If ever irrational markets cried out for efficiency-enforcing arbitrage, the dot-com bubble surely was a clear example. Equity analysts usually value companies by looking at their earnings and their likely growth—these give a measure of the cash that will ultimately flow to investors. But the technology start-ups that flooded the market in the late 1990s had no earnings at all; by traditional yardsticks, their intrinsic worth was zero. Nevertheless, investors fell over themselves to buy tech stocks, or even stocks that in some way seemed connected to the Internet. In November 1998, for example, a plodding bookseller named Books-A-Million announced it was improving its Web site; within three days of this unremarkable news, its share price jumped tenfold. The following March a start-up called Priceline.com gained 425 percent on its first day of trading, which meant that this untested Web site for selling airline tickets was deemed to be worth more than United Airlines, Continental Airlines, and Northwest Airlines combined. The airlines own terminals, landing slots, and fleets of passenger aircraft, but never mind. Priceline.com owned some software, a couple of computers, and a chunk of William Shatner, the Star Trek actor who appeared in its commercials.9
How would hedge funds respond to this insanity? If they were the efficiency-enforcing actors that optimists imagine, they would sell the Internet stocks short until they brought their prices down to a more rational level. If they were trend followers, on the other hand, they would buy into the bubble and reinforce it. For believers in markets, it is hard to accept that intelligent investors would miss the opportunity to short something that is evidently overpriced—indeed, this is what investors need to do in order to justify their existence. The case for tolerating highly paid investment managers, after all, is that they contribute something useful to society: By enforcing efficient pricing, they allocate scarce capital to the companies that will use it best—not to bubbly start-ups with underwhelming ideas that will take scarce capital and waste it. Bubbles channel money to managers who don’t know how to manage. They finance business plans that nobody wants. And when they eventually burst, they leave ordinary savers with losses.
But there are limits to arbitrage, as we have seen. No one investor can deflate a bubble by himself. Even the biggest hedge funds of the late 1990s, Tiger and Quantum, had just over $20 billion under management at their peaks; they could hardly challenge the momentum of the technology-heavy NASDAQ stock index, whose total capitalization topped $5 trillion. Because hedge funds remained small relative to the market, a bet against the bubble would come good only if others bet the same way, and a hedge fund could sustain heavy losses in the meantime. If those losses spooked investors into yanking their money out of the hedge fund, the fund would have to unwind its bet against the bubble before it paid off. “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.
As the bubble inflated in 1999, Julian Robertson declined to fight it. He had no doubt that technology stocks were way too high, but he had lost money on technology shorts the previous year and had concluded that there was no safe way to bet against the bubble. He was comfortable shorting individual companies, because he could hedge out the risk of a general rise in the market by going long similar stocks. But when the entire technology sector was overvalued, hedging became hard: Robertson couldn’t short all tech stocks while going long an equivalent bucket of assets, since there was no such equivalent. Besides, the momentum in the tech bubble seemed almost unstoppable. Robertson likened the NASDAQ to a locomotive hurtling down the tracks. It was certain to come off the rails, but there was no telling when. Only a fool would stand in front of it.10
Rather than fight a bubble he viewed as absurd, Robertson decided to ignore it. Having resolved to scale back his macro bets after his losses on the yen, he resolved to stay clear of the tech sector also. But this strategy brought fresh problems of its own. Tiger had grown so big that it was hard to deploy its capital at the best of times; now, with two investment frontiers considered off limits, Tiger’s size problem grew critical. Robertson concentrated his bets on traditional value stocks such as Federal-Mogul Corporation, an auto parts supplier, and Niagara Mohawk, a power company—the very essence of the old economy. But it was hard to find appealing companies in which Tiger could take meaningful stakes.
