Steinhardt traded the markets as though he were fighting a war, and the effort exhausted him. In the fall of 1978, he took a sabbatical from his firm, declaring that his aim was to shrink his waistline and expand his head: to find meaning in life beyond wealth accumulation. Some said he might be leaving for good, but others had their doubts; “there’s as much chance of Michael giving up Wall Street for a year as there is of Vladimir Horowitz giving up the piano permanently,” one friend insisted.49 As it turned out, Steinhardt managed to stay away from trading until the fall of the following year. Then he stormed back, broke up with his partners, and marched into the 1980s.
3
PAUL SAMUELSON’S SECRET
In famous congressional testimony in 1967, the great economist Paul Samuelson delivered his verdict on the money-management industry. Citing a recent dissertation by a PhD candidate at Yale, he suggested that randomly chosen stock portfolios tended to beat professionally managed mutual funds. When the House banking committee chairman sounded incredulous, the professor stood his ground. “When I say ‘random,’ I want you to think of dice or think of random numbers or a dart,” he emphasized.1 Three years later, Samuelson became the third economist to win the Nobel Prize, but the recognition did not mellow him one bit. “Most portfolio decision makers should go out of business—take up plumbing, teach Greek, or help produce the annual GNP by serving as corporate executives,” he wrote in 1974. “Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed.”2
Samuelson’s pronouncements did not sound much like an endorsement of hedge funds. But his condemnation of professional investors left room for exceptions. Even if most fund managers might contribute more to society as plumbers, Samuelson believed that a giant with genuinely fresh insights could beat the market.3 “People differ in their heights, pulchritude, and acidity,” he wrote. “Why not in their P.Q. or performance quotient?”4 Of course, these exceptional investors would not rent themselves out cheaply “to the Ford Foundation or to the local bank trust department. They have too high an I.Q. for that.” The giants were more likely to form small partnerships that would capture the gains for themselves: They were more likely to start hedge funds. Samuelson never lacked for confidence—by the age of twenty-five, he had published more papers than he was years old—and he naturally believed he could pick out the rare exceptions from the ranks of should-have-been plumbers. In 1970 he became a founding backer of an investment start-up called Commodities Corporation, diversifying his portfolio around the same time with an investment in Warren Buffett.5
Commodities Corporation was among the first boutiques created by hard-core “quants”—the breed of computer-wielding modelers sometimes known as “rocket scientists.”6 The company’s premise, as proclaimed on the first page of its prospectus, was to harness “large scale econometric analysis, impossible prior to the introduction of computers.”7 The founding traders at Commodities Corporation included Paul Cootner, a colleague of Samuelson’s at the Massachusetts Institute of Technology, who was ironically famous in academia for his contribution to efficient-market theory.8 Along with several other economics PhDs, the firm later hired a programmer who had worked on the Apollo project—he was literally a rocket scientist.9 The venture was legally structured as a corporation rather than a partnership, but it was in other ways a typical hedge fund.10 It went both long and short. It used leverage. Its astronomical profits were shared between its managers and a small number of investors. Samuelson paid $125,000 for his stake in Commodities Corporation and agreed to become an active board member.
