In 1949, when Alfred Winslow Jones set up his hedged fund, the old-line merchant banks that ultimately emerged as modern investment banks were neither global nor public. Firms such as Goldman Sachs, Morgan Stanley, and Lehman Brothers began as private operations that deployed the partners’ capital in a flexible way, much like today’s hedge funds. They managed risk ferociously—they were speculating not with other people’s money but rather with their own—and they were largely unregulated. Over the next half century, however, the investment banks sold shares in themselves to the public and opened offices around the world, not so much because sprawling public enterprises are superior platforms from which to manage risk but because the rewards to the leaders of these firms were irresistible. Every investment bank that went public unlocked millions of dollars of instant wealth for the partners, who swapped illiquid ownership stakes for liquid stock. Every expansion into a new market created a fresh opportunity to risk shareholders’ capital and to collect the 50 percent quasi performance fee if the risks turned out to be lucrative. The incentives that are baked into a public company pushed the investment banks to take ever greater risk, until eventually they paid the price. When Goldman Sachs and Morgan Stanley became bank holding companies at the end of 2008, they were admitting that they could survive the consequences of their public-company status only if the Fed backstopped them.
Today, hedge funds are the new merchant banks—the Goldmans and Morgans of half a century ago. Their focus on risk is equally ferocious, and they are equally lightly regulated. But the same logic that tempted the old merchant banks to go public will seduce some hedge funds too; already a handful have sold shares in themselves, and doubtless more will follow. When that happens, hedge funds will pose the threat to the financial system that they have wrongly been accused of posing in the past. The wheel of Wall Street turns. Greed and risk are always with us.
ACKNOWLEDGMENTS
My first debt is to my sources. Over the course of three years, I conducted hundreds of interviews, including perhaps 150 face-to-face recorded encounters lasting anywhere up to four hours. Many of my subjects responded to multiple requests for additional detail, patiently helping me to reconstruct events as accurately as possible. I am especially grateful to those who shared old letters, e-mails, and memoranda that captured the protagonists’ reasoning at key moments. Robert Burch IV provided me with the founding manifesto of hedge funds, the “Basic Report” written in 1961 by his grandfather, A. W. Jones. Julian Robertson allowed me to read all his monthly letters to investors, spanning the twenty-year life of his Tiger fund; spiced with observations about fur-wearing men in Aspen and the difficulty of lowering one’s body temperature after a tennis match in Hong Kong, the two fat binders of Roberston’s letters were a book in themselves. Rodney Jones kept almost daily notes of the Asian financial crisis, allowing me to reconstruct the Soros funds’ role in Thailand, Indonesia, and South Korea in more detail than would have been possible based on interviews alone. Paul Tudor Jones wrote nocturnal e-mails that illustrated his thought process brilliantly. John Paulson’s memo to his investors laid out the logic of betting against the credit bubble so clearly that it makes you wonder how anyone could have been on the other side. For all these gems, and for the hours of conversation, I am deeply grateful. Where possible, I name sources in my endnotes, sometimes also quoting their memories and views at greater length than could be worked into my narrative. Inevitably, some of those to whom I am indebted cannot be thanked publicly. They know who they are.
Throughout this project, I have had the good fortune to work at the Council on Foreign Relations, where I direct the Maurice R. Greenberg Center for Geoeconomic Studies. Richard Haass, the council’s president, has succeeded in building the study of international finance and economics into the council’s traditional focus on international relations. This book is one consequence of his view that “the last time I checked, the world is not stovepiped.” Gary Samore and James Lindsay, the two directors of studies for whom I have worked, were generous in allowing me the time needed to complete a project of this scale. Richard and Jim provided useful comments on the manuscript; I am pleased that Gary did not do so, since by the time I finished, he was responsible for the U.S. government’s efforts to control weapons proliferation, a task from which he must not be distracted. My CFR colleagues Benn Steil and Brad Setser (until he followed Gary to the White House) have been terrific debating partners on questions of international finance. Leigh Gusts, Marcia Sprules, and Nicholaos Fokas of the CFR library tracked down microfilm of key articles that predated the online era. My loudest and most emphatic thank you goes to the CFR researchers who helped me assimilate vast quantities of material from primary and secondary sources. They mined financial history books, assembled news accounts, and transcribed those endless hours of interviews. Peter Rudegeair in particular immersed himself in this project for almost two years, and his talent for ferreting out colorful detail made him an invaluable collaborator. Chad Waryas, Peter Tillman, Jaclyn Berfond, and James Bergman all made extensive contributions. Paul Swartz, the data guru at the council, downloaded and analyzed the numbers I needed to anchor my story. I once asked Paul to check the performance of Italian bonds in the spring of 1994. He reported that no convenient Italian-bond index exists—and therefore he had constructed one.