Robertson’s difficulties were summed up by his investment in US Airways. In early 1996, the airline’s board had appointed a cost-cutting turnaround artist as chief executive, and Robertson had wisely bought a large stake in the company. By the summer of 1998, the bet had paid off: US Airways stock had quintupled. But rather than declaring victory and selling, Robertson had held on—despite the fact that the stock’s appreciation meant that his stake was now worth an astronomical $1.5 billion and represented about one fifth of the company.11 Recognizing the dangers, Tiger’s airline analyst had counseled Robertson to sell part of the position when US Airways organized a share buyback in early 1998, but Robertson had refused: “It’s one of my best ideas,” he had countered.12 Given the finite number of opportunities available to a supersized value investor, Robertson was prepared to hold on to a position long after his original investment thesis had paid off, never mind the fact that it had grown too big to be liquid.
The risks in this behavior soon became apparent. At the start of 1999, US Airways reported disappointing profits and the stock dropped like a stone, shedding 29 percent in three weeks of trading. Robertson wrote to his investors, defiantly predicting that the stock could triple by the end of the year as the market regained its respect for old-economy companies. But the news failed to get better. In July the airline’s machinists voted to reject a pay contract, and a strike seemed on the cards; in August work stoppages forced some flight cancellations. As the stock continued to head down, there was no way that Robertson could sell his vast position on the open market without sending its price into free fall; he had become an owner rather than an investor. Tiger was reduced to rooting around for a strategic buyer of the airline that might take a large block off its hands, and meanwhile, Robertson’s other value bets were souring. Federal-Mogul, the auto parts maker, fell 30 percent in the first half of the year, while Niagara Mohawk was flat. The investing public was losing interest in old-fashioned value stocks. “We are going through a most unusual market where in many instances fundamentals are being ignored,” Robertson wrote to his investors in April.13
By the summer of 1999, Robertson’s decision to ignore the tech boom was causing a crisis on Park Avenue. Tiger had lost 7.3 percent in the first half of the year; meanwhile, technology-heavy mutual funds were up by a quarter or more, and day traders operating from kitchen tables were outperforming Robertson’s special-forces unit. Coming on top of the losses on the yen in the fall of 1998, the latest setbacks strained investors’ patience: Having withdrawn a net $3 billion from Tiger in the six months to March, Robertson’s partners withdrew another $760 million at the end of the second quarter. The more investors pulled out, the more Robertson was forced to liquidate holdings.14 And once Wall Street understood that Tiger had become a forced seller, the old predatory instincts returned. Each month in his letter to investors, Robertson reported Tiger’s top ten stock positions, so there was no secret as to what he held; naturally his rivals did their best to sell ahead of him. On one hair-raising day in June, a rumor that Tiger would face $3 billion in withdrawals at the end of the month triggered a spasm of predatory sales: Tiger’s portfolio lost $72 million in fifteen minutes, at a time when the broad market was steady.15 The rumor turned out to be wrong, but that was only modest consolation.
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. Commentators who insist that hedge-fund transparency would stabilize markets might usefully ponder this lesson.16
ONE MILE NORTH OF TIGER’S OFFICE, A SHORT WALK FROM Central Park, Robertson’s friends and rivals at Quantum were fighting a parallel battle. At the start of 1999, Stan Druckenmiller, Quantum’s supremo, had shared Robertson’s conviction that tech stocks were too high; but he had acted differently. Undeterred by the market’s momentum, Druckenmiller had placed an unhedged, outright bet against the tech bubble, picking a dozen particularly overvalued start-ups and shorting $200 million worth of them. Immediately, all of them shot up with a violence that made it impossible to escape: “They’d close one day at a hundred and open at one forty,” Druckenmiller remembered with a shudder.17 Within a few weeks the position had cost Quantum $600 million. By May 1999, Druckenmiller found himself 18 percent down. For the first time in his long career, he faced the prospect of a year with significant negative performance.18
Druckenmiller confronted an acute form of the danger that menaced Robertson. The previous year Quantum had been up 21 percent up while Tiger was down 4 percent, but now that he had stood in front of the technology locomotive, Druckenmiller’s losses were twice as bad as Robertson’s. Inevitably, investors chafed. In May a big feeder fund called Haussmann Holdings announced that it had cut its investments in Soros Fund Management by more than half, and the press reported on a stream of Quantum analysts who were leaving for better opportunities. Commentators started to ask whether the Druckenmiller legend was over. There were rumors that the big man might take a three-month medical leave. When these were vigorously denied, a fresh round of rumors intimated that Soros might be tiring of his alter ego.
