More Money Than God: Hedge Funds and the Making of a New Elite

by Sebastian Mallaby

“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.”

Capitalism works only when institutions are forced to absorb the consequences of the risks that they take on. When banks can pocket the upside while spreading the cost of their failures, failure is almost certain.

Jones believed that investor emotions created trends in stock prices. A rise in the stock market generates investor optimism, which in turn generates a further rise in the market, which generates further optimism, and so on; and this feedback loop drives stock prices up, creating a trend that can be followed profitably. The trick is to bail out at the moment when the psychology turns around—when the feedback loop has driven prices to an unsustainable level, and greed turns to fear, and there is a reversal of the pendulum.

The art of investment is not merely to maximize return but to maximize risk-adjusted return, and the amount of risk that an investor takes depends not just on the stocks he owns but on the correlations among them.

Starting in the early 1950s, he invited brokers to run “model portfolios” for his fund: Each man would select his favorite shorts and longs, and phone in changes as though he were running real money. Jones used these paper portfolios as a source of stock-picking ideas.

Even in the 1960s, when Jones’s enterprise had grown big enough to have half a dozen stock pickers on its payroll, he continued to cultivate a Darwinian system. He convened remarkably few investment meetings because he found committees intolerably tedious.48 Instead, he allotted each in-house manager a segment of the partners’ capital, laid down the desired market exposure, and left him to invest the money. At the end of each year, the managers who performed best were also the best rewarded.

The linking of compensation to results was the key to Jones’s formula. When a broker passed a stock tip to a normal mutual fund, there was no certain connection between the quality of the tip and what the broker would be paid for it. For one thing, the mutual funds lacked Jones’s system for tracking how stock recommendations turned out.

In the three years starting in the summer of 1966, Jones’s investors pocketed returns, after subtracting fees, of 26 percent, 22 percent, and 47 percent.64 But this Indian summer concealed trouble. The Jones funds were losing their distinctive edge: Their stock pickers were defecting to set up rival firms, and Jones’s hedging principles no longer seemed so relevant.

Between the close of 1968 and September 30, 1970, the 28 largest hedge funds lost two thirds of their capital.1 Their claim to be hedged turned out to be a bald-faced lie; they had racked up hot performance numbers by borrowing hard and riding the bull market.

By the fall of 1978, when Steinhardt took his leave from Wall Street for a sabbatical year, his group’s eleven-year record was one of the most remarkable of all time. A dollar invested in 1967 would have been worth $12 by 1978, whereas a dollar invested in the broad market would have been worth only $1.70. After subtracting fees, the partnership compounded at an average annual rate of 24.3 percent in this period,

IN SHORT, THE SUCCESS OF STEINHARDT, FINE, BERKOWITZ is difficult to explain, including for the former partners. But it does not follow that their success was merely lucky. When you sift through the story of the partnership, two factors stand out. Each helps to account for success in a way that is consistent with the commonsense rendition of efficient-market teaching: The market is difficult to beat—except when you come up with an approach that others haven’t yet exploited.

In famous congressional testimony in 1967, the great economist Paul Samuelson delivered his verdict on the money-management industry. Citing a recent dissertation by a PhD candidate at Yale, he suggested that randomly chosen stock portfolios tended to beat professionally managed mutual funds. When the House banking committee chairman sounded incredulous, the professor stood his ground. “When I say ‘random,’ I want you to think of dice or think of random numbers or a dart,” he emphasized.

Weymar was initially skeptical of Vannerson’s project.27 His trend-following concept seemed disarmingly simple: Buy things that have just gone up on the theory that they will continue to go up; short things that have just gone down on the theory that they will continue to go down. Even though Vannerson’s program took a step beyond that—it tried to distinguish upticks that might signify a lasting trend from upticks that signified nothing—Weymar still doubted that anyone could make serious money from something apparently so trivial.

Like the storied hedge-fund traders who emulated this method later, Marcus reckoned that he caught the wave on less than half of his attempts. But his winning rides earned profits of twenty or thirty times the small losses he took when he got stopped out of his position.

Even in finance, a field in which research findings can be translated directly into business plans, trial and error turns out to be key. A. W. Jones started out expecting that chart following would allow him to call the broad market; this turned out to be a blind alley, but he succeeded by improvising a new system of incentives for stock pickers. Steinhardt, Fine, and Berkowitz started out as equity analysts. But their success owed much to block trading plus an eccentric focus on monetary policy.

The big jump in insurance seeking explains part of the success of Commodities Corporation. But the most important factor by far was the firm’s conversion to trend following. By developing his Technical Computer System and demonstrating how wrong the random walkers were, Frank Vannerson gave Commodities Corporation the confidence to hire trend followers such as Michael Marcus and to turn to his combination of fundamental analysis and charts into a sort of company credo.