Samuelson’s involvement was principally a bet on F. Helmut Weymar, the driven, anguished, and mildly megalomaniacal president of the company.11 Weymar had recently completed a PhD dissertation that proposed a method of anticipating the price of cocoa: It crunched historical data to determine the extent to which economic growth boosted chocolate consumption and hence cocoa demand, the extent to which drought or humidity in West Africa impacted supply, and so on. Weymar had studied at the Massachusetts Institute of Technology, where he had known both Samuelson and Cootner. But although Weymar looked to his teachers for help in refining his mathematical and computing skills, he was unimpressed by their efficient-market theories. “I thought random walk was bullshit,” he said later. “The whole idea that an individual can’t make serious money with a competitive edge over the rest of the market is wacko.”12
Weymar was tall and bespectacled, with high cheekbones and a distinguished Northern European air inherited from his German parents. He had moved cities frequently during his childhood, and the experience had left him with an independent streak and a determination to make so much money that he would be beholden to nobody. Even as a graduate student, he had built an ambitious mathematical model of the frozen-orange-juice industry, and when the model suggested that the price of orange-juice concentrate would double, he borrowed $20,000 to buy a large consignment from a warehouse. The model turned out to be accurate, and the price duly shot up. The only hitch was that local supermarkets were leery of buying wholesale orange juice from a student. Weymar had to sell the juice back to the warehouse, which raked off a fifth of his profit.13
After completing his PhD on the cocoa market, Weymar went to work for the food company Nabisco, where he soon persuaded his bosses to trade on his forecasts. The idea was that as cocoa prices fell relative to his model’s prediction, Nabisco would buy to cover its chocolate-making needs; if the market rose higher than the model expected, Nabisco would pause its procurement. As soon as Weymar’s program began trading, cocoa prices fell way below what the model predicted, so Weymar started to buy cocoa futures by the truckload. Then the price fell even more, which meant that Weymar had registered a loss; but following the rules of his program, Weymar carried on buying anyway. Nabisco’s chief financial officer started to worry, and Weymar had to fend him off with a smoke screen of quantitative jargon; meanwhile, he found himself sitting on enough beans to cover two years of Nabisco’s production. “You sure you know what you are doing?” Weymar’s boss demanded more than once; and Weymar projected as much confidence as he could while inwardly sweating bullets. But just as Weymar’s nerves were breaking, the African crops failed and cocoa prices almost doubled. Weymar sold back part of his stockpile at a vast profit. “This wasn’t a period of maximum modesty or self-doubt in my life,” he confessed later.14
Emboldened by that success, Weymar resolved to start up his own enterprise. He began plotting with Frank Vannerson, another freshly minted economics PhD who had joined him at Nabisco’s forecasting unit. The two made an unlikely pair. Weymar brimmed with sunny confidence, while Vannerson was bearded and subdued; one colleague imagined him as a medieval friar with leather sandals and a hooded robe; another suggested he gave off the vibes of a friendly psychotherapist.15 But Weymar and Vannerson were close friends, and Vannerson’s PhD thesis on the wheat market complemented Weymar’s expertise in cocoa. Weymar pulled in other coconspirators, and they coalesced around a plan. After raising start-up capital of $2.5 million, the founders opened up shop in Princeton, New Jersey, near where Weymar and Vannerson were living. Their farmhouse headquarters were surrounded by flowering trees and acres of lawn. On his first day at the office, Weymar wore a suit. Vannerson showed up with a polo shirt, khakis, and his dog, Peanuts.16
Weymar’s office was kitted out with a huge walnut executive desk and a big red leather chair; the combination suited him perfectly. But Vannerson’s informal and egalitarian style quickly came to dominate the firm; if there was a company meeting at Commodities Corporation, Agnes, the cook, was invited. The community in the old farmhouse included a German shepherd dog named Cocoa that had lost one leg to a collision with a car. Weymar’s small band of employees, comprising seven professionals and six support staff, sometimes pitched horseshoes at lunch and played softball after the markets closed. The informal atmosphere signaled the firm’s distance from the hustle of New York: Commoditi
es Corporation was not about salesmanship and relationships and looking like a market insider; it was about beating the market with computer models, math, and superior information. The founders exchanged trading theories at regular seminars, filling a blackboard with formulas. It was a long way from the stock-jockey ethos at A. W. Jones or from the pizza-strewn chaos of Michael Steinhardt’s trading room.
Weymar had assembled a team that was heavy on fundamental analysis. He wanted econometricians who built models that predicted where prices ought to be, on the theory that profits would ensue when reality caught up with the forecasts. Weymar traded cocoa; Vannerson took responsibility for wheat; Paul Cootner, the MIT professor, arrived at the firm armed with an econometric model of the pork-belly market. Kenneth Meinken, an econometrician who had taught at Rutgers University, signed on to trade soybeans and feed grains. By recruiting specialists in different commodities, Weymar hoped to diversify the firm’s exposure to any one market.
