More Money Than God_Hedge Funds and the Making of a New Elite

by Sebastian Mallaby

  AT THE START OF 1964, ALFRED JONES INVITED A YOUNG analyst to lunch at his Manhattan club. Now in his sixties, he had achieved the material comfort he had sought fifteen years earlier; his family had graduated from its Dodge station wagon to a Citroën DS and finally to a monstrous Mercedes. Jones peered at the young analyst and asked, “When you go to pee in a restaurant urinal, do you wash your hands before or after you pee?”

  The analyst was a bit surprised. “Afterwards, sir,” he ventured.

  “That’s the wrong answer,” Jones retorted. “You’re a conventional thinker and not rational.”52

  Jones was trying to be funny. He was recycling a version of a joke that was doing the rounds, but he had mangled it hopelessly. The analyst, a future Wall Street grandee named Barton Biggs, took instantly against Jones, and although he accepted the opportunity to run a model portfolio for his fund, he never grew to like him. Jones seemed aloof, conceited, and ignorant about stocks. He was reaping the fruits of young analysts’ hard work while himself appearing in the office sporadically.

  Perhaps not surprisingly, the man who had spent his early adulthood among clandestine anti-Hitler activists never had much passion for investing. He disdained the monomaniacal market types with no interests beyond finance: “Too many men don’t want to do something after they make money. They just go on and make a lot more money,” he complained to one interviewer.53 Jones cultivated literary infatuations: He was enthralled by the theory that Edward de Vere, the seventeenth Earl of Oxford, was the true author of Shakespeare’s plays, and he named his poodle Edward. He carved a tunnel through the weeping willows at his country house and nursed his lawn tennis court as though it were a sickly infant. He founded a philanthropy devoted to what he called “the humiliated poor” and set to work on a book that he intended as a sequel to Michael Harrington’s famous poverty study, The Other America. Dorothy Parker was now too drunk to be invited over much, but Alfred and Mary entertained a cosmopolitan cast of intellectuals and United Nations diplomats, and dinner conversation was less likely to be about finance than about Russian hegemony in Yugoslavia.54 It was not surprising that committed Wall Streeters resented him.

  Soon after Jones’s lunch with Biggs, the resentments burst out into the open. One of Jones’s in-house money managers left to set up a rival hedged fund called City Associates.55 From the point of view of the defector, the choice was rational: The hedged concept was easy to copy, and there was no need to share the loot with a dilettante overseer. Jones had his lawyers harass his departing partner but the old man took the blow in stride; and at the end of 1964 he spent his Christmas vacation on a Himalayan tiger shoot hosted by Indian friends from the United Nations. There were elephant-back outings, a big bonfire and fine food, and incongruous sessions in which the Hindu hosts sang Christmas carols. But while Jones was away, more trouble was brewing. Barton Biggs, the audience for Jones’s urinal joke, persuaded Jones’s longest-serving fund manager to quit and start up a rival fund. On his way out the door, the defector took some of Jones’s clients with him.56

  Sooner or later, every great investor’s edge is destined to unravel. His techniques are understood and copied by rivals; he can no longer claim to be more efficient than the market. Jones’s extraordinary profits had fostered jealousies among the partners about how the money should be shared, and after the first two defections, others inevitably followed. At the start of 1968, there were said to be forty imitator firms; by 1969 estimates ranged from two hundred to five hundred; and many of the leading lights were run by people who had worked for Jones or served him as brokers.57The Economist claimed that this new investment industry had about $11 billion under management, or five times the figure of two years earlier.58 The expression “hedge fund,” a corrupted version of Jones’s “hedged fund,” entered the Wall Street lexicon.59 Every sideburned gunslinger was determined to work for one.