Popper’s central contention was that human beings cannot know the truth; the best they can do is to grope at it through trial and error. This notion had an obvious appeal to someone of Soros’s background.

He was willing to take the plunge without waiting for conclusive evidence that he was right. If he found an investment idea attractive on cursory examination, he figured that others would be seduced too; and since he believed that perfect cognition was impossible, there was no point in sweating the details.

Soros saw no point in knowing everything about a few stocks in the hope of anticipating small moves; the game was to know a little about a lot of things, so that you could spot the places where the big wave might be coming.

His appetite for risk was startling: “As a general rule, I try not to exceed 100 percent of the Fund’s equity capital in any one market,” he remarked breezily in his diary, “but I tend to adjust my definition of what constitutes a market to suit my current thinking.”21 The idea that a hedge fund should actually be hedged had been casually discarded.

Soros’s investment decisions were often balanced on a knife edge. The truth is that markets are at least somewhat efficient, so most information is already in the price; the art of speculation is to develop one insight that others have overlooked and then trade big on that small advantage.

Some Tiger alumni suggest that he achieved this by focusing on small companies. According to this theory, the market price of a big corporation such as United Airlines is likely to be efficient because Wall Street analysts pore over its books; lesser firms escape scrutiny. It’s true that Tiger did seek out small companies that lazier investors missed; but it made money on big ones too—including, spectacularly, on that very same United Airlines.

short selling came naturally to him. In a typical letter to his investors in July 1983, he complained of bullishness gone wild. “The media, public and analysts, virtually everybody, are so bullish that they could be described as ‘eating grass,’ ” Robertson declared. “When this happens it may be best to crawl in a log and slurp some honey.”

If Robertson’s achievement had stood by itself, it might have been possible to dismiss him as a lucky coin flipper. But the success of Tiger’s numerous offshoots puts paid to that thesis. Whatever the source of Robertson’s investment edge, it was profitable—and transferable.

To those who watched Robertson up close in his heyday, there was no doubt about his talent. He could drop in on a meeting with a chief executive and demonstrate a grasp of company detail that rivaled that of the analyst who tracked it.27 He could listen to a presentation on a firm he knew nothing about and immediately pounce on the detail that would make or break it. He could play golf with the chief executive, see the man nudge his ball into a better position when it landed in the rough, and write himself a mental note never to buy stock in the man’s company.

The macro traders who worked for Robertson in the 1990s struggled to adapt to his style of investing. They quickly found that the boss could not abide charts, which he had been known to describe as “hocus-pocus, mumbo-jumbo bullshit.” They also found that their risk-control instincts rankled with him.

From the start of 1988 to the end of 1992, Tiger beat the S&P 500 index for five straight years; and the next year Robertson surpassed himself. He returned 64 percent to his investors after subtracting fees, and BusinessWeek estimated that his personal earnings for the year had come to $1 billion.

But after the 1987 crash, something profound changed. By one count in 1990, six hundred hedge funds had sprouted from the desert, and by 1992 there were over a thousand.1 Financial commentators began to refer knowingly to the “Big Three”—Soros, Robertson, and Steinhardt—and 1993 was celebrated as “the year of the hedge fund.”

A dollar invested with Steinhardt in 1967 would have been worth $480 on the day he closed the firm, twenty-six times more than the $18 it would have been worth if it had been invested in the S&P 500 index. The debacle of 1994 had cost Steinhardt’s funds an astonishing $1.5 billion, but he had earned more than twice that much between 1991 and 1993, and his returns over the rest of his career had been excellent.

And so, in the aftermath of the bond-market crisis of 1994, there were two verdicts on hedge funds. Regulators were forced to confront worrisome questions about the industry; but lacking a good theory of how to tame it, they ultimately chose to look the other way. Meanwhile, institutional investors reached a critical verdict: Notwithstanding the turmoil of 1994, hedge funds promised risk-adjusted returns that were simply irresistible.

But it is hard to escape the suspicion that Soros’s dual persona contributed to the missed opportunity as well. The boss wanted to be a statesman, not a wrecker of nations. If he was going to get involved in South Korea, it would be not as a scourge but as a savior.38

The real lesson of LTCM’s failure was not that its approach to risk was too simple. It was that all attempts to be precise about risk are unavoidably brittle.

At the end of the month, Meriwether put a call in to Vinny Mattone, an old friend from Bear Stearns. “Where are you?” Mattone asked brusquely. “We’re down by half,” Meriwether replied. “You’re finished,” Mattone said matter-of-factly. “What are you talking about?” Meriwether protested. “We still have two billion. We have half—we have Soros.” “When you’re down by half, people figure you can go down all the way,” Mattone said. “They’re going to push the market against you.”40

LTCM’s failure had shown the craziness of insuring the whole world against volatility without holding capital in reserve; but over the next decade, the giant insurer AIG repeated the same error. LTCM’s failure had exposed the fallacy that diversification could reduce risk to virtually zero; but over the next decade investors repeated this miscalculation by buying bundles of supposedly diversified mortgage securities. Most fundamental, LTCM’s failure had provided an object lesson in the dangers of leveraged finance. And yet the world’s response was not only to let leveraged trading continue. It was to tolerate a vast expansion.57

“The market can stay irrational longer than you can stay solvent,” Keynes famously declared. Being early and right is the same as being wrong, as investors have repeatedly discovered.

