The recasting of the academic consensus had three parts to it. The efficient-market hypothesis had always been based on a precarious assumption: that price changes conformed to a “normal” probability distribution—the one represented by the familiar bell curve, in which numbers at and near the median crop up frequently while numbers in the tails of the distribution are rare to the point of vanishing. Even in the early 1960s, a maverick mathematician named Benoit Mandelbrot argued that the tails of the distribution might be fatter than the normal bell curve assumed; and Eugene Fama, the father of efficient-market theory, who got to know Mandelbrot at the time, conducted tests on stock-price changes that confirmed Mandelbrot’s assertion. If price changes had been normally distributed, jumps greater than five standard deviations should have shown up in daily price data about once every seven thousand years. Instead, they cropped up about once every three to four years.
Having made this discovery, Fama and his colleagues buried it. The trouble with Mandelbrot’s insight was that it was too awkward to live with; it rendered the statistical tools of financial economics useless, since the modeling of abnormal distributions was a problem largely unsolved in mathematics. Paul Cootner, the efficient-market theorist and cofounder of Commodities Corporation, complained that “Mandelbrot, like Prime Minister Churchill before him, promises us not utopia but blood, sweat, toil and tears. If he is right, almost all of our statistical tools are obsolete—least squares, spectral analysis, workable maximum-likelihood solutions, all our established sample theory, closed distribution functions. Almost without exception, past econometric work is meaningless.”66 To prevent itself from toppling into this intellectual abyss, the economics profession kept its eyes trained the other way, especially since the mathematics of normal distributions was generating stunning breakthroughs. In 1973 a trio of economists produced a revolutionary method for valuing options, and a thrilling new financial industry was born. Mandelbrot’s objections were brushed off. “The normal distribution is a good working approximation,” Fama now contended.67
The crash of 1987 forced the economics profession to reexamine that assertion. In terms of the normal probability distribution, a plunge of the size that befell the S&P 500 futures contracts on October 19 had a probability of one in 10160—that is, a “1” with 160 zeroes after it. To put that probability into perspective, it meant that an event such as the crash would not be anticipated to occur even if the stock market were to remain open for twenty billion years, the upper end of the expected duration of the universe, or even if it were to be reopened for further sessions of twenty billion years following each of twenty successive big bangs. Mandelbrot, who had abandoned financial economics after the brush-off in the early 1970s, returned to the subject with a vengeance. His Soros-like thinking on “chaos theory,” which emphasized that small pieces of information could generate large price moves because of complex feedback loops, acquired a cult following among money managers.
As well as challenging the statistical foundation of financial economists’ thinking, Black Monday forced a reconsideration of their institutional assumptions. Efficient-market theory assumed investors always had the means to act: If they knew that a share of IBM was worth $90 rather than the prevailing price of $100, they would sell it short until the weight of their trading moved the price down by $10. This assuming away of institutional frictions involved a number of heroic leaps. You had to presume that the knowledgeable speculators could find enough IBM stocks to borrow in order to be able to sell them short. And you had to gloss over the fact that, in real life, the “knowledge” that IBM was worth $90 would be less than certain. Speculation always involved risk, and there was only so much risk that speculators could shoulder. They could not necessarily be counted upon to move prices to their efficient level.
Before the 1987 crash, these quibbles seemed insignificant. To be sure, the great mass of ordinary investors might lack the means and confidence to act, but efficient-market theory pinned its hopes on the exceptional minority. It would take only a small handful of investors armed with information and capital to pounce on mispricings and correct them.68 But Black Monday demonstrated that sophisticated investors would not always succeed in correcting prices. In the chaos of the market meltdown, brokers’ phone lines were jammed with calls from panicking sellers; it was hard to get through and place an order. Any leveraged investor feared that his credit lines might be canceled; access to borrowing, assumed to be straightforward in efficient-market models, was in reality uncertain. And, most important, the sheer weight of selling made it too risky to go against the trend. When the whole world is selling, it doesn’t matter whether sophisticated hedge funds believe that prices have fallen too far. Buying is crazy.
