Thorp stood ramrod straight from his habit of continual exercise. Until 1998, when he injured his back, he ran a few marathons a year. He was trim, six feet tall, with the etched features of an aging athlete. His gaze was clear and steady behind a pair of square gold-framed glasses. Thorp had been taking a large number of pills every day, as part of his hope that he will live forever. After he dies, his body will be cryogenically frozen. If technology someday advances far enough, he’ll be revived. Thorp estimates that his odds of recovering from death are 2 percent (he’s quantitative literally to the end and beyond). It is his ultimate shot at beating the dealer.
Even if corporeal immortality was unlikely, Thorp’s mark on Wall Street was vast and indelible. One measure of that influence lay in a squat chalk-white building, its flat-topped roof flared like an upside-down wedding cake, a short walk from his office in Newport Beach.
The building houses Pimco, one of the largest money managers in the world, with nearly $1 trillion at its disposal. Pimco is run by Bill Gross, the “Bond King,” possibly the most well-known and powerful investor in the world besides Warren Buffett. A decision by Gross to buy or sell can send shock waves through global fixed-income markets. His investing prowess is legendary, as is his physical stamina. When he was fifty-three, he decided to run a series of marathons—five of them, in five days. On the fifth day, his kidney ruptured. He saw blood streaming down his leg. But Gross didn’t stop. He finished the race, collapsing into a waiting ambulance past the finish line.
Gross would never have become the Bond King without Ed Thorp. In 1966, while a student at Duke University, Gross was in a car accident that almost killed him—he was nearly scalped, as a layer of skin was ripped from the top of his head. He spent six months recovering in the hospital. With lots of time to kill, he cracked open Beat the Dealer, testing the strategy in his hospital room over and over again.
“The only way I could know if Ed was telling the truth was to play,” said Gross later that day in a conference room just off Pimco’s expansive trading floor. His red tie hung jauntily untied around his neck like a scarf. A tall, lanky man with combed-back orange-tinted hair who meditates daily, Gross appeared so relaxed it was as if he were getting an invisible massage as he sat in his chair. “And lo and behold, it worked!” Thorp, sitting to Gross’s right, gave a knowing chuckle.
After he recovered from his accident, Gross decided to see if he could make the system pay off in the real world, just as Thorp had done in the early 1960s. With $200, he headed out to Las Vegas. In rapid fashion, he parlayed that into $100,000. The wad of cash helped pay for graduate school at the University of California, Los Angeles, where Gross studied finance. That’s where he came across Beat the Market. Gross’s master’s thesis was based on the convertible-bond investment strategies laid out in the book—the same strategies Ken Griffin used to build Citadel.
Soon after reading Thorp’s book, Gross had an interview at a firm then called Pacific Mutual Life. He had no experience trading and had little chance of landing a job. But his interviewer noticed that his thesis was on convertible bonds. “The people who hired me said, ‘We have a lot of smart candidates, but this guy is interested in the bond market.’ So I got my job because of Ed,” said Gross.
As Gross and Thorp sat together in Pimco’s conference room, they got to musing about the Kelly criterion, the risk management strategy Thorp used starting with his blackjack days in the 1960s. Pimco, Gross noted, uses a version of Kelly. “Our sector concentration is predicated on that—blackjack and investments,” he said, gesturing toward the trading floor. “I hate to stretch it, but professional blackjack is being played in this trading room from the standpoint of risk management, and that ultimately is a big part of our success.”
Thorp nodded in agreement. The key behind Kelly is that it keeps investors from getting in over their heads, Thorp explained. “The thing you have to make sure of is that you don’t overbet,” he said.
The conversation turned to hedge funds and leverage. A river of money had flowed into hedge funds in recent years, turning it from an industry with less than $100 billion under management in the early 1990s to a $2 trillion force of nature. But the amount of actual investing opportunities hadn’t changed very much, Thorp said. The edge had diminished, but hedge fund managers’ and bankers’ appetite for gigantic profits had only grown more voracious. That led to massive use of leverage—in other words, overbetting. The inevitable end result: gambler’s ruin on a global scale.
