THE SUCCESS OF STEINHARDT, FINE, BERKOWITZ DEMONSTRATED the capacity for contrarianism that marked later hedge funds. A. W. Jones had invented the hedge-fund structure to control market exposure. His go-go imitators had turned it into a way of maximizing market exposure. But the troika made it into something else—a vehicle for betting against conventional wisdom. Indeed, aggressive contrarianism became a sort of company credo, especially for Michael Steinhardt.
Some contrarians balance a faith in their opinions with a reluctance to offend, but Steinhardt positively enjoyed baiting people. He loved taking guests to see the exotic animals on his upstate New York farm, especially the Falkland flightless steamer duck, which would viciously bite anyone who approached too closely. He loved calling up a broker and placing a juicy order for a nonexistent stock, leaving the poor man scrambling to identify the company so that he could collect the commission. For a while in the 1980s, Steinhardt allowed he might need help: He permitted a psychiatrist to roam around his premises offering “organizational therapy.” The psychiatrist conducted interviews with staff members and noted the prevalence of expressions such as “battered children,” “random violence,” and “rage disorder.” But the therapy was cut short when Steinhardt lost his temper with the man and threw him out of the office.
If Steinhardt didn’t mind offending people, he loved offending the consensus. During the liberal 1970s he was a Republican, and during the Reaganite 1980s he leaned toward the Democrats. In the early 1990s he bankrolled the centrist Democratic Leadership Council, which helped to put Bill Clinton in the White House; as soon as Clinton was installed, Steinhardt turned against the movement.13 In his relationship with Judaism, he followed his own course: He declared he had no faith in God but gave millions to Jewish causes. And when it came to investing, Steinhardt’s contrarian instincts reached full flower. He trawled Wall Street for unconventional ideas and backed them on a scale that would terrify a normal mortal.
John LeFrere, an analyst hired by Steinhardt in the 1970s, recalls his first weeks on the job; he visited IBM and returned convinced that its profits were headed upward. At the partnership’s Monday-morning meeting, LeFrere recommended buying IBM stock ahead of that Friday’s quarterly results, but Steinhardt pushed back. The boss had been watching IBM splutter about aimlessly on the stock ticker, and he had a black feeling in his gut that the stock was going nowhere.
“Mike, I think you’re wrong,” LeFrere said. It took courage to contradict Steinhardt, but LeFrere had a strong build and figured he could bench him.
“I hate the pig,” said Steinhardt.
“Mike, I don’t care how it looks on the tape. The results are going to be good and the stock’s going up.”
Steinhardt’s contrarian radar flickered. “How much you want to buy then?”
“How about ten thousand?” LeFrere ventured, calculating that, with IBM trading at $365, owning three and a half million dollars’ worth of one stock was about the maximum conceivable.
Steinhardt hit a button and ordered his trader to buy 25,000 IBM immediately.
“Mike, I said ten thousand,” LeFrere said anxiously.
“How convinced are you of your fuckin’ opinion?” Steinhardt barked.
“I’m very convinced.”
“You better be right,” Steinhardt said grimly. He hit the button again and bought another 25,000.
That exchange left Steinhardt with some $18 million worth of IBM, representing perhaps a quarter of his capital. It was a hefty concentration of risk in one stock, five times the size that LeFrere had recommended. But when IBM’s results came out at the end of the week, the stock shot up 20 points, yielding an instant profit of $1 million. LeFrere had survived his rite of passage.14
If there was one quality that Steinhardt valued in people, it was the balls to take a position. At first, the partnership’s big bets were based on straightforward intellectual confidence, bolstered by a 1960s faith in youth: Each member of the young troika had studied at Wharton; each knew himself to be extremely smart; each had no problem sorting through the footnotes in company reports and shorting the life out of a firm that appeared to be concealing something. But soon this high-octane analysis was blended with a dash of eccentricity. In 1970, Steinhardt recruited Frank “Tony” Cilluffo, a mathematically gifted autodidact with limited formal education.
