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

by Sebastian Mallaby

  Jones’s real achievement was not just to predict that Japan would fall, nor even how it would experience brief rallies on the way down. It was to spot a situation in which the odds were so good that they warranted a bet, even in the absence of predictive certainty. In October 1987 and again in January 1990, Wall Street and the Tokyo market could have recovered, in which case Jones would have bailed out of his short positions with a small loss. But Jones could see that a decline was more likely than a market rise; and, crucially, that a decline, if it happened, would be far more dramatic than any conceivable rally. He was like a gambler playing a roulette game that has been doctored in two ways: There are two extra red numbers on the wheel, giving red a somewhat-better-than-even chance of winning; and the croupier is paying out five to one if red comes up, creating a mouthwatering skew in the reward-to-risk ratio. Jones had no way of being certain that his bets would win. But he knew that it was time to shove his chips onto the table.

  MANY OF JONES’S TRADING SUCCESSES OWED SOMETHING to this formula. From his time on the floor of the cotton exchange, he had understood the importance of watching how other players were positioned. If you knew whether the big guys were sitting on cash stockpiles or were already fully invested, you could tell which way a market might break out—you could sense the mix of risk and reward in any situation. Pit traders knew how their rivals were positioned because they watched them yelling out their bids, and once Jones migrated off the floor he ad-libbed various tricks to reproduce that same feel for the markets. He would call up brokers who represented big institutional clients, check in with the trading companies that used the commodity markets to hedge physical positions, and speak frequently with fellow hedge-fund managers. He tracked the data that showed whether investors were buying more call options (signaling that they expected stocks might rise) or put options (signaling they feared that stocks might crater); he consulted reports on the balance between cash and stocks in pension and insurance portfolios. But it was not enough simply to know what other investors were holding. You needed to know what they wanted to hold—what their objectives were, how they would react in different situations. If you knew that Japanese fund managers were obsessed with clearing that 8 percent hurdle, you knew that they might switch to bonds if the market fell in January.

  Jones’s method was an extension of the psychological insights that were common at Commodities Corporation. He understood that behavioral quirks colored the markets, tinting the pure randomness imagined by efficient-market theorists. But Jones was attuned to a different sort of bias too. If investors could buy and sell irrationally for psychological reasons, they could do much the same thing for institutional ones. Sometimes psychological and institutional factors combined. Cotton farmers, for example, invariably clung to part of their harvest for weeks after it had been picked, hoping that prices would turn higher. But at the end of the year their psychological bias against selling ran into an institutional factor: They had to unload crops or they would suffer adverse tax consequences. As a result, Jones recognized a pattern: Each year the cotton market would be hit by a wave of sell orders in December; and each year the market would recover its lost ground in January.27 Similar distortions lurked in other commodity markets too. It took nearly a year for a calf to gestate inside its mother’s belly, so the supply of cattle responded only sluggishly to rising prices; as a result, supply could take months to catch up with demand, and upward trends in cattle futures tended to be durable. Or, to take an example from the equity market, stocks in the Dow Industrials index tended to do well on the closing Friday of each quarter, because that was when arbitrage traders bought back stocks that they had sold short to hedge expiring futures contracts.

  Jones’s focus on institutional distortions helps to explain how he could beat the market. It allowed him to buy and sell in situations where he knew he was getting a good price because the person on the other side of the trade was a forced seller. The efficient-market theorists had demonstrated that it was hard for an investor to foresee the future movement of a stock or a commodity because all relevant information is reflected in today’s price. But Jones sidestepped the theory by getting something better than the going price—from farmers who had no choice but to dump cotton at the end of the year, or from arbitrage traders who were forced to buy back stocks on the last Friday of each quarter. Jones’s success, in this sense, resembled Steinhardt’s: In the 1970s and 1980s, Steinhardt could buy blocks of equities at a discount because institutional sellers needed to unload in size and were willing to pay for the privilege. This sort of trading did not require Jones or Steinhardt to predict the future course of prices with godlike prescience. It merely required them to provide liquidity when it was needed.

  There was a further element in Jones’s success, and it goes back to the swashbuckling style that he displayed in the 1987 documentary. If Jones’s method was to look for the trigger that might set off a sudden market move, he was also willing on occasion to become that trigger himself—to jump-start a reversal in the market with a massive trade, so initiating a stampede that would make his script become reality. Again, this technique homed in on a weakness in efficient-market thinking. The theory presumes that if, say, Ford’s stock was too low, a handful of smart investors could buy Ford shares until they forced the price up to its efficient level. But in reality there is a limit to smart investors’ firepower; they may lack sufficient cash to keep buying Ford until it hits its rational level. When a whole market is out of kilter, the smart investors are especially likely to fall short. They might know that Japan’s equity bubble—or the dot-com bubble or the mortgage bubble—makes no sense, but they cannot borrow enough to bet against it with the force that would deflate it. This is why there is a limit to the power of contrarians. It is why markets swing in trends and why finance is prone to bubbles.