The Council on Foreign Relations draws strength from its members, and this book is no exception. In New York, Robert Rubin, the council’s cochairman, convened a series of dinners with investment experts to discuss portions of my manuscript; his comments on several chapters helped me to sharpen my message. In Washington, D.C., Peter Ackerman led a similar series of meetings with financial policy makers, and was himself a terrifically enthusiastic reader. The council arranged for John Y. Campbell of Harvard and Richard Sylla of New York University to review the manuscript; since both waived their anonymity, I can thank them for their flattering and helpful comments. Several friends read all or portions of the book and provided their feedback. I should like to thank in particular Morris Goldstein and Ted Truman, both of the Peterson Institute for International Economics, as well as Craig Drill of Craig Drill Capital, Steve Freidheim of Cyrus Capital Partners, Tom Hill of the Blackstone Group, Douglas Elliott of the Brookings Institution, and my father, Christopher Mallaby. Throughout the three years of this project, my wife, Zanny Minton Beddoes of The Economist, has been my intellectual soul mate and much more besides.
This book would never have gotten off the ground without the enthusiasm of Scott Moyers, who was my editor at the Penguin Press and is now my agent at the Wylie Agency. Scott’s encouragement was seconded by Andrew Wylie, who rightly insisted that I rethink my original proposal and grapple harder with the rich variety of thought that explains the success of hedge funds. When Scott left Penguin, I was extremely fortunate to be adopted by Ann Godoff, the publisher at the Penguin Press. Ann’s flair for narrative, and her gut sense for the right balance between analysis and storytelling, make her the perfect editor. The team she has built around her at Penguin has been helpful throughout. I should particularly like to thank Karen Mayer for her careful and good-humored legal vetting, and Lindsay Whalen for keeping track of photos, copy edits, and cover designs. In London, Michael Fishwick and his team at Bloomsbury have been a joy to work with.
When I began this project, my youngest daughter, Molly, was three. Now she is six; the book has taken half her lifetime. The rest of my family may sometimes have felt that way too. For their love and patience, I am hugely grateful.
APPENDIX I: DO THE TIGER FUNDS GENERATE ALPHA?
Between its inception in May 1980 and its peak in August 1998, Julian Robertson’s Tiger fund 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.1 Counting in the collapse in 1999 and 2000, average performance was around 26 percent per year, still an impressive number. Over the twenty-one calendar years in which Tiger’s investment decisions were controll
ed by Robertson, the fund was up in seventeen of them. This is particularly striking given that Tiger’s staple business was stock selection, the discipline at which consistent outperformance has been found by academic studies to be nonexistent.
Could it be that Robertson was merely lucky? The laws of probability lay down that if one thousand people flip twenty-one coins, four of them will come up with heads seventeen or more times, mimicking Robertson’s performance. That still means that there are 996 in 1,000 chances that Robertson’s performance reflected skill. But, following the argument of Warren Buffett described in chapter five, there is a way to test the four-in-one-thousand possibility that Robertson’s record was a fluke. If fund managers who worked for Robertson went on to do well, it would suggest that they learned something from him. Robertson’s results could then be ascribed to skill with almost complete confidence.
