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Leon Metzger in January 2009 speaking at a House Financial Services Committee hearing on the Madoff Ponzi scheme.Source: Bloomberg News
Leon Metzger left a high-powered job as vice chairman and chief administrative officer of Paloma Partners in 2006 to become a part-time faculty member at various business schools where he teaches graduate-level classes about how the hedge fund industry operates.
After 18 years at then-$1.6 billion Paloma in Greenwich, Conn., he left amid a sweeping reorganization designed to boost flagging returns following $600 million of redemptions during the previous six months. Metzger continues to hold a legacy investment in Paloma Partners, which now manages $1.9 billion, but he does not hold any positions in other hedge funds.
Instead of retiring, Metzger, who earned degrees from The Wharton School of the University of Pennsylvania and Harvard Business School, became a teacher, serving as an adjunct professor at Yale and at NYU’s Stern School of Business. He has also lectured at Columbia University’s Fu Foundation School of Engineering and at Cornell University’s financial engineering program in Manhattan.
In addition to his teaching the next generation of investors, Meltzer has lectured the U.S. House Financial Services Committee about financial oversight, urging the hedge fund industry to get serious about risk management. This week, he delivered a speech at an alternative investment conference in New York titled “What will hedge funds not tell you?”
In a telephone interview, the 56 year old spoke to AR about his life as an academic and his views on the hedge fund industry:
AR: You went from holding a top position at a prestigious hedge fund to being an adjunct professor working semester-to-semester in contract positions. Do you feel like you’ve taken a step down?
Leon Metzger: I tell my students I run the classroom like a hedge fund—the only exception is that expletives are not allowed in the classroom. And obviously no harassment is allowed in the classroom, either.
Particularly in times of crises, the students treat you with respect. During the week this summer when stocks were all over the place, I was teaching in Tel Aviv. We threw out all of the course materials and just asked “What would we do?”
We talked specifically about whether gold was overpriced, then at $1,800 per ounce. Even if it were, it could still rise to, say, $2,200 before any eventual decline. Nevertheless, it could be expensive to hold on to a short position even if, ultimately, the asset is overpriced. Someone who is convinced that gold is overpriced might still avoid shorting it.
Another question was whether or not it was a good idea to be short the two-year Treasury, given that at some point interest rates should rise, and if interest rates rise while you are short the note, its value should decline.
AR: What has changed for you over the past five years?
Leon Metzger: I’ve watched student interest in the course (on hedge fund management) go up and down and back up again, consistent with the economy. Post-2008, I saw a decreased interest and I think it’s going back up again.
AR: In the wake of the high-profile role some hedge funds played in the financial crisis, have you seen students come in with different perspectives or more skepticism?
Leon Metzger: All my students are more knowledgeable in particular about operations. When I first started teaching the course in 2006, all they wanted to know was how to make investments. Today, they are much more interested in operations. But for many investors, due diligence still too often stops and starts with past performance record.
AR: You recently gave a speech titled “What will hedge funds not tell you?” What are some things you think investors don’t realize?
Leon Metzger: I question whether volatility, also known as standard deviation, is the appropriate measure for risk in these hedge funds strategies. It’s industry practice, but there are a lot of things that are industry practice that I don’t believe in. Modern portfolio theory says standard deviation is the correct measure, but that should not apply when the payoff is a high probability of a small profit and a low probability of an extreme loss. A fund’s track record may hide its risk.
I teach my students not how to make money, but how not to lose it because of weak controls. Just because someone was a wildly successful trader on Wall Street and decides to launch a hedge fund does not mean he will be successful.
AR: What else would you tell investors?
Leon Metzger: Size is the enemy of performance. Investors who want to maximize their returns should start their search by looking for younger funds and smaller funds. Less capital should be easier to manage than more capital. Emerging managers are more aggressive because they haven’t reached the stage yet where they have to preserve their own capital.
AR: How do you reconcile that with your experience at Paloma, which managed $1.6 billion when you departed?
Leon Metzger: Paloma was known for investing with smaller managers early in their lifecycles—for example, putting its money with managers such as David Shaw, Dan Arbess, and Amaranth. And they took it out of Amaranth when they thought it got too big.
AR: Besides Paloma, what else are you invested in?
Leon Metzger: I’d rather not talk about my own investments. I’m not an investment advisor.
AR: You have testified for Congress that operational risk is “the great unspoken-about danger.” What do you think are the biggest operational risks for hedge funds today?
Leon Metzger: If you had asked me in 2006 I would have said risk management after Amaranth imploded. From 2002 to 2004 it was valuations. That was the big thing. After 2008, it became liquidity. To me, valuations are the biggest risk today. If you have the wrong valuations, your risk management could be wrong.
Are the valuations being done by an independent and sophisticated knowledgeable party or are they being done by a trader whose compensation is being based on the valuation of the books?
Investors should be given enough information so they can assess the risk in their portfolio. What really matters is not the data but the judgment of those in power to make decisions based on the data.
Interview has been condensed and edited.