At a minimum, it seemed, the efficient-market hypothesis did not apply to moments of crisis. But the crash raised a further question too: If markets were efficient, why had the equity bubble inflated in the first place? Again, the answer seemed to lie partly in the institutional obstacles faced by speculators. In the summer of 1987, investors could see plainly that stocks were selling for higher multiples of corporate earnings than they had historically; but if the market was determined to value them that way, it would cost money to buck it. Hedge fund managers knew better than anyone that borrowing stocks to short is difficult and that the few skilled operators who do this have limited war chests. Because of these institutional realities, the overvaluation might well last. The efficient-market assumption of wise speculators pushing prices into line was, at a minimum, exaggerated.
The third post-1987 assault on efficient-market theory was perhaps the closest to Soros’s own complaint about it. This line of attack went after the protagonist at the center of economists’ models, the impeccably rational figure known as Homo economicus. When investors could revise their valuation of corporate America by as much as a quarter in a single day, something other than rational analysis was in play; homo was not fully economicus. Economists were suddenly open to ideas that might explain the extent of the divergence. In 1988 Richard Thaler of the University of Chicago began to publish regular features in the Journal of Economic Perspectives that pointed out instances in which human choices appeared to violate economists’ expectations of rational beings. To Soros, who had obsessed about the limits to cognition since his student days in London, it was another victory.
The triple attack on efficient-market theory—statistical, institutional, and psychological—was in some ways a vindication for the hedge-fund industry. It helped to explain how Michael Steinhardt’s block trading or Helmut Weymar’s commodity speculators could have done so well, and it showed that market practitioners had often been ahead of academic theorists. The realization that market efficiency is imperfect encouraged a wave of finance professors to launch their own hedge funds, and it persuaded sophisticated endowments to pour money into their coffers, triggering the industry’s headlong growth after 1987. But there was a darker side to this revolution in ideas. If markets were not always efficient and rational, their effects on society might be pernicious too: Boom-bust sequences could distort and destabilize the economy, damaging ordinary workers and households. And if markets could be demons, surely fast-trading hedge funds must be demons on steroids? This suspicion, however exaggerated, haunted hedge funds repeatedly as they entered their golden era of expansion.
5
TOP CAT
In the late spring of 1984, Columbia Business School played host to a clash of the financial titans. It invited Michael Jensen, one of the deans of academic finance, to make the case for the efficient-market view; and it invited Warren Buffett to challenge him. Knowing that he faced a New York audience stacked with professional investors, Jensen bravely rehearsed the random walkers’ argument. If stock pickers remain in business, it is only because befuddled laymen have a “psychic demand for answers” about where to invest—and never mind the fact that the answers are worthless. The few money managers who appear to defy the random-walk hypothesis are merely lu
cky, Jensen assured his listeners. Sure, some beat the market for five years straight. But if you asked a million people to flip coins, some would flip five heads in a row. There is no skill in coin flipping—and investment is no different.1
Then Warren Buffett delivered a rejoinder that could serve as a hedge-fund manifesto. He began by playing along with Jensen’s argument, inviting his audience to imagine a national coin-flipping contest. At the start of the competition, everyone in America would flip a coin, and those who turned up tails would withdraw from the contest. At the end of ten rounds, 220,000 flippers would be left—and, human nature being what it is, the survivors would start to get a little cocky. At parties they would occasionally admit to attractive members of the opposite sex what their technique was and what marvelous insights they brought to the field of flipping. At the end of twenty rounds, the 215 remaining contestants would start to wax insufferable, publishing fatuous books on the art and science of coin flipping. But then some business-school professor would point out that if 225,000,000 orangutans engaged in a coin-flip-a-thon, the results would be the same. There would be 215 egotistical orangutans with twenty straight winning flips.
Having made Jensen’s argument better than Jensen, Buffett proceeded to cut holes in it. If the 215 winning orangutans were distributed randomly about the country, their success could be dismissed as luck. But if 40 of the 215 winners hailed from the same zoo, wouldn’t something else explain their coin flipping? Phenomena that appear statistically random can appear altogether different when you consider their distribution, Buffett was saying. If you found that a rare cancer was common in a particular village, you would not put that down to chance. You would analyze the water.