“A classic example is Long-Term Capital Management,” Thorp said. “We’ll be seeing more of that now.”
“The available edge has been diminished,” Gross agreed, noting that Pimco, like Warren Buffett’s Berkshire Hathaway, used very little leverage. “And that led to increased leverage to maintain the same returns. It’s leverage, the overbetting, that leads to the big unwind. Stability leads to instability, and here we are. The supposed stability deceived people.”
“Any good investment, sufficiently leveraged, can lead to ruin,” Thorp said.
After about an hour, Gross stood, shook hands with the man responsible for getting him started, and walked onto Pimco’s trading floor to keep an eye on the nearly $1 trillion in assets he ran.
Thorp walked back to his own office. It turned out that he was doing a little trading himself.
Sick and tired of watching screwups by managers he’d hired to care for his money, Thorp had decided to take the reins himself once again. He’d developed a strategy that looked promising. (What was it? Thorp wasn’t talking.) In early 2008, he started running about $36 million with the strategy.
By the end of 2008, the strategy—which he called System X to outsiders—had gained 18 percent, with no leverage. After the first week, System X was in positive territory the entire year, one of the most catastrophic stretches in the history of Wall Street, a year that saw the downfall of Bear Stearns, AIG, Lehman Brothers, and a host of other institutions, a year in which Citadel Investment Group coughed up half of its money, a year in which AQR fell more than 40 percent and Saba lost nearly $2 billion.
Ed Thorp was back in the game.
On a sultry Tuesday evening in late April 2009, the quants convened for the seventh annual Wall Street Poker Night in the Versailles Room of the St. Regis Hotel in midtown Manhattan.
It was a far more subdued affair than the heady night three years earlier when the elite group of mathematical traders stood atop the investing universe. Many of the former stars of the show—Ken Griffin, Cliff Asness, and Boaz Weinstein—were missing. They didn’t have time for games anymore. In the new landscape, the money wasn’t pouring in as it used to. Now they had to go out and hustle for their dollars.
Griffin was in Beverly Hills hobnobbing with former junk bond king Michael Milken at the Milken Institute Global Conference, where rich people gathered for the primary purpose of reminding one another how smart they are. His IPO dreams had evaporated like a desert mirage, and he was furiously trying to chart a new path to glory. But the wind was blowing against him in early 2009. Several of his top traders had left the firm. And why not? Citadel’s main fund, Kensington, had lost more than half its assets in 2008. In order to collect those lucrative incentive fees—the pie slice managers keep after posting a profit—the fund would need to gain more than 100 percent just to break even. That could take years. To instant-gratification hedge fund managers, you might as well say forever. Or how about never?
Griffin wasn’t shutting down the fund, though. Instead, he was launching new funds, with new strategies—and new incentive fees. He also was venturing into the investment banking world, trying to expand into new businesses as others faded. The irony was rich. As investment banks turned into commercial banks after their failed attempt to become hedge funds, a hedge fund was turning into an investment bank.
Some saw it as a desperate move by Griffin. Others thought it could be another stroke of genius. The toppled hedge fund king from Chicago was moving to take over b
usiness from Wall Street as his competitors were shackled by Washington’s bailouts. His funds had made something of a comeback, advancing in the first half of the year as the chaos of the previous year abated. Whatever the case, Griffin hoped investors would see the debacle of 2008 as a one-time catastrophe, never to be repeated. But it was a tough sell.
Weinstein, meanwhile, was in Chicago hustling for his hedge fund launch. He was busy trying to convince investors that the $1.8 billion hole he’d left behind at Deutsche Bank was a fluke, a nutty mishap that could only happen in the most insane kind of market. By July, he’d raised more than $200 million for his new fund, Saba Capital Management, a big fall from the $30 billion in positions he’d juggled for Deutsche Bank. Setting up shop in the Chrysler Building in mid-town Manhattan, Saba was set to start trading in August.