To conduct this test, I sought the help of the Hennessee Group, which has been collecting data on hedge funds since 1987. No hedge-fund database is perfect, since all rely on voluntary self-reporting. Hennessee turned out to have monthly results for half of the thirty-six “Tiger cub” funds run by managers who had worked for Robertson at some point before 2000. (Tiger cubs are separate from “Tiger seeds,” which are funds that have received capital from Robertson since 2000.) The Hennessee data included two funds that blew up, so it was not subject to the “survivorship bias” that bedevils hedge-fund performance statistics. And because Tiger cubs tend to invest in equities rather than in less liquid loans or derivatives that are not traded on an exchange, their results are likely to be adjusted to reflect price moves promptly and cleanly. Every up and down wiggle is captured, minimizing the “smoothing bias” that occurs when hedge funds mark their portfolios to market infrequently.
Hennessee had never examined Robertson’s protégés as a group, but Hennessee’s senior vice president, Samuel Norvell, agreed to construct a Tiger Index for me. The results are presented at the end of this appendix, and the first striking finding is that the Tiger Index rose a lot. Between 2000 and 2008, it gained 11.9 percent per year, and that was despite the fact that performance was dragged down by a fall of almost 20 percent in 2008. The Tiger cub returns beat the pants off the S&P 500 index, which fell by an average of 5.3 percent per year during this period. It also beat Hennessee’s general hedge-fund index (up just 4.8 percent per year) and Hennessee’s index of hedge funds that practice the same long/short equity style as the Tiger group (up an average of 4.4 percent per year).
The strong performance of the Tiger Index suggests that Robertson transferred some kind of advantage to his offshoots—meaning that skill, not coin-flipping luck, would be likely to explain his own returns between 1980 and 2000. But the argument does not end there. Conceivably, the Tiger cubs might have achieved higher returns by taking extra risk, in which case there would be nothing to brag about. Thanks to the Nobel laureate William Sharpe, we have a way of testing whether this was so: If you divide the Tiger cubs’ returns by their volatility, you get a Sharpe ratio of 1.42—that is, a risk-adjusted return that is superior by far to any of the benchmarks. For instance, Hennessee’s general hedge-fund index had a Sharpe ratio of just 0.59. The comparison makes it difficult to resist the conclusion that the Tiger cubs learned something from Robertson.
Let’s try to resist a little longer. There are ways for hedge funds to game the Sharpe ratio by behaving like undercapitalized insurance companies.2 For example, a fund can sell options that insure against extreme swings in the market. For months and maybe years, the insurer will collect a steady stream of premiums from these options, delivering consistent, market-beating returns; but one day the extreme market swing will occur, at which point the fund will go bankrupt. Theoretically, unscrupulous hedge-fund managers may deliberately take this sort of hidden risk, calculating that the extreme swings may not arrive for years, allowing them to grow rich in the meantime. But the odds that the Tiger results reflect this sort of strategy are vanishingly small. For one thing, option writing is not a big part of the Tiger culture; nor do Tiger funds specialize in the sort of trades that can be equivalent to insurance selling. For another, the period covered by the Hennessee data includes the end of 2008, a period of extreme volatility in which undercapitalized quasi-insurance funds would have gone out of business.3 (Indeed, some did.) So the Tiger cubs’ superior Sharpe ratio looks like real evidence of skill, not the product of sly insurance selling.
Just for fun, let’s throw in one final thought experiment. Think of the Tiger Index as a contestant in Buffett’s coin-flipping contest. Between 2000 and 2008, the Tigers had positive returns in 79 months out of 108 and beat the S&P 500 index in 62 months out of 108. The chance of beating the market index that frequently by luck is only 7.43 percent. So the coin-toss test suggests that there are twelve chances out of thirteen that the funds in the Tiger Index had real skill, or alpha.
Pinpointing alpha is a slippery game, and imperfect data can only yield imperfect conclusions. But the weight of the evidence is overwhelmingly that both Robertson and his protégés had real skill, even though they practiced a branch of investing in which alpha generation is sometimes said to be impossible.