Cilluffo hailed from the wild fringes of Wall Street. He had grown up in Brooklyn, dropped out of City College without a degree, and spent much of his youth devising a mathematical system to predict the outcome of horse races. He had found his way to Arthur Lipper and Company, a brokerage firm known for servicing a notorious con man named Bernie Cornfeld, and he was an avid student of Kondratiev wave theory. The theory held that capitalist economies move in long cycles, with the upswings occurring during periods of technological innovation and abundant investment and the downswings occurring as new investments dry up and old ones lose value. Nikolai Kondratiev, the theory’s Russian inventor, founded the Institute of Conjuncture in Moscow in 1920; he identified upswings between 1789 and 1814, 1849 and 1873, and 1896 and 1920. Cilluffo was convinced that the pattern of twenty-four-year advances would repeat itself again, meaning that the economy would hit the rocks in 1973, twenty-four years after the start of the postwar bull market. It was not exactly clear why cycles of innovation should echo themselves so precisely across different centuries and circumstances: Kondratiev’s conjuncture was based mainly on conjecture. But Cilluffo was undeterred; the more the theory was pooh-poohed by the mainstream, the more he seemed to like it. This suited Steinhardt fine. The boss wanted people with contrarian views, and he didn’t mind how they arrived at them.15
Steinhardt recruited Cilluffo to work with him on the trading desk. The two of them sat in a room strewn with the residue of unfinished lunches, chain-smoking relentlessly. Cilluffo calculated that it took eight minutes and thirteen seconds to smoke a Dunhill, and he got through four packs of them per day; Steinhardt smoked a milder brand, but he would light up two cigarettes at once when the markets got difficult. Both men approached trading with a spiritual intensity; but whereas intensity drove Steinhardt to volcanic eruptions of temper, Cilluffo’s main symptom was a superstitious eating habit. During times when the partnership was making money, he would order precisely the same lunch day after day, switching only when the markets turned; he ordered two toasted English muffins with jam for one two-year stretch, following that up with a long run of cream-cheese-and-olive sandwiches.16 Meanwhile, he would gulp down gallons of coffee and invoke Kondratiev’s teachings, declaring with unwavering conviction that a particular stock that was then trading at $80 would hit $10 by next summer. Not all his colleagues knew how to respond. “He was either brilliant or crazy,” one of them recalls. “You can’t do four packs of Dunhills a day and eight cups of coffee without waking up at three in the morning and seeing pink elephants flying around.” But Steinhardt had great faith in Cilluffo. As he wrote later in his memoir, Tony “truly had a direct line to God (if indeed there was one).”17
Whether by luck or some mysterious power, the Kondratiev prediction of a turndown in 1973 proved uncannily accurate. The bear market that began that year completed the crack-up of the postwar economic order; for the rest of that decade markets were in a funk and the economy was plagued by stagflation, an ugly new term for an ugly new condition. The number of Americans owning stock actually fell by seven million over the course of the decade, and in the summer of 1979 a Business Week cover proclaimed “The Death of Equities.” But throughout this difficult period, Steinhardt’s contrarian style paid off. Having returned 12 percent and then 28 percent by holding short positions in the 1973–74 bear market, the partnership turned bullish in time to return 54 percent after fees in the strong market of 1975; and for the next three years, returns continued to be solid.
By the fall of 1978, when Steinhardt took his leave from Wall Street for a sabbatical year, his group’s eleven-year record was one of the most remarkabl
e of all time. A dollar invested in 1967 would have been worth $12 by 1978, whereas a dollar invested in the broad market would have been worth only $1.70. After subtracting fees, the partnership compounded at an average annual rate of 24.3 percent in this period, a performance virtually identical to that of A. W. Jones in its heyday. And unlike A. W. Jones, Steinhardt and his friends were fighting the headwind of a lousy economic climate.