  The early effect of this unraveling was paradoxical. As the first imitator funds sprang up, word got about the Street, and Jones came to be seen as the founder of a hot new movement. A flattering profile appeared in Fortune in 1966: “There are reasons to believe that the best professional manager of investors’ money these days is a quiet-spoken, seldom-photographed man named Alfred Winslow Jones,” the article began, though somehow Fortune had obtained a large photo of Jones, showing him with a thick thatch of white hair and large dark-framed glasses.60 Investors fell over one another to get money into the Jones funds, ambitious young analysts came looking for jobs, and for a while the party continued.61 Jones himself was said to be earning “something in the millions,” and the Jones defectors were raking in the money too: One City Associates partner acquired a penthouse, a helicopter, a wine cellar, and bodyguards; his office was staffed by curvaceous women who allegedly were secretaries.62 It all added to the gossip and the envy and fun. Hedge funds embodied the spirit of the age; and as New York magazine proclaimed in 1968, A. W. Jones was their big daddy.

  The boom attracted the attention of regulators—much as other hedge-fund booms did later. In 1968, the New York Stock Exchange and the American Stock Exchange began to consider restrictions on their members’ dealings with hedge funds. In January 1969, the Securities and Exchange Commission sent out a questionnaire to two hundred hedge funds, demanding to know “who they are, how they came into being, the way in which they are organized”—and especially “what impact their trading may have on the market.”63 Commission officials made no secret of the fact that they wanted hedge funds to register under one of the federal acts, but some of the complaints about the new upstarts seemed a bit curious. It was said that hedge funds accounted for half the short interest in certain stocks; nobody explained why this short selling, which presumably prevented indifferent companies from attaining unsustainable market valuations, might be pernicious. It was noted that hedge funds turned over their portfolios more aggressively than mutual funds, but somehow this boost to market liquidity was portrayed as a bad thing. There was a tall story about an A. W. Jones manager who bought a large block in a go-go company one morning and sold it after lunch. Nobody could explain how this alleged crime harmed anyone. However much they might be envied and adored, hedge funds were also the object of not-quite-rational resentment.

  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. The hedge[d]-fund model deserved to drop its d: Caught up in the bull market, the Jones men came to regard shorting as a sucker’s game and lost interest in protecting the fund against a fall in the S&P 500. Instead, they pushed the boundaries of leverage: Each segment manager was out to buy as many go-go stocks as possible. Even the velocity calculations fell by the wayside. The Jones men did not like being told to buy less of a hot stock merely because it might be volatile. Because the stock market was roaring, and because Jones himself was increasingly absent, the stock pickers did what they wanted.65 This was the sixties; they were young; the market belonged to their generation.

  For most of his financial life, Jones had been lucky. He had opened his hedged fund just as the trauma of the crash was beginning to wear off: In 1950 only one in twenty-five American adults owned stocks; by the end of the 1950s, one in eight did.66 As retail brokerages sprang up on every high street, the S&P 500 index rose from 15 at the time of Jones’s launch to a peak of 108 in late 1968, and meanwhile the financial culture changed: The trustee bankers were eclipsed by go-go types for whom the crash was ancient history. The new generation believed that financial turmoil would never rear its head again. The Fed was watching over the economy, the SEC was watching over the market, and Keynesian budget policies had repealed the tyranny of the business cycle. This state of blissful optimism found its apotheosis in the Great Winfield, the semifictional
investor immortalized by Jerry Goodman, the financial writer and broadcaster who became famous under the pseudonym “Adam Smith.” The Great Winfield entrusts his money to twentysomething managers with no memories and no fear—whose chief virtue is inexperience. “Show me a portfolio, I’ll tell you the generation,” he says. “You can tell the swinger stocks because they frighten all the other [older] generations.”67

  Jones had caught the go-go era early. A portion of his wealth, though certainly not all, was the result of riding a long bull market. But the multimanager structure that empowered go-go segment managers was not designed to save Jones from a sudden reversal—a problem that multimanager hedge funds were to discover later. On the contrary: The more the market rose, the more Jones’s performance-tracking system rewarded aggressive segment managers who took the most risk. There was no mechanism for getting out before disaster struck; and in May 1969 the stock market started to fall hard, shedding a quarter of its value over the next year. When Jones reported his results for the year ending in May 1970, he was obliged to tell his clients that he had done even worse than the market. He had lost 35 percent of their money.68