Asness stayed home with his two pairs of twins and watched his beloved New York Rangers lose to the Washington Capitals in the decisive game seven of the National Hockey League’s Eastern Conference playoff series. He was also busy launching new funds of his own. AQR had even ventured into the plain-vanilla—and low-fee—world of mutual funds. In a display of confidence in his strategies, Asness put a large chunk of his own money into AQR funds, including $5 million in the Absolute Return Fund. He also put $5 million into a new product AQR launched in 2008 called Delta, a low-fee hedge fund that quantitatively replicated all kinds of hedge fund strategies, from long-short to “global macro.” Several of AQR’s funds had gotten off to a good start for the year, particularly his convertible bond funds—the decades-old strategy laid out by Ed Thorp in Beat the Dealer that had launched Citadel and hundreds of other hedge funds in the 1990s. Asness even dared to think the worst, finally, was behind him. He managed to find a bit of time to unwind. After working for months straight with barely a weekend off, Asness took a vacation in March to hike the craggy hills of Scotland. He even left his BlackBerry behind. But there were still reminders of his rough year. A newspaper article about AQR mentioned Asness’s penchant for smashing computers. To his credit, he was now able to laugh at the antics he’d indulged in at the height of the turmoil, writing a tongue-in-cheek note to the editor protesting that it had “happened only three times, and on each occasion the computer screen deserved it.”
But there was Peter Muller, walking briskly among the poker crowd in a brown jacket, well tanned, slapping old friends on the back, beaming that California smile.
Muller seemed calm on the outside, and with good reason: having earned north of $20 million in 2008, he was one of Morgan’s highest earners for the year. Inside, he was seething. The Wall Street Journal had broken a story the week before that PDT might split off from Morgan Stanley, in part because its top traders were worried that the government, which had given the bank federal bailout funds, would curb their massive bonuses. Muller had been working on a new business model for PDT for more than a year but was biding his time before he went public with his plans. The Journal article beat him to the punch, causing him no end of bureaucratic headaches. PDT had, in a flash, become a pawn in a game of giants—Wall Street versus the U.S. government. The move looked to some as if Morgan had crafted a plan to have its cake and eat it, too—spin off PDT, make a big investment, and get the same rewards while none of the traders lost a dime of their fat bonuses.
To Muller, it was a nightmare. Ironically, Morgan insiders even accused Muller of leaking the story to the press. Of course, he hadn’t: Muller didn’t talk to the press unless he absolutely needed to.
But he had one thing to look forward to: poker. And when it came to poker, Muller was all business.
Jim Simons, now seventy-one years old, was in attendance, hunched over a crowded dining table in a blue blazer and gray slacks, philosophically stroking his scraggly gray beard. But all was not well in Renaissance land. While the $9 billion Medallion fund continued to print money, gaining 12 percent in the first four months of the year, the firm’s RIEF fund—the fabled fund that Simons once boasted could handle a whopping $100 billion (a fantasy it never even approached)—had lost 17 percent so far in 2009, even as the stock market was rising, tarnishing Simons’s reputation as a can’t-lose rainmaker. RIEF investors were getting upset about the disparity between the two funds, even though Simons had never promised that it could even approach the performance of Medallion. Assets in Renaissance had fallen sharply, sliding $12 billion in 2008 to $18 billion, down from a peak of about $35 billion in mid-2007, just before the August 2007 meltdown.
There were other big changes in Simons’s life, hints that he was preparing to step down from the firm he’d first launched in 1982. In 2008, he’d traveled to China to propose a sale of part of Renaissance to the China Investment Corp., the $200 billion fund owned and run by the Chinese government. No deal was struck, but it was a clear sign that the aging math whiz was ready to step aside. Indeed, later in the year Simons retired as CEO of Renaissance, replaced by the former IBM voice recognition gurus Peter Brown and Robert Mercer.
Perhaps most shocking of all, the three-pack-a-day Simons had quit smoking.
Meanwhile, other top quants mixed and mingled. Neil Chriss, whose wedding had seen the clash of Taleb and Muller over whether it was possible to beat the market, held session at a table with several friends. Chriss was a fast-rising and brilliant quant, a true mathematician who’d taught for a time at Harvard. He’d recently launched his own hedge fund, Hutchin Hill Capital, which received financial backing from Renaissance and had knocked the cover off the ball in 2008.