And yet in an important way, Druckenmiller was better equipped for the technology boom than Robertson. Tiger’s value-investing tradition made it almost unthinkable for Robertson to buy into the bubble.19 Druckenmiller’s blend of traditional analysis and charts made him altogether less predictable. Whereas Robertson had no patience for investing on the basis of momentum, Druckenmiller was fully capable of following the fundamentals in one period and surfing the trend in the next one. In May 1999 Druckenmiller allocated some of Quantum’s capital to a new hire named Carson Levit, who loaded up on dot-com stocks. The skeptic who had shorted the bubble now climbed aboard the bandwagon.
Two months later, Druckenmiller attended the annual technology and media conference in Sun Valley, Idaho. It was a festival of new-economy bullishness and buzz: Everyone from Hollywood moguls to presidential contenders to Silicon Valley whiz kids got together in the shadow of breathtaking mountains; and even Warren Buffett, whose value-investing style had been hammered by the bubble, could be seen pottering about in a polo shirt and baseball cap, chatting with Bill Gates and Michael Bloomberg.20 When Druckenmiller returned from Sun Valley that summer, he had the zeal of the convert.21 He allocated more of Quantum’s capital to Carson Levit and hired a second technology enthusiast named Diane Hakala, whose hobby was to perform dizzying spins as an aerobatic pilot. Levit and Hakala piled into the same sorts of stock that Druckenmiller had shorted in the first part of the year. They were “in all this radioactive shit that I don’t know how to spell,” Druckenmiller said later.22
The radioactivity did wonders for Quantum’s performance. Tech stocks took off like a rocket: Names like VeriSign, Qualcomm, and Gemstar were hailed as the heroes of the new era. Whereas in the first half of the year Quantum had trailed Tiger, now Quantum actually benefited from its rival’s misfortune. As withdrawals by Tiger’s investors forced Robertson to sell stocks, he dumped a vast stake in South Korea Telecom that he had bought before the bubble. The pressure of Robertson’s selling caused South Korea Telecom to drop by a third in July and August. Carson Levit bought into this liquidation on the cheap. The stock promptly tripled.23
In the last months of 1999, Druckenmiller made more from surfing tech stocks than he had made from shorting sterling eight years earlier. Quantum went from down 18 percent in the first five months of the year to up 35 percent by the end of it. Druckenmiller had pulled off one of the great comebacks in the story of hedge funds, and it had nothing whatever to do with pushing markets to their efficient level.
MEANWHILE, OTHER HEDGE FUNDS WERE GRAPPLING with the tech bubble. In early 1999, an army of short sellers picked a fight with the Internet service provider America Online, which had embraced a bubbly new way of accounting for its marketing expenditures. If the company spent $1 million on attracting new subscribers, it did not recognize that cost immediately; it treated its advertising as an investment, to be counted against revenues bit by bit, like the cost of buying plant and machinery. The short sellers were correct that this was a low trick, and eventually America Online abandoned it.24 But the company’s share price refused to break its upward stride: The short sellers won the accounting argument, but they still lost their shirts in the investment. Mary Meeker, the Morgan Stanley analyst who had been dubbed the “Queen of the Net” by Barron’s, conceded that old-school value investors, brought up on the classic teachings of Ben Graham and David Dodd, might have trouble seeing the value in a company that would report losses if it respected the accounting rules.25 But that was the old timers’ problem. At one new-economy gathering, a banker was overheard saying, “No traditional Graham and Dodd investor invested in AOL. They shorted it. And got fucked. They’re learning the new model.”26
A few months later, a hedge fund called Greenlight Capital took another shot at a puffed-up Internet outfit. Its target was Chemdex, a business-to-business network for companies to sell chemicals to one another. Chemdex earned a commission on every trade that the companies made through its network, but it booked the entire value of the goods exchanged as revenue. This stratagem seemed so outrageous that Greenlight’s founder, David Einhorn, could not resist having a go: He took a large short position in Chemdex in September 1999, when the company’s stock was trading at $26. But in the unhinged atmosphere of the bubble, even the most questionable accounting failed to faze other investors. In December, Queen Mary of Morgan Stanley declared, “We think Chemdex has got what it takes,” and by February the stock had risen more than sixfold, to a mind-bending $164. Needless to say, by late 2000 Chemdex had collapsed to $2 per share. But that was too late to help Einhorn, who was forced out of his Chemdex short before the bubble burst, nursing enormous losses.27