Weymar fed his cocoa model with a vast array of data. To anticipate the supply of cocoa before the West African growing countries reported officially on their harvests, he examined the correlation between weather and cocoa yields in the Ivory Coast and Ghana. By tracking rain and humidity patterns, he could predict the cocoa harvest, and hence cocoa supply, and hence, ultimately, prices. The start-up group also included Hans Kilian, a German who toured the African countryside in a Land Rover, surveying cocoa trees and recording the number, length, and condition of the pods. A cocoa tree is as tall as an apple tree and contains about twenty-five pods, so the pod counter complained of a stiff neck. His Land Rover frequently broke down. He battled to get his hands on the large amounts of Ghanaian currency needed to pay local workers who helped with the counting. But the effort provided a way of confirming or correcting the supply projections derived from weather patterns. Weymar had devised a sophisticated model for pricing cocoa, and now he had sophisticated data to feed into it.
SOPHISTICATION DID NOT GUARANTEE SUCCESS, HOWEVER. Shortly after Commodities Corporation got under way, U.S. cornfields were hit by a fungal disease known as the corn blight. Some plant experts predicted that the blight would reappear the following year, and on a bigger scale; corn futures started to move up in expectation of impending scarcity. Faced with a thicket of semiscientific rumor that was scaring the market, Weymar and his colleagues saw a chance to get an edge. They retained a plant pathologist at Rutgers University who advised the state of New Jersey, increasing his research budget and covering his expenses as he journeyed around the country attending scientific conferences. After some weeks of investigation, the Rutgers pathologist concluded that the blight fright was overdone: The plethora of scare stories reflected nothing more infectious than the alarmist bias of the media. Weymar and his colleagues jumped. The pathologist’s conclusion meant that corn prices would be coming down, so the traders started to pile in, building vast short positions in anticipation of the time when the alarmism would prove to be unfounded. Then one Friday night, alongside its regular coverage of Vietnam, CBS News ran a special report on the corn blight. It featured the Illinois state plant pathologist, a man representing a state with a lot more corn than New Jersey. And the man from the corn state was predicting a catastrophic corn harvest.
Weymar and his colleagues didn’t sleep much that weekend. They had built a vast short position in the corn market, betting their firm on the advice of a pathologist who was now being contradicted by a senior colleague. When the markets finally opened on Monday, corn futures jumped so steeply that trading was immediately suspended: Commodity exchanges place a limit on allowable daily movements to dampen extreme swings in prices. There was no chance whatever to get out of the market; prices hit their limit after a smattering of contracts had changed hands, and Weymar and his friends were trapped in their positions. It wasn’t until Tuesday that the Commodities Corporation traders managed to dump their short positions, and by then the damage had been done: The firm’s start-up capital of $2.5 million now stood at $900,000. Weymar’s young company was crashing before his eyes. It was not much consolation that the pathologist from Rutgers eventually turned out to be right. There was no corn blight, and Commodities Corporation had closed out its short positions at the absolute top of the market.
The corn debacle of 1971 brought Commodities Corporation to within a hairbreadth of closure. The relationships among the founding traders frayed; Weymar wondered how nervous he should be about the shotgun that an angry cofounder kept in his office to shoot rabbits and pheasants. Several of the firm’s founding board members wanted to withdraw their capital: Despite their quantitative sophistication and impressive PhDs, Weymar and his team appeared to lack that high “performance quotient” that Samuelson was after. But Weymar was determined, and he had come back from adversity before. Once, as a student, he had lost all his money on a series of bad bets and had taken himself off to the bleachers at a Red Sox game to drink too many beers and think his way to a recovery. This time he was in Princeton, and the booze-and-baseball therapy was less conveniently to hand, but he was no more ready to give in. He pictured himself as the romantic hero in one of the great novels he had been raised on; he responded to his setback with a sort of fascinated masochism, wallowing in the angst and introspection that accompany adversity. He had no intention of abandoning his young company, with the late-afternoon softball and the flowering trees. If Cocoa the watchdog could soldier on despite losing a leg, a cocoa trader could soldier on despite losing a large chunk of his capital.