In a back room, before play began, a small private poker game was in session. Two hired-gun poker pros, Clonie Gowen and T. J. Cloutier, looked on, wincing from time to time at the clumsy play.
The crowd, still well heeled despite the market trauma, was dining on rack of lamb, puff pastry, and lobster salad. Wine and champagne were served at the bar, but most were taking it slow. There was still a lot of poker to play. And the party atmosphere of years gone by was diminished.
A chime rang out, summoning the players to the main room. Rows of tables with cards fanned out across them and dealers prim in their vested suits awaited them. Simons addressed the gathering crowd, talking about how the tournament had been getting better and better every year, helping advance the cause of teaching students mathematics. The quants in attendance somehow didn’t think it ironic that their own profession amounted to a massive brain drain of mathematically gifted people who could otherwise find careers in developing more efficient cars, faster computers, or better mousetraps rather than devising clever methods to make money for the already rich.
Soon enough play began. The winner that night was Chriss, whose hot hand at trading spilled over to the poker table. Muller didn’t make the final rounds.
It had been a wildly tumultuous three years on Wall Street, drastically changing the lives of all the traders and hedge fund managers who’d attended the poker tournament in 2006. A golden era had come and passed. There was still money to make, but the big money, the insane money, billions upon billions … that train had left the station for everyone but a select few.
Muller, ensconced in his Santa Barbara San Simeon, was hatching his plans for PDT. Its new direction wasn’t just a change for Muller and company; it marked a seminal shift for Morgan Stanley, once one of the most aggressive kill-or-be-killed investment banks on Wall Street. By 2009, PDT, even in its shrunken state, was the largest proprietary trading operation still standing at Morgan. Its departure, if it happened, would cement the historic bank’s transformation from a cowboy, risk-hungry, money-printing hot rod into a staid white-shoe banking company of old that made money by making loans and doing deals—not by flinging credit default swaps like so many Frisbees through the Money Grid and trading billions in other tangled derivatives through souped-up computers and clumsy quant models.
Most assuredly, it would be a big change for PDT, once Morgan’s secret quant money machine, and its mercurial captain.
Griffin, Muller, Asness, and Weinst
ein were all intent on making it work again, looking boldly into the future, chastened somewhat by the monstrous losses but confident they’d learned their lessons.
But more risk lurked. Hedge fund managers who’ve seen big losses can be especially dangerous. Investors, burned by the losses, may become demanding and impatient. If big gains don’t materialize quickly, they may bolt for the exits. If that happens, the game is over.
That means there can be a significant incentive to push the limits of the fund’s capacity to generate large gains and erase the memory of the blowup. If a big loss is no worse than a small loss or meager gains—since either can mean curtains—the temptation to jack up the leverage and roll the dice can be powerful.
Such perverse and potentially self-destructive behavior isn’t countenanced by the standard dogmas of modern finance, such as the efficient-market hypothesis or the belief that the market always trends toward a stable equilibrium point. Those theories were increasingly coming under a cloud, questioned even by staunch believers such as Alan Greenspan, who claimed to have detected a flaw in the rational order of economics he’d long championed.
In recent years, new theories that captured the more chaotic behavior of financial markets had arisen. Andrew Lo, once Cliff Asness’s teacher at Wharton and the author of the report on the quant meltdown of August 2007 that warned of a ticking Doomsday Clock, had developed a new theory he called the “adaptive market hypothesis.” Instead of a rational dance in which market prices waltz efficiently to a finely tuned Bach cantata, Lo’s view of the market was more like a drum-pounding heavy-metal concert of dueling forces that compete for power in a Darwinian death dance. Market participants were constantly at war trying to squeeze out the last dime from inefficiencies, causing the inefficiencies to disappear (during which the market returns briefly to some semblance of equilibrium), after which they start hunting for fresh meat—or die—creating a constant, often chaotic cycle of destruction and innovation.
The Quants Page 34