  The following September, Jones marked his seventieth birthday. It was a time of celebration for his family: Jones’s daughter-in-law was expecting his first grandchild, and his daughter’s wedding engagement was announced at the birthday party. A marquee was put up on the lawn of his beloved country house, up the hill from the grass tennis court that he nurtured like an infant. The band played dance music, and the young men traded guesses about who Miss Jones’s betrothed might be. But the patriarch was out of sorts. He fretted that his segment managers would resent the extravagance of the occasion: “I hate the boys seeing me spending money like a drunken sailor,” he kept saying.69 After two decades of eminence, Jones’s investment edge was gone. The markets had finally caught up with him.

  2

  THE BLOCK TRADER

  The years from 1969 to 1973 marked a watershed for the American economy. The nation had brimmed with confidence for the previous two decades: Jobs were plentiful, wages rose, and finance was almost quaintly stable. The dollar didn’t fluctuate because it was pegged firmly to gold; interest rates moved within a narrow range and were capped by regulation. But starting in the late 1960s, inflation tore this world apart. Having stayed below 2 percent in the first half of the decade, it hit 5.5 percent in the spring of 1969, forcing the Federal Reserve to jam on the monetary brakes and squeeze the life out of the stock market. The bear market that followed was only the first shock. In 1971 the Nixon administration was forced to acknowledge that inflation had eroded the real value of the dollar, and it responded by abandoning the gold standard. Suddenly money could be worth one thing today, another tomorrow; and the realization inevitably fueled further inflationary pressure. Another round of monetary tightening soon followed, and the market crashed again in 1973–74. Go-go was gone-gone. The 1960s were over.

  The turbulence put an end to the first hedge-fund era. 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 January 1970, there were said to be only 150 hedge funds, down from between 200 and 500 one year before; and the crash of 1973–74 wiped out most of the rest of them.2 The Securities and Exchange Commission gave up on its campaign to regulate a sector that was now too small to bother with, and in 1977 Institutional Investor magazine ran an article asking where all the hedge funds had gone.3 As late as 1984, a survey by a firm called Tremont Partners identified only 68 of them. The A. W. Jones partnership withered from the $100 million plus it had managed in the late 1960s to $35 million in 1973 and a mere $25 million a decade after that.4 It proved hard to keep going in hard times. Performance fees dried up in an era of nonperformance.

  Adversity did not rule out success, however; and the first winner amid the new uncertainty was Steinhardt, Fine, Berkowitz & Company. The firm’s dominant partner, Michael Steinhardt, became a legend in the story of hedge funds, partly because of his success as a trader but also because of his personality. He had been brought up by a single mother in hardscrabble Brooklyn, and his father was confrontational, short-tempered, and addicted to gambling—traits that the younger Steinhardt later brought to his own trading. At sixteen he was admitted to the University of Pennsylvania, from which he graduated at nineteen; and by the mid 1960s, when Steinhardt was still only about twenty-five, he had become, in his own estimation, the “hottest analyst on Wall Street.”5 He was short, barrel-chested, and prone to terrifying outbursts. When the volcano stirred within him, his face and then his temples would turn red. He would let forth a bloodcurdling torrent of abuse that left his colleagues shaking.

  Steinhardt quit the brokerage business in 1967, launching a hedge fund with two equally young friends named Jerrold Fine and Howard Berkowitz. The bull market was still very much alive, and at first Steinhardt, Fine, Berkowitz seemed typical of the outfits that sprang up in imitation of the A. W. Jones partnerships. The three founders equipped their offices with a pool table, proclaimed the intellectual superiority of youth, and ignored the advice of their lawyer, who said that Steinhardt, Fine, Berkowitz sounded too much like a Jewish delicatessen.6 In their first full year in business, the trio loaded up on the story stocks of the era. They owned King Resources, whose charming chief executive claimed to have discovered new oil and gas reserves. They owned National Student Marketing because they believed in the youth market. They owned technology companies whose names featured “Data” or “-onics.” It was a time when investors loved anything that had the scent of growth, and at the end of their first full year they were up 84 percent after subtracting fees. “My God, I am rich,” Jerry Fine recalls thinking.7 Indeed, he and his two friends had each become millionaires.