APPENDIX II: PERFORMANCE OF THE PIONEERS
NOTES
INTRODUCTION: THE ALPHA GAME
1. Joseph Nocera, “The Quantitative, Data-Based, Risk-Massaging Road to Riches,” New York Times Magazine, June 5, 2005, p. 44.
2. Visiting Asness in July 2009, I found the superheroes piled up on a coffee table pending their return to their usual positions on a recently cleaned windowsill. Asness regarded the task of arranging them in the correct order as too delicate to delegate to an assistant and had not had time to restore them to their usual glory.
3. It should be noted that in 2007, when Blackstone went public, Schwarzman got a cash payment of more than $600 million and retained shares in the company estimated to be worth more than $7 billion. On the other hand, public offerings by hedge funds around the same time also created enormous paper wealth for the founders.
4. Michael Steinhardt, No Bull: My Life In and Out of Markets (New York: John Wiley & Sons, 2001), p. 179.
5. Elaine Crocker, who was in charge of identifying and seeding portfolio managers at Commodities Corporation in the 1980s and who became president of Moore Capital in 1994, comments, “Rarely do portfolio managers articulate why they are successful. Sometimes they try to do so but are wrong. I have worked with hundreds of portfolio managers and found that articulating why they are successful is quite difficult for them—although often they are not aware that it is.” (Elaine Crocker, e-mail communication with the author, September 8, 2009.) Similarly, Roy Lennox, a longtime macro trader at Caxton, says, “Trading can be intuitive. We are looking at so many factors in the markets [that] a lot of our analysis operates on a subconscious level. All of a sudden you just know this is the right trade. If somebody really quizzed you, you probably couldn’t clearly articulate your views and would just say, no no no, I know this is the right trade. It’s because all these things have been taken in—the market action, the technicals, the things that you read in the newspapers or on Bloomberg and the conversations you have with other traders, analysts and policy makers. It just comes together.” (Roy Lennox, interview with the author, June 24, 2009.)
6. Jonathan R. Laing. “Trader With a Hot Hand—That’s Paul Tudor Jones II,” Barron’s, June 15, 1987.
7. Malcolm Gladwell, Blink: The Power of Thinking Without Thinking (New York: Penguin Books, 2005), p. 67. I am grateful to Chad Waryas for pointing out the parallel between trading and tennis.
8. Andrei Shleifer and Lawrence H. Summers, “The Noise Trader Approach to Finance,” Journal of Economic Perspectives 4, no. 2 (Spring 1990). In the wake of the financial crisis of 2007–2009, it was said that financial economists had finally been forced to wake up to market inefficiencies. But their existence had already been widely accepted among economists for at least two decades.
; 9. There are many more examples. Richard Thaler, the leading light in behavioral finance, is involved in the investment-management firm Fuller & Thaler. At Long-Term Capital Management, Eric Rosenfeld, a former finance professor at Harvard Business School, was more important but less famous than Merton and Scholes, the Nobel laureates. Kenneth French is a director of Dimensional Fund Advisors. Asness set up AQR with John Liew, whom he had known at Chicago’s PhD program.
10. Gwynne Dyer, “The Money Pit and the Pendulum,” The Globe and Mail, January 17, 1998.
11. For a description of this trade-off, see Jeremy C. Stein, “Sophisticated Investors and Market Efficiency” (working paper downloaded from Stein’s Web site at Harvard).
12. See Benn Steil, “Lessons of the Financial Crisis,” Council Special Report No. 45 (Council on Foreign Relations, March 2009).
13. Near the end of 2008, the ratio of Citigroup’s total assets to its tangible net worth was fifty-six to one. At the end of 2007 the total assets of the Swiss bank UBS exceeded its equity by fifty-three times.
14. It is true that hedge funds do not always mark their assets to market in a perfect way: There is evidence that they fudge them to make their returns appear less volatile. But hedge funds are nonetheless much closer to marking assets to market than are other financial institutions, notably banks.
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