  This insight—christened “the limits to arbitrage” by the economists Andrei Shleifer and Robert Vishny—points to an opportunity that Jones could sense intuitively. Markets can move away from fundamental value because speculators lack the muscle to challenge the consensus; a trend can keep going far beyond the point at which it ceases to be rational. But if you are a trader with more ammunition and courage than the rest, you can ambush the market and jolt it out of its sleepwalk. And because you will have started a new trend, you will be the first to profit from it.

  Jolting the market was something of a Jones specialty. He had seen the cowboys in the cotton pit wrong-foot their rivals, but he was perhaps the first trader to deploy this tactic across multiple markets. Most “upstairs traders” tried to conceal their positions by placing orders discreetly through multiple brokers, but Jones saw that sometimes it could pay to be as loud as possible.28

  In one sequence in the documentary, Jones reacts with skepticism to an OPEC agreement to cut oil production. In theory, a production cut will push prices higher, so the OPEC announcement starts an upward trend in oil prices. But Jones knows that OPEC countries seldom muster the collective discipline to abide by lower quotas, so he figures that the upward trend has no basis in reality. His challenge is to break the market’s baseless momentum and profit from its reversal.

  At first Jones proceeds with stealth. He calls in multiple small sell orders, hoping to disguise his intentions so that the upward trend won’t be disturbed while he is building his short position. But once those quiet trades are done, Jones switches to his wild cowboy style. Now he wants the market to know that some big swinger is selling. He wants to scare the daylights out of it.

  “Offer a thousand!” he yells at his broker. “No, offer fifteen hundred! Show ’em size! Tell him that there’s more behind it! Do it! Do it! There’s more behind it!”

  Having rattled the market, Jones calls a friend at an oil-trading firm to gauge whether his macho sales have broken oil’s momentum. He is doing what a pit trader would do—feeling the mood of his adversaries. The two talk for some minutes, then Jones hangs up.

  “He said, ‘Those guy
s, they’ve sold the hell out of it,’” Jones reports, with evident delight. “The people he works with don’t know that it was…” and here Jones winks conspiratorially and points melodramatically at his own chest. “That’s even better. I hope they think it’s some wild-as-shit Arab who knows the whole agreement is getting ready to fall apart.”29 Sure enough, the Jones ambush succeeded and the oil rally was reversed. Rather than await the trigger that would make his script for oil come true, Jones had succeeded in creating it.

  In the spring of 1987, Jones decided it was silver’s moment. Gold had already staged a rally, and silver usually followed; besides, there were rumors that output at key mines might be disrupted. Early on a March morning, Jones executed a pincer movement worthy of his hero, General George S. Patton: He bought a gutsy position in silver futures, buying up contracts from floor traders and leaving them all short; then he bought physical silver from four dealers. Soon the dealers were doing precisely what Jones expected them to do. Because they understood that gold had already rallied and silver was positioned to follow, the dealers didn’t want to be caught with depleted inventories; they immediately phoned the silver exchange with purchase orders to replace what they had sold to Jones some minutes earlier. When their phone calls reached the exchange, the dealers were in for a surprise: The traders who would usually have had silver futures to off-load had already sold out to Tudor. The traders, for their part, followed Jones’s script too. When the dealers called them with urgent buy orders, they assumed that the rumors of a supply disruption must have come true, and they rushed to buy back some of the contracts that they had sold to Jones earlier. Before very long, pandemonium broke out; the speculators and dealers whom Jones had left short were scrambling to protect themselves from spiking prices, driving those prices up further as they did so. By sensing when the market was poised for a rally and having the guts to give it a kick start, Jones made off with a handsome profit.30

  These maneuvers did not mean that Jones had boundless power over markets. “I can go into any market at just the right moment, by giving it a little gas on the upside, I can create the illusion of a bull market,” he once confessed. “But, unless the market is really sound, the second I stop buying, the price is going to come right down.”31 Yet although Jones was trying to emphasize the limits to his power over prices, it was more the admission than the qualification that stood out: The fact that Jones could move the market, if only for a short time, was in itself remarkable. Jones was like a boy atop a mountain after a fresh snowfall; if a great mass of powder was ready to tumble down the slope, he could throw a well-aimed stone and set off an avalanche of money. Of course, as Jones insisted, he could no more move a market against fundamental economic forces than a boy on a mountain can cause snow to fall uphill. But the ability to start an avalanche is a formidable thing. If he could judge a market’s potential for a move, Jones could set off a chain reaction at a time of his choosing—and be the first to win from it.