FOR BELIEVERS IN EFFICIENT MARKETS, STEINHARDT’S success presents a puzzle. Did he triumph because he had a real investment “edge,” or was he merely fortunate? The law of probabilities predicts that if two hundred people flip eleven coins, five will have the luck to get heads nine out of eleven times. Perhaps it is not surprising that of the two hundred-plus hedge funds founded in the late 1960s, at least one called the market right for nine of the next eleven years—the two misses coming in 1969 and 1972, when Steinhardt, Fine, Berkowitz was down by just a fraction.
Steinhardt’s attempts to explain the partnership’s success sometimes fuel the suspicion that luck played a part in it. “The stock market is an inexact phenomenon,” he confesses. “Laypersons’ opinions often seem as worthy as professionals’, and shoeshine men and brokers compete for genius.”18 Unable to articulate a precise investment philosophy, Steinhardt falls back on vague talk about instinct. He deployed “an often inchoate judgment,” he believes—a sixth sense that grew out of the experience of making investment judgments daily. Steinhardt had been fascinated by finance since his thirteenth birthday, when his absentee father presented him with stock certificates as a bar mitzvah gift, and he believes that constant immersion in the market creates an “intuition [that] should be lauded and worshipped.”19 The idea that experience builds judgment may sound plausible, but it falls short of a testable truth. And it is weakened by the fact that Steinhardt made his biggest errors late in his career, at times when experience should presumably have protected him.
Steinhardt also believes that sheer “intensity” favored him. “I had an overriding need to win every day,” he says. “If I was not winning, I suffered as though a major tragedy had occurred.” It is true that not winning could be tragic for Steinhardt’s colleagues; the boss’s tantrums would blaze over the firm’s “hoot-and-holler” intercom system, which broadcast Steinhardt’s voice to every corner of the office, compounding the humiliation for his victim. It is also true that, even when Steinhardt was winning, the intensity (read: temper) remained; one time, when a stock favored by a Steinhardt analyst netted a fantastic profit for the firm, the boss yelled at the poor man for recommending it a bit early.20 Perhaps this way of doing business gave Steinhardt an edge: There was an emotional penalty for failure that drove his team forward. But again, this is not a testable theory. The opposite hypothesis—that Steinhardt’s temper inhibited the sharing of ideas and drove good colleagues away—seems at least as compelling.21
If Steinhardt’s explanations of his own success are not always satisfying, those offered by his former colleagues don’t completely fill the gap, either. Howard Berkowitz and Jerry Fine believe that the quality of their stock analysis was simply better than that of other firms: Hence, the partnership made money. “Why did we do well? We cared a lot. We worked very hard. It meant everything to us,” Fine says simply.22 There is almost certainly much truth in this: As we will see later in our story, stock-picking prowess has driven the success of other celebrated funds, even though academic studies have doubted that this sort of skill really exists in practice.23 But superior stock picking remains a less complete explanation for success in the case of Steinhardt, Fine, Berkowitz than in the case of A. W. Jones. The Jones funds could beat the market because they had created a novel system to pay for performance; but by the time Steinhardt, Fine, Berkowitz got going in the late 1960s, there were dozens of hedge funds. Besides, pension funds, endowments, and other institutions that had been half asleep in Jones’s day were now altogether more professional.
IN SHORT, THE SUCCESS OF STEINHARDT, FINE, BERKOWITZ is difficult to explain, including for the former partners. But it does not follow that their success was merely lucky. When you sift through the story of the partnership, two factors stand out. Each helps to account for success in a way that is consistent with the commonsense rendition of efficient-market teaching: The market is difficult to beat—except when you come up with an approach that others haven’t yet exploited.