The board of Commodities Corporation met in July 1971 and agreed to give Weymar a last chance: The firm would be closed if it lost another $100,000.17 In the bloodletting that followed, four of the original seven founding professionals, including Cootner, left the firm. But the recovery came soon, and it laid the foundations for one of the most successful trading operations of the era.
AFTER THE 1971 DEBACLE, WEYMAR SET ABOUT RETHINKING his theory of the market. He had begun with an economist’s faith in model building and data: Prices reflected the fundamental forces of supply and demand, so if you could anticipate those things you were on your way to riches. But experience had taught him some humility. An exaggerated faith in data could turn out to be a curse, breeding the sort of hubris that leads you into trading positions too big to be sustainable. If Commodities Corporation had bet against the corn blight on a more modest scale, it might not have been scared out of its positions by an item on the evening news. The result would have been a profit rather than a near-death experience.
Weymar’s rethink began with a new approach to risk taking. The most dangerous people in the world, he now liked to say, were very smart traders who had never gotten their teeth kicked in.18 In moments of self-awareness, he probably acknowledged that the wildest trader at the company might be none other than himself; a colleague once suggested that putting Weymar in charge of risk controls was like putting Evel Knievel in charge of road safety.19 In the first year of its existence, Commodities Corporation had operated a risk-control system designed by Paul Cootner; it was mathematically elegant but too complex to enforce effectively. Under Cootner’s system, the firm’s trading capital sat in one big pot. The traders could dip into it freely, but the firm charged them penal interest rates on the money if they added to large and volatile positions. In theory, a trader had to be brimming with confidence to double up a bet in a turbulent market. But the corn blight proved that brimming confidence was alarmingly abundant in a company of strong egos, and the clerical staff was so far behind in tracking traders’ exposure that there was effectively no risk control of any nature. Now that Cootner’s system had proved defective and Cootner himself was gone, Weymar set about creating a practical replacement.20
The upshot was a risk-control system that survives, more or less, in the contemporary hedge funds whose origins are entwined with Commodities Corporation.21 Its basics resembled the segment-manager system used at A. W. Jones: Each trader was treated as an independent profit center and
was allocated a pot of capital whose size reflected previous performance.22 But the system also forced traders to control bets, something that scarcely mattered in the relatively stable world of stock-market investing, but that was crucial in commodities. Under the rules that governed equities, an investor could only borrow up to half the value of the stocks he bought; there was no way he could leverage himself more than two to one, even if he was crazy enough to want to do so. But commodity futures were a whole different world. Traders could borrow most of the value of their positions, putting down only a small “margin” of hard cash; because their leverage was higher, one ill-conceived bet could wipe out a large chunk of their capital. The new Commodities Corporation system capped the risk that a trader could take in any one position; and if a trader racked up big losses, more controls kicked in. Anyone who blew half of his initial capital had to sell all his positions and take a month off. He was required to write a memo to the management explaining his miscalculations.23
The new risk-control system was connected to another rethink that followed the corn debacle: Weymar and his colleagues developed fresh respect for trends in prices. Of course, efficient-market theory holds that such trends do not exist: The random-walk consensus was so dominant that, through the 1970s and much of the 1980s, it was hard to get alternative views published in academic journals.24 But Frank Vannerson had gotten his hands on a trove of historical commodity price data that had been gathered and formatted by Dunn & Hargitt, a firm in Indiana. Before leaving Nabisco, Vannerson had spent a year working on the Dunn & Hargitt data, analyzing daily prices for fifteen commodities; and by the time Commodities Corporation opened its doors in March 1970, he had satisfied himself that price trends really did exist, no matter what academics might assert to the contrary.25 Moreover, Vannerson had devised a computer program that could trade on that finding. He called his brainchild the Technical Computer System, or TCS. It was one of the first in a long line of automated trading systems spawned by the hedge-fund industry.26
More Money Than God_Hedge Funds and the Making of a New Elite Page 8