Buffett then argued that stock-picking success is not randomly distributed. On the contrary, clusters of excellence spring from certain “villages,” defined not by geography but by their approach to investment. To demonstrate his point, Buffett laid out the records of nine money managers from the value-investing tradition started by Ben Graham, Buffett’s mentor. Three had worked at the Graham-Newman Corporation in the mid-1950s; the others had been converted to the Graham approach by Buffett or his associates. Buffett insisted that he had not cherry-picked his examples; he was reporting the results of all Graham-Newman alumni for whom there were records and all the fund managers whom he had won over to the value-investing method. Without any exception, and without copying one another’s stock choices, each of Ben Graham’s heirs had beaten the market.2 Could this be simple fortune?
Buffett’s general point was indisputable. When investment managers are viewed merely as sets of performance numbers, the handful of success stories can be dismissed as products of chance—the equivalent of ten-heads-in-a-row coin flippers. But if investment managers are understood as belonging to distinct intellectual “villages” or styles, their success may be concentrated in a way that is not random. The story of hedge funds features several of these high-performance clusters, and the most famous of them all was created by a booming North Carolina native. His name was Julian Robertson.3
MASTERS OF THE MARKET CAN SOMETIMES BE ALOOF. They have no use for the sorts of flattery and tolerance that lubricate human affairs. There are just facts; you make money or you don’t; social skills won’t change the bottom line on your portfolio. Visiting the legendary macro trader Louis Bacon in his office one day, a fellow hedge-fund manager found an Oz-like figure hidden behind banks of screens. When Bacon later bought a private island, there seemed little to be gained. He was already as isolated as he could be.4
Julian Hart Robertson came out of a different tradition. He was a charmer in a southern way, a networker in a New York way; and far from being coldly in control, his mood could swing alarmingly. Tall, confident, and athletic of build, he was a guy’s guy, a jock’s jock, and he hired in his own image. To thrive at Robertson’s Tiger Management, you almost needed the physique; otherwise you would be hard-pressed to survive the Tiger retreats, which involved vertical hikes and outward-bound contests in Idaho’s Sawtooth Mountains. The Tigers would fly out west on Robertson’s private plane and be taken to a hilltop. They would split up into teams, each equipped with logs the size of telephone poles, some rope, and two paddles. Then they would heave the equipment down to a nearby lake, lash the logs together, and race out to a buoy—with the twist that not all of the team could fit on the raft, so some had to plunge into the icy water. Even away from these adventure holidays, the testosterone quotient at Tiger remained exceptional. The firm retained a private trainer, and if an analyst showed signs of shirking his workouts, the trainer would come up to him. “You’re going to a business dinner in fifteen minutes?” he would ask. “Do you have time to run two miles and shower before that?”
Like Soros and Steinhardt, Robertson was inspired to set up his hedge fund by A. W. Jones’s example. While working at Kidder Peabody in the 1970s, Robertson had befriended Bob Burch, A. W. Jones’s son-in-law. Occasionally, the friends would take the old patriarch to lunch, and Robertson would quiz Jones on the mechanics of his partnership. Robertson was also close to a fellow southerner named Alex Porter, who had moved to New York in the 1960s, bunked in Robertson’s apartment, and gone on to become an A. W. Jones segment manager. Robertson’s sister was a Fortune magazine journalist who had written about the Jones-style funds, and through her Robertson got to know Carol Loomis, the Fortune writer who had first explained the hedged investment structure. A few years after Robertson launched Tiger, Bob Burch entrusted him with $5 million, a fifth of the Jones money that remained.5 It was a wise decision.