Despite periodic suspicions that short sellers at hedge funds can manipulate markets, the tech market of 1999 swatted away hedge-fund skeptics like flies on the rump of an elephant. The manipulation took place elsewhere: Companies were cooking their accounts, auditors were turning a blind eye, and investment banks engaged in shameless hype about the tech companies they brought to market. Seeing that they had no hope of bucking the mania, hedge funds mostly chose to jump on for the ride. Some bought into the bubble because they believed the hype or because their style was to milk trends. Some reasoned that the Fed’s monetary policy was extraordinarily loose, so the hot asset of the moment would attain stratospheric valuations.28 And some bought initial public offerings of tech stocks because they were insiders in a dubious game: As part of the hype that fueled the bubble, investment banks created a scramble for tech stocks by parceling out new issues cheaply, virtually printing money for the lucky funds with access to initial offerings. In sum, hedge funds were no more prone to ride the bubble than other types of money managers; but they were not more contrarian, either.29 While the bubble was building, only the bravest value investors were foolhardy enough to fight it.
The bravest and the foolhardiest of all was Julian Robertson. Tiger lost 17 percent in the third quarter, even as momentum surfers were reaping extraordinary profits. The hemorrhaging of investors continued: When the window for redemptions opened at the end of September, a net $1.3 billion was yanked away from Robertson. Tiger had gone from a peak of $21 billion in assets in August 1998 to $9.5 billion just over a year on, and some $5 billion
of the decline was due to clients voting with their wallets. For Robertson, it was not just money that he was losing. He had made Tiger his family, his personal network of power brokers and friends; he had run a special-forces unit and led team-building excursions out west; he was not used to defeat, still less the ignominious rout he was experiencing. Sometimes in his lowest moments, he would call his old lieutenant, John Griffin, who was now running a hedge fund of his own. “John, can you believe that I got a letter from so-and-so who has been in Tiger since 1982?” Robertson would say. “He says he’s buying a house. He needs his money back. He’s just lost faith in me.”30
In an attempt to slow the race for the exit, Robertson announced that he would allow investors to redeem capital from his funds on two occasions per year rather than four. But although this was a mild restriction compared with the lockups that hedge funds imposed on clients in the next decade, Robertson backed down from his new policy. His investors protested that they had proved their loyalty by keeping their money in his funds through the past, terrible year, so why should they now be chained to the Titanic? Robertson conceded that they had a point, but the next generation of hedge-fund managers learned from his defeat. To reduce the mismatch between yankable capital and potentially illiquid investments, they permitted investors to withdraw their cash at ever less frequent intervals.
Unable to lock in money, Robertson was forced to sell positions whether or not they were liquid. This made him a sitting duck. His rivals knew what he had to unload, and they went short in anticipation. Between August and October, as rumors of Tiger’s unraveling mounted, the number of US Airways shares sold short rose from 1.6 million to 3.8 million, driving the already battered stock down by another tenth; between September and October, short sales of Federal-Mogul leaped from 3.7 million shares to 6.5 million, forcing the stock down by 80 percent. Reflecting on Tiger’s gargantuan liquidations—Robertson had sold some $40 billion of stocks and $60 billion of other positions over the past year—some considered it a miracle that Tiger was still standing at all. “How many financial institutions could have a $100 billion downsizing of their balance sheet?” asked Philip Duff, Tiger’s chief operating officer. “Few of those would probably survive,” he added.31
More Money Than God_Hedge Funds and the Making of a New Elite Page 30