  Jones’s power to cause avalanches reflected his willingness to risk enormous trades, but his reputation was also significant. When people saw the wild cowboy coming, they assumed that he would make the market move; their assumption was self-fulfilling. The more Jones gained in size and notoriety, the more his power grew—even in the deepest and most liquid markets. In the late 1980s, for example, Treasury bond futures changed hands routinely in $50 million lots, but Jones would sometimes send a broker into the pit with an order twice that size, triggering a panicked reaction from traders who wanted to be on the right side of the stampeding elephant.32 James Elkins, one of the biggest traders of S&P 500 stock-index futures in the early 1990s, recalls the effect that Jones could have. “Whenever he entered the market, the whole pit would run scared. My size could be bigger than his size, but his reputation was such that when he entered, it would throw the whole thing off whack. The reactions were dramatic.”33

  From his earliest days in the cotton pit, Jones had understood that the market is influenced by psychology; he was anticipating the academic findings on behavioral finance that surfaced from the late 1980s. Meanwhile, Jones also saw that markets have institutional quirks; here he anticipated an academic literature on tax-driven buying and selling, which created numerous kinks in the efficient-market hypothesis. But Jones’s most distinctive strength lay not in his awareness of the markets but in the fact that he was self-aware. He understood how his own trading could change the calculations of others, setting off profitable chain reactions.

  The more hedge funds grew in size and stature, the greater the consequence of Jones’s insight. For as billions of dollars flowed into the war chests of the most famous hedge titans, it was no longer just oil traders or silver traders who needed to beware. Starting in the 1990s, hedge funds became large enough to move markets of all kinds. They could even overpower governments.

  7

  WHITE WEDNESDAY

  In the autumn of 1988, Stan Druckenmiller agreed to join Soros Fund Management. His friends had advised him against entrusting his future to Soros, and Druckenmiller half expected the relationship to break down within a year or so.1 Soros had been dangling offers, saying that Druckenmiller was a genius who would take over his fund. But his record suggested that he would have trouble ceding real authority, and Druckenmiller wondered how far to rely on Soros’s assurances. The day before he started the new job, Druckenmiller went out to see the great man at his weekend home in Southampton. There on the front lawn he encountered Soros’s son, Robert. “Congratulations,” he was told, “you’re my father’s ninth permanent successor.”2

  Soros and Druckenmiller were stylistic opposites. If Soros’s hobby was to write philosophical books, Druckenmiller’s was to watch the Pittsburgh Steelers butt heads at Three Rivers Stadium. But as investors the two men were an ideal fit. Like Soros, Druckenmiller came out of a stock-picking background. Like Soros, he was not really attached to it.

  Druckenmiller began his career as an equity analyst at the Pittsburgh National Bank, but his rapid progression prevented him from mastering the tools that most stock experts take for granted. Promoted to the position of research director at the grand old age of twenty-five, he never spent long enough in the trenches to develop an edge in analyzing corporate balance sheets.3 Instead, his forte lay in combining different disciplines. To a solid sense of equities he added a strong feel for currencies and interest rates, picked up from the PhD course in economics that he had begun before deciding that the ivory tower was not to his liking. As one admiring colleague put it, Druckenmiller understood the stock market better than economists and understood economics better than the stock pickers; it was a profitable mixture. By following equities and speaking regularly with company executives, Druckenmiller got advance warning of economic trends, which informed his view of bonds and currencies. By following economies, he got advance warning of the climate for stocks. If a currency was heading downward, export stocks would be a buy. If interest rates were rising, it was time to short real-estate developers.

  To his sense of companies and economies Druckenmiller added a third skill: technical analysis. His first boss in Pittsburgh had been a student of charts, and although most stock pickers disdained this pattern recognition as voodoo, Druckenmiller soon found it could be useful. It was one thing to do the fundamental analysis that told you that a stock or bond was overvalued; it was another to know when the market would correct, and the charts hinted at the answers. Technical analysis taught Druckenmiller to be alert to market waves, to combine the trading agility of Paul Tudor Jones with the stock-picking strengths of Julian Robertson. He survived the crash of 1987 and profited richly in the days after. The same could not be said for any of the managers who came out of a pure equity background—not even Soros.

  After four years at the bank in Pittsburgh, Druckenmiller gave a presentation in New York. At the end of the meeting he was accosted by an impressed member of the audience.

  “You’re at a bank! What the hell are you doing at a ba
nk?”

  After chatting with Druckenmiller for a few minutes, the man asked: “Why don’t you start your own firm?”

  Druckenmiller didn’t have enough capital behind him, but the man persisted: “I’ll pay you ten thousand dollars a month just to speak to you.”4

  And so in February 1981, at the age of twenty-eight, Druckenmiller launched Duquesne Capital Management and began to hone his style as a macro trader of the new school, blending views on companies and economies with a sense of the charts to create a freewheeling portfolio. Four years later he attracted the attention of the mutual-fund company Dreyfus, which invited him to manage several funds while also running Duquesne; one Druckenmiller fund shot up 40 percent within three months, turning the young manager into a Wall Street celebrity. In 1987, when the publication of The Alchemy of Finance revealed Soros’s blend of fundamental and technical trading, Druckenmiller saw that the master had a style that resembled his approach. The two men met over lunch at Soros’s office and experienced an instant meeting of the minds. By the end of that first encounter, Soros had made his first attempt at hiring Druckenmiller.