In 1998, LTCM had gone into its death spiral as its brokers began to call in loans, leading Robertson to write to his investors about the dangers of excessive leverage. In 1999, Tiger was in danger of unraveling too— not because brokers were calling in their loans but because investors were calling in their equity. In both cases, moreover, widespread knowledge of the hedge funds’ holdings contributed to their troubles.

By the time the NASDAQ began to fall, Robertson had made his decision to get out, and he was too beaten up to change it. On March 30, with the NASDAQ already 15 percent off its peak, Robertson broke the news to his investors. After months of assuring them that there would be light at the end of the tunnel, he confessed that he was sick of waiting for it.

Having earlier worried that the bubble might blow up in his face, he now worried about losing face: He had doubted the new economy and misjudged the euro, and now these kids and their radioactive stocks were making a fool of him. Not for the first time, Druckenmiller turned on a dime. He bought all his tech stocks back and gave Levit and Hakala room to run. For a while the good times rolled again.

Druckenmiller had been saying for some time now that he wished Quantum were not so large, that he needed some kind of exit, that he could not go on forever. In the end, Soros reflected, Druckenmiller had only been able to free himself by blowing up the fund. It was an expensive method of escape, but it was certainly effective.

The more endowments displaced rich individuals as the chief investors in hedge funds, the more it mattered that hedge-fund strategies could be understood. A rich investor can bet his personal fortune on a mysterious genius if he so chooses. Endowment committees must protect their backs with PowerPoint presentations.

A magazine writer who visited Shaw’s outfit in 1994 was struck by what he saw: By now the firm employed 135 people and accounted for as much as 5 percent of the daily turnover on the New York Stock Exchange. The dress code was casual and the firm had a faintly Bohemian feel. Staffers rolled out sleeping bags to stay over at night. “It is easier to focus if you don’t go home,” explained a young employee named Jeffrey Bezos, who went on to found the Internet retailing giant Amazon.11

At Tudor, for example, Sushil Wadhwani trained a machine to approach markets in a manner that made sense for human traders. By contrast, Brown and Mercer trained themselves to approach problems in a manner that made sense for a computer.

Indeed, it is the nonintuitive signals that often prove the most lucrative for Renaissance. “The signals that we have been trading without interruption for fifteen years make no sense,” Mercer explains. “Otherwise someone else would have found them.”

By the end of 2008, most funds had lost money; almost 1,500 had gone bust; many a titan found his reputation justly deflated. And yet, even in the worst period of their history, hedge funds proved their worth. The industry as a whole was down 19 percent in 2008, but the S&P 500 fell twice that much. And unlike the banks, investment banks, home lenders, and others, hedge funds imposed no costs on taxpayers or society.

The larger the hedge fund, the more peremptory and arrogant the managers tended to be—and frequently it was the bigger funds that had the worst performance. The big alpha factories were stuck in losing positions when liquidity dried up:

Rock Creek Capital, a savvy fund-of-funds, calculated that hedge funds with assets under $1 billion were down a relatively modest 12 percent in 2008. Meanwhile the funds that Rock Creek tracked with $1 billion to $10 billion in assets were down 16 percent, and those with more than $10 billion were down 27 percent.

In November 2008, after two months of market pandemonium, five hedge-fund barons were called to testify in Congress, in what promised to be a show trial: The billionaires would be scolded for upending the economy. But some way through the proceedings, an unexpected tone emerged. Peering down from his dais, Representative Elijah Cummings, Democrat of Maryland, recounted his neighbor’s reaction to the day’s hearing. It was not a reproach, an accusation, nor even an expression of pity. It was a simple question, tinged with awe. “How does it feel to be going before five folks that have gotten more money than God?”37

But the unpleasant truth is that government insurance encourages financiers to take larger risks; and larger risks force governments to increase the insurance. It is a vicious cycle.

do—regulators are like air-traffic controllers, who are ignored when things go well and excoriated after a disaster. But at each step of the way, the regulators’ desire for safety will bump up against financial institutions’ appetite for risk. Given the brainpower and political influence of large financial firms, they are bound to win some of the arguments over judgment calls. Regulation will be softer than it should be.

Hedge funds are clearly not the answer to all of the financial system’s problems. They will not collect deposits, underwrite securities, or make loans to small companies. But when it comes to managing money without jeopardizing the financial system, hedge funds have proved their mettle. They are nearly always small enough to fail: