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

by Sebastian Mallaby

  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. But by the summer of 1971, Weymar had reversed himself. The humiliation of the corn episode was one reason: The great virtue of an automated trading system was that risk controls had to be programmed into the computer from the start, and there was no danger of overconfident traders exceeding their allowed limits. But the TCS had proved itself to be superior at calling the market too. Weymar’s cocoa model, which had worked so well at Nabisco, had misjudged the direction of the market expensively during Commodities Corporation’s first year. But Vannerson’s trend-following model, which watched patterns in the market rather than the fundamentals of chocolate consumption or rainfall, had made money consistently from the day the firm opened.

  After the debacle of the corn blight, Weymar began to allocate more capital to the Technical Computer System, and the human traders developed a fresh respect for the program’s decisions. Indeed, the new risk-control system gave them little choice: It prohibited traders from committing more than a tenth of their capital in betting against a trend, and the trends used in implementing the controls were the ones identified by Vannerson’s program. Even Paul Samuelson was won over to the new approach. He stumped up a fresh chunk of capital to be invested by the TCS, even though trend following had little standing within academia and none within his own research.

  IN 1974 A YOUNG RECRUIT NAMED MICHAEL MARCUS joined the team at Commodities Corporation. He was far removed from Weymar’s original conception of the model trader. He was not an econometrician specialized in one commodity; indeed, he lacked even a degree in economics. He had no use for computers and little use for math; he had dropped out of a PhD program in psychology, and was one of the first Commodities Corporation traders to be hired without a doctorate.28 Marcus’s arrival raised some eyebrows, but the skeptics were soon silenced as he started to earn triple-digit returns on his capital. Over a ten-year period at Commodities Corporation, Marcus increased the value of his trading account by 2,500 percent. There were years when his profits exceeded those of all the other traders put together.

  Marcus was intense, quiet, and fearsomely controlled, a trait that found expression in his approach to his own body. He believed that most foods contained poisons, and he monitored his intake; he once purified himself with a diet of raw vegetables and fruits, becoming so emaciated that he hired a dietician-cum-driver to coax him back to equilibrium. He splashed his winnings on elaborate parties and exotic travel; at one point he owned about ten homes, some of which he later sold without spending a single night in them. He chartered a jet and had a bus converted into a traveling dwelling, stocked with an entourage of admirers. He took kick-boxing lessons with an international champion.29

  Whatever the extremes of his lifestyle, Marcus’s intensity did wonders for his trading. In keeping with the founding vision for Commodities Corporation, he studied the economic fundamentals that might drive markets. He would arrive in the office each morning with an oversized briefcase packed full of market reports; there were no Post-its back then, but Marcus used sticky tape to attach careful handwritten notes to key pages from his reading. He pored over newsletters and scanned data about the basic drivers of supply and demand, searching for shifts that would push prices. He thought through scenarios that might threaten his portfolio. If corn went up, would wheat follow? And if the weather turned colder, which crops would be first affected? But in keeping with Frank Vannerson’s trend following, Marcus did not restrict himself to watching the fundamental drivers of prices. He was a keen student of price charts, which he regarded as a window into the psychology of investors, and he focused especially on the interaction between charts and fundamentals. For example, if the fundamentals delivered bad news but the charts showed the market continuing to trend up, it meant that investors had already digested the possibility of setbacks. Nothing was going to spoil their mood. There was nowhere to go but upward.

  Marcus’s respect for trends reflected his experience. He had spent time on the floor of the cotton exchange early in his career and had watched traders respond to the tempo of their colleagues. Sometimes they would work one another up into a crescendo of shouting, and sometimes they would fall back, exhausted. If the price of a commodity headed up past its high point of the previous day, there was a decent chance that it would keep riding upward on a wave of excitement; so Marcus would take a large position at those crossover moments, protecting himself with a stop-loss order that would kick him out of the market if the trade went against him. Either the market took off and ran or Marcus was out: It was like mounting a surfboard, ready for the wave; if your timing was off, you just plopped back into the water. 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.

  As Marcus developed his investing style, he absorbed lessons from his colleagues and vice versa, so that the Princeton set converged upon a common culture. As the traders watched the price charts, looking for waves that could be profitably surfed, they recognized recurring patterns. Market bottoms tended to be rounded, because a bumper harvest not only drives the price down but causes excess produce to be held in storage; this inventory overhang keeps prices low for an extended period. By contrast, market tops tend to be spike shaped: If there is a sudden shortage in a crop, consumption has to fall sharply and prices shoot up; but if the next harvest is good, the shortage goes away and prices quickly shoot down again. The details of these patterns varied from one commodity to the next. Pork bellies and eggs, for example, were notorious for their spike bottoms. There were limits to how long these commodities could be stored, so a glut got dumped on the market rather than being held in inventory.

  The Commodities Corporation traders also developed views on investor psychology. People form opinions at their own pace and in their own way; the notion that new information could be instantly processed was one of those ivory-tower assumptions that had little to do with reality. This gradual absorption of information by investors explained why markets moved in trends, as new developments were gradually digested. But market psychology was more subtle than that; there were times when investors’ reactions accelerated. Human being do not simply make forward-looking judgments about markets, the Commodities Corporation traders recognized; they react to recent experiences. For example, losses might trigger an anxious bout of selling; gains might set off waves of euphoric buying. This realization led to an insight about congestion points—the places on the charts where prices bounced within a narrow range before speeding off in one direction or the other. When a commodity broke out of its usual price band, investors who had bet wrong would experience a sharp loss; panicking, they would close their positions in a rush, hastening the market’s escape from its old price range. The patterns reminded the traders of travelers in a train station crowding around a door. They took a long time to pass through the bottleneck in either direction, but once they were through they usually accelerated.

  The triumph of Michael Marcus’s trading style rendered Weymar’s initial concept for his firm inoperative. Later in the story of hedge funds, the hard-core quants would have their day; but so long as trend surfing delivered marvelous profits, it made little sense to focus obsessively on econometric modeling. The original Weymar data crunching seemed relatively thankless: There were so many variables that drove prices, it was virtually impossible to get all of them right; moreover, even if you were right you
could go broke waiting for the rest of the market to catch up with you.30 Marcus’s performance also upended Weymar’s initial belief in specialized traders. If the profits came from financial surfing, then the game was to spot the commodities that generated strong waves; there was no point wasting time studying sugar or wheat, for example, if these markets were going through a tranquil period. Having worked on the floor of the cotton exchange, Marcus knew what it was like to specialize. He preached the gospel of generalization with the zeal of the converted.31

  Marcus’s determination not to specialize made him a natural pioneer in the new field of currency trading. Following Nixon’s abandonment of the dollar-gold link, Chicago’s Mercantile Exchange began trading futures in seven free-floating currencies in May 1972. Marcus quickly saw an opportunity to apply his surfing skills to a new beach; investor psychology could be counted upon to generate the same waves in currency markets as existed in commodities. By the mid-to late 1970s, about a third of Marcus’s trading was in currencies, and by the end of the decade, two thirds was.32 Marcus’s colleagues at Commodities Corporation began to trade currencies as well, as did many of the independent traders whom the firm seeded. A new kind of hedge-fund player—the “macro” traders who became the scourge of central bankers in the 1980s and beyond—was starting to stir in the incongruous setting of a Princeton farmhouse.

  Marcus was a libertarian, and his political outlook turned out to be useful in the climate of the 1970s.33 In some eras, markets appear destabilizing while governments are heroes, but in the stagflationary 1970s the libertarian view that big government screws up was frequently vindicated. At the start of the decade, Nixon imposed price controls that turned out to be the functional equivalent of the misguided currency controls of later years: They made for bad public policy because they proved not to be sustainable, and they created a bonanza for speculators. By fixing plywood, for example, at $110 per thousand square feet, the Nixon administration was putting up traffic cones in the path of an invading tank: The United States was in the midst of a construction boom, and demand for plywood was booming; builders were willing to buy planks for much more than the price mandated by the government. Pretty soon, plywood warehouses were shipping supplies to Canada and back again to get around Nixon’s controls, or they were performing “added-value services” such as shaving a sliver off their planks and then charging $150 per thousand square feet for them. Meanwhile, builders who could not get all the wood they needed were starting to buy it in the futures market, where prices were not regulated. Confident that artificial scarcity in the physical market would drive the futures up and up, Marcus bought plywood futures by the truckload. Their value virtually doubled.34

  When Nixon’s price controls were abandoned at the start of 1973, Marcus made even more money. As any libertarian could see, incompetent government was debasing the currency by inflating the money supply, so a trader was likely to get rich simply by leveraging himself up and holding huge positions in grains and beans and metals. In 1974 alone, the coffee price went up by a quarter, rice went up by two thirds, and white sugar doubled; anyone who bought these commodities on margin was multiplying his money.35 Then food commodities turned around and embarked on an equally tradable downward trend: Sugar lost 67 percent of its peak value, cotton and rubber lost 40 percent, and cocoa fell more than 25 percent.36 When the Carter administration tried to stimulate the economy, the boost to inflation caused the dollar to drop by a third against the yen and the deutsche mark, and the big moves gave surfers of the new currency-futures markets ample opportunity.37

  In early 1975, Marcus spied an opportunity that anticipated the victories against exchange-rate pegs for which later hedge funds became notorious. In his search for dumb government policies that violated good market sense, he fixed on an intervention as enticing as Nixon’s price controls: Saudi Arabia had pegged its currency to the dollar. It didn’t take a genius to notice that the peg was in trouble. As Saudi Arabia’s export revenues ballooned along with the oil price, its economy was flooded with money, creating upward pressure on the exchange rate. Of course, revaluation was not certain: Saudi Arabia could decide to live with the capital inflows, even though they stoked inflation. But, following the logic of currency speculators who later attacked exchange-rate pegs everywhere from Britain to Thailand, Marcus saw that, whether or not revaluation happened, devaluation was inconceivable. This made betting on the Saudi currency a hugely attractive one-way gamble: There could be no guarantee of winning, but there was a near guarantee of not losing. So Marcus took huge positions in the riyal, leveraging himself up with borrowed money and sleeping perfectly soundly. In March 1975, Saudi Arabia abandoned its dollar link and revalued. Marcus made another killing.38

  BY THE END OF THE 1970S, THE SUCCESS OF COMMODITIES Corporation had become prodigious. The corn-blight fiasco was a faded memory; trend surfing, Michael Marcus style, was delivering returns of 50 percent plus for many of the firm’s traders. The company’s capital swelled from under $1 million at its low point to some $30 million; the farmhouse acquired an extra wing and a new building was commissioned. Weymar hired new traders, and each trader hired researchers to keep track of the charts; new administrative staff arrived at a rate the old-timers found absurd, especially since the overhead came out of their trading profits. But the profits were large enough to paper over the problem. In 1980 alone, they came to an astronomical $42 million, so that even after shelling out $13 million in bonuses to 140 employees, Weymar’s quiet firm outearned fifty-eight of the Fortune 500 companies. Weymar flew his employees and their families first class to a company retreat in Bermuda. The traders hijacked the occasion to lambaste Weymar for his free-spending ways, but they of all people recognized that Commodities Corporation was a phenomenon.39

  The phenomenon was first and foremost a triumph of flexibility. In moving beyond econometric analysis to focus on trends, Weymar had demonstrated a pragmatism that crops up repeatedly in the history of hedge funds—and indeed in business history generally. Innovation is often ascribed to big theories fomented in universities and research parks: Thus Stanford’s engineering school stands at the center of Silicon Valley’s creativity, and the National Institutes of Health underpin innovation in the pharmaceutical industry. But the truth is that innovation frequently depends less on grand academic breakthroughs than on humble trial and error—on a willingness to go with what works, and never mind the theory that may underlie it. 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.

  Much like Michael Steinhardt’s troika, Commodities Corporation benefited from an approach that fit the 1970s. Financial markets are mechanisms for matching people who want to avoid risk with people who get paid to take it on: There is a transfer from insurance seeker to insurance seller. In the 1960s not many people sought insurance against commodity price fluctuations. Government set minimum prices for agricultural products, while surpluses prevented prices from rising; traders at the Chicago Board of Trade whiled away the hours on the steps of the soybean pit by reading newspapers. But in the inflationary 1970s, the new volatility in food prices created a rush for insurance: Food companies used the futures market to hedge the risk of high prices; food growers used the futures market to hedge the risk of low prices.40 Similarly, the new volatility in exchange rates created a rush for currency hedging; multinational firms woke up to the fact that the dollar’s rise or fall could upend their performance. During the first half of the 1970s, turnover on the Chicago Board of Trade rose rapidly. The traders in the pits had no time to waste on newspapers.

  This rush of insurance seekers int
o the market was bound to profit the insurance sellers—that is to say, the speculators. The farmers and the food companies were buying and selling futures because they needed to shed risk, not because they had a sophisticated view on the direction of prices; speculators who did have such a view were bound to have the upper hand in trading with them. Moreover, the speculators earned especially good profits because they faced relatively little competition. The exchanges imposed limits on the number of contracts a speculator could buy, thereby limiting the supply of “insurance” and boosting its value artificially. Commodities Corporation pocketed the higher insurance premiums created by this artificial scarcity, then figured out another way to win as well. It got around the exchanges’ restrictions by arranging off-exchange trades with wholesalers.41

  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.42 Years later, financial academia caught up with Vannerson’s discovery. In 1986 a paper in the prestigious Journal of Finance found that trend following in the currency markets could earn sizable profits, and in 1988 another study found the same for commodities as well as currency futures.43 There was an amusing symmetry to some of this research. Scott Irwin, one of the authors of the 1988 paper, had been prompted to begin his investigations by an encounter with Dennis Dunn, whose firm, Dunn & Hargitt, had provided Vannerson with the data to build the Technical Computer System. Examining the same price series that Vannerson had worked on almost two decades before, Irwin came to the same conclusion.44