Robertson launched Tiger in 1980, at the relatively advanced age of forty-eight. During his first winter the heating in his tiny office broke and he caught a cold and lost his voice, so that he squeaked out buy and sell orders. He brought along a carefree partner named Thorpe McKenzie, but there was no doubt who was in control: “When we disagreed, I caved,” McKenzie recalled later.6 Throughout his reign at Tiger, Robertson kept a close hold on the responsibility for buying and selling, rather than delegating to segment managers beneath him; but in most other ways he was faithful to the Jones model.7 He picked stocks, long and short, hedging out part of the risk in the market.8 He dismissed commentary about the market’s overall direction as “gibberish” and promised his clients that he would prosper through stock selection.9 As the fund grew, Robertson picked stocks internationally, not just in the United States; and he played in commodities, currencies, and bonds, so that the original Jones method acquired a macro-investing overlay. He sometimes hedged his market exposure with futures or options, a method unavailable to Jones; but he emphasized that these speculative instruments were being used for conservative ends, echoing Jones’s language.10
Between its inception in May 1980 and its peak in August 1998, Tiger earned an average of 31.7 percent per year after subtracting fees, trouncing the 12.7 percent annual return on the S&P 500 index.11 The fact that stock picking succeeded in this period was an affront to the efficient-market hypothesis. It was understandable that A. W. Jones could prosper in an earlier era, when rivals at bureaucratic trust banks made investment decisions by committee. It was understandable that Michael Steinhardt could make money by being inside the charmed circle of block traders; that the quants and trend surfers at Commodities Corporation were ahead of their rivals; and perhaps even that George Soros, autodidact and seer, had a feel for turning points in markets. But Robertson made no claim to have discovered institutional weaknesses in markets, a fancy quantitative strategy, or some philosophical vision. He once summed up his approach to investing in a letter to Robert Karr, Tiger’s man in Tokyo, and the sheer blandness of his message underlined the mystery of his success. A Tiger should manage the portfolio aggressively, removing good companies to make room for better ones; he should avoid risking more than 5 percent of capital on one bet; and he should keep swinging through bad times until his luck returned to him.12 The simple truth was that the big jock and his lieutenants—a handful at the o
utset, perhaps a dozen later on—just analyzed companies, currencies, and commodities and bet on their prospects. This was exactly what the efficient marketers believed to be impossible.
Efforts to explain away this anomaly are mostly unsatisfying. Like the Jones funds, Tiger was undoubtedly launched at a propitious time, at the start of an equity bull market. The 401(k) retirement plan was invented in 1981, the year after Robertson opened for business; by the time Tiger closed its doors, 401(k) pensions were ubiquitous and their owners had stashed 75 percent of their assets in equities. For long stretches of this period, the market rode skyward on the back of corporate mergers and buyouts: Between 1981 and 1988, for example, almost 1,550 American companies went private, and every transaction made remaining public stocks scarcer and more valuable. It was a good time to be an equity investor.
Robertson certainly made the most of this bonanza. He was instinctively in tune with the merger boom: His aim as a stock picker was to look through the price of a company as announced by the market and to discern its true value; this process often led him to buy stocks that were also attractive to takeover artists. In 1985, for example, Tiger bought Empire Airlines at $9 a share and was taken out by a corporate acquirer that bid $15. It bought Aviall, a distributor of aviation parts, at $12.50 a share; it was taken out at $25.13 At the end of that year, Tiger was up an astonishing 51.4 percent after subtracting fees, and Robertson broke the news to his investors with a note of mock warning. “Bluntly,” his letter to them advised, “if you are not planning on buying emeralds or diamonds, don’t show your wife this letter.”
Yet it would be wrong to presume that Robertson generated his record simply by riding the bull market upward. Because of the shorts in his portfolio, his fund was not set up to rise as fast as the market, but he nearly always beat it.14 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. But the deeper objection to the small-stock theory is that its logic is debatable. The fact that small stocks are underanalyzed does not tell you there are easy profits to be had from them. To be sure, the majority of investors may never have heard of a particular provincial retailer or third-tier bank, but they are not the ones holding the stock. When Tiger bought shares in those companies, it was buying from people who knew enough to own the shares themselves—and who also knew enough to want to become sellers.15
More Money Than God_Hedge Funds and the Making of a New Elite Page 13