.MoAF.org
hedge funds from the 1990s on, seeking
the uncorrelated returns that endowment
gurus called “alpha.”
The new inefficient-market view also
imbued hedge funds with a social function. This was the last thing they had
sought: They had gotten into the alpha
game with one purpose above all, and
that was to make money. But if alpha
existed because markets were inefficient, it followed that savings were being
allocated in an irrational manner. The
research of Fama and French, for example,
showed that unglamorous “value” stocks
were underpriced relative to overhyped
“growth” stocks. This meant that capital
was being provided too expensively to
solid, workhorse firms and too cheaply
to their flashier rivals: Opportunities for
growth were being squandered.
Similarly, the discounts in block trading
showed that prices could be capricious in
small ways, raising risks to investors, who in
turn raised the premium that they charged
to users of their capital. It was the function
of hedge funds to correct inefficiencies like
these. The more markets could be rendered
efficient, the more capital would flow to its
most productive uses. The less prices got
out of line, the less risk there would presumably be of financial bubbles — and so of
sharp, destabilizing corrections.
But hedge funds also raised an unsettling question. If markets were prone to
wild bubbles and crashes, might not the
wildest players render the turbulence
still crazier? In 1994, the Federal Reserve
announced a ti