  The following year, the bull market ended. Other go-go funds blew up; Fred Mates, the top-performing mutual-fund manager of 1968, found himself working as a bartender. But almost alone among the gunslingers, Steinhardt, Fine, and Berkowitz had sensed that the long postwar expansion had finally overreached and that a time of uncertainty was beginning. Fifteen years earlier, the famous value investor, Benjamin Graham, had made the fateful decision not to buy shares in the Xerox maker, Haloid, saying he saw no reason to buy stocks on the basis of their future growth; Haloid had sextupled in the next two years, and the cult of the growth stock had since gone unquestioned. But in 1969, Steinhardt, Fine, and Berkowitz concluded that this cult had gone too far; it was one thing to pay a premium for a company with bright prospects, another to pay so much that uninterrupted, supersonic growth was extrapolated into the hereafter.

  At the start of 1969, Steinhardt and his friends shorted enough of the story stocks to balance their long positions; unlike most hedge funds, they were actually hedging. When the S&P 500 index fell by 9 percent that year, the firm preserved all but a sliver of its capital; the following year, when the S&P 500 dropped by another 9 percent, the troika actually made money.8 Having survived 1969–70, the firm went on the offensive; it turned bullish in 1971, catching the bounce from the bear market. When Fortune published its list of the top twenty-eight hedge funds that year, Steinhardt, Fine, Berkowitz was the only one to have actually expanded during the shakeout. The partnership had racked up a return of 361 percent since opening for business in July 1967, a performance that was thirty-six times better than that of the stock market index over that period.9

  In 1972, the young troika turned pessimistic again. This time the sources of their doubt went beyond the cult of growth investing. The edifice of America’s postwar confidence seemed to be cracking: The Nixon administration was covering up the truth about its failures in Vietnam; it was covering up inflation with an impractical wage-and-price-control program; and meanwhile, America’s finest companies were covering up the truth about themselves with accounting shenanigans. Jerry Fine and Howard
Berkowitz, who led the firm’s analytical effort, were finding red flags in the footnotes of annual reports on a regular basis, and no less a figure than Leonard Spacek, chairman emeritus of Arthur Andersen and the most respected accountant of the era, had exclaimed that “financial statements are a roulette wheel.” “The research reports that were released in the early seventies were so simplistic that we looked at them as nonsense,” Howard Berkowitz recalled. “Deferred this, different tax rate that, capital gains that they put as operating earnings,” said Jerry Fine of the company reports of the period.10 In short, the stock market was trading at levels that reflected broad political and financial delusions. So whereas in 1969 the young troika shorted enough stocks to protect themselves from a downturn, they went further in 1972. They positioned their portfolio so that their short positions greatly outweighed their longs, and they waited for the crash to happen.

  At first, it did not happen. The market sailed along for the rest of 1972, and the fund was down 2 percent in the year to September, at a time when the S&P 500 index rose 9 percent. But then the payoff came: The S&P fell 2 percent in the year to September 1973 and a shocking 41 percent the following year, and Steinhardt, Fine, Berkowitz racked up gains of 12 percent and then 28 percent after fees, an extraordinary performance in a bear market. The young partners were raking in the money while just about every other portfolio manager was losing his proverbial shirt; their results looked great, but they were not universally popular. As the stock market careened downward, desperate sellers called up the troika’s trading desk, knowing that the firm had borrowed shares to sell them short, urging that now would be the time to buy shares back to cover their positions. Michael Steinhardt, who ran the firm’s trading, generally gave these supplicants the cold shoulder, and the troika watched their short positions generate ever bigger profits as the market rout continued. In this climate, the old prejudice against short selling came back with a vengeance: Steinhardt, Fine, and Berkowitz were resented as arrogant, greedy, and even un-American; betting against American companies was portrayed as one step away from treason.11 Thinking back on that period, Steinhardt recalls the vilification this way: “That was, for me, the height of professional satisfaction.”12