The first example of innovation at Steinhardt, Fine, Berkowitz concerns Tony Cilluffo. His enthusiasm for Kondratiev may have been weird, but he brought another passion to the firm that was evidently sensible. Starting in the 1960s, Cilluffo had begun tracking monetary data, hoping it might anticipate shifts in the stock market. A decade or so later, this sort of exercise was common on Wall Street: Everybody recognized that fast monetary growth predicted inflation and therefore would compel the Federal Reserve to force up interest rates; when that happened, investors would move their money into bank deposits or bonds, preferring to collect interest rather than incur the risk of staying in the stock market. As money shifted out of stocks, the market inevitably would fall; and stocks in companies that were sensitive to interest rates—home builders, equipment suppliers—would fall the hardest. But during the 1960s, Wall Street’s equity investors could not be bothered with this sort of analysis. They had learned their trade during the first half of the decade, a time when the inflation rate never exceeded 2 percent. Monetary conditions and the Federal Reserve’s response were marginal to their thinking.24 An eccentric autodidact from out of the mainstream, Cilluffo was the exception.
By the time he joined Steinhardt, Fine, Berkowitz in 1970, Cilluffo had already devised a crude monetary model. He tracked the large banks that formed the Federal Reserve System, and the moment they switched from reporting spare lending capacity to reporting that they had hit the limit of what could be supported by their capital reserves, Cilluffo’s radar bleeped: Banks had maxed out on their lending, so monetary growth was set to slow, so economic growth would head down and stocks would be in trouble. Cilluffo examined historical patterns and found that stocks began falling two months after the crossover point in the bank data. The relationship also worked in the opposite direction. If banks switched from reporting no lending capacity to reporting free reserves, the stock market would turn up imminently.25
Cilluffo had grasped the rules of investing in the high-inflation, post–gold standard world—even before that world had emerged fully. His approach gave Steinhardt, Fine, Berkowitz an edge in anticipating the hairpin bends in the stock market. Cilluffo anticipated both the collapse of 1973–74 and the sharp recovery that followed; in each case he reinforced the conclusions of colleagues who formed their view of the market using traditional stock analysis. If Cilluffo deserves a significant part of the credit for the fund’s positioning in 1973–75, it follows that he deserves a significant part of the credit for the whole decade. The firm’s performance in those three years accounted for the bulk of its profits during the 1970s.
Cilluffo’s colleagues were only dimly aware of his insights because he was bad at explaining them. They knew, for example, that the wiry guy on the trading desk hated Kaufman & Broad, the nation’s biggest home builder, and they knew that the firm was short 100,000 shares; they did not necessarily know that Cilluffo hated Kaufman because home builders are vulnerable to rising interest rates and the monetary data screamed that rates were heading upward. But Steinhardt saw to it that Cilluffo was empowered to test his views: He adored this guy’s conviction, and he didn’t care if others were baffled by his reasoning. The short position on Kaufman earned Steinhardt, Fine, Berkowitz over $2 million. And so, wittingly or otherwise, Cilluffo’s colleagues were the beneficiaries of his innovation: the application of monetary analysis to stock markets.26
THE SECOND INNOVATION AT STEINHARDT, FINE, BERKOWITZ began with another change in the financial climate. Just as the partnership anticipated how stock-market investing would adapt to inflation, so it anticipated how the professio
n would respond to shifting patterns in the custodianship of money.
Until the 1960s, the stock market was dominated by individual investors. Pension funds, insurance funds, and mutual funds—the institutional managers of savings—were not yet significant. In 1950, for example, only about ten million American workers were covered by a company pension, and because most of these plans were in their infancy, they had relatively few assets. By 1970, however, the number of workers with company pensions had more than tripled; pension-fund assets now stood at an eye-popping $130 billion and were growing at $14 billion annually.27 Meanwhile, individuals sold their direct stock holdings and entrusted the proceeds to a new breed of money men. By the late 1960s mutual funds managed more than $50 billion, up from $2 billion in 1950. Investing was no longer the province of amateurs, advised by gentleman-brokers. It had become a professional business.28
This transformed Wall Street. It was now harder to beat the market simply by knowing about stocks, since the chances were that six other professional investors had the same information you did. But the professionalization of investment created a new opportunity just as it clouded the old one. That opportunity came in the activity of trading, which would come to play a central role in the story of hedge funds.
More Money Than God_Hedge Funds and the Making of a New Elite Page 6
