More Money Than God_Hedge Funds and the Making of a New Elite

by Sebastian Mallaby

  IN 1977 MICHAEL MARCUS PLACED AN AD IN THE FINANCIAL press for an assistant trader. It was answered by an unlikely character who had dropped out of a Harvard PhD program and was now working part-time as a cab driver. When the candidate presented himself, it was love at first sight. Marcus picked up the phone and called Weymar. “Helmut,” he said eagerly, “I have in my office the next president of Commodities Corp.”45

  The candidate was Bruce Kovner, and Weymar could see why Marcus was enthusiastic. The young man was tall, imposing, with a big head topped by a thick crop of hair; he exuded confidence and natural ease, and his intellectual range was striking. He had been part of a circle of political scientists at Harvard that included James Q. Wilson and Daniel Patrick Moynihan; he had devoted himself for a while to the full-time study of music; he had worked on a number of political campaigns; and he had contributed freelance articles to Commentary magazine on subjects from music to the purposes of economic growth. Trading was just another thing that he had learned along the way. Prompted by a conversation with a friend, he had studied the futures markets, borrowed $3,000 against a MasterCard, and turned it into $22,000. Marcus and Weymar tested the would-be trading assistant by mentioning a couple of financial texts, but Kovner had read more than they had, starting with historical classics such as Charles Mackay’s Extraordinary Popular Delusions and the Madness of Crowds and extending to contemporary newsletters. “I really value richness in intellect, and Bruce was rich up the kazoo,” Weymar recalls.46 Kovner was hired in short order, not as an assistant but as a trader.47

  Kovner’s encounter with Marcus and Weymar launched one of the most illustrious careers in hedge-fund history. Over the next decade, Kovner racked up gains averaging some 80 percent per year; he launched his own hedge fund, Caxton Corporation; and he emerged as a colorful figure in the arts and politics. He became a godfather of the conservative movement through his chairmanship of the American Enterprise Institute and his backing of the New York Sun. He chaired the Juilliard School of music and sponsored an artist who produced an illustrated edition of the Bible, the Pennyroyal Caxton, complete with an engraving of Kovner in the image of King Solomon. When Kovner needed a bachelor pad following a divorce, he converted Manhattan’s International Center of Photography into a private residence. The mansion has a vault for Kovner’s collection of rare books and a study that doubles as a radiation-proof bomb shelter.

  Michael Marcus, who had once studied psychology, noticed something about Kovner early on: He had a physical and psychological strength that set him apart from his colleagues. Kovner knew how to let go of distractions; he did not overthink his trades and had no trouble sleeping. Other traders might make money faster, but they would lose it faster too; Kovner was consistent, and he had a sort of nerveless temperament. One time Kovner took a hit on a silver position, suffering the sort of loss that would have left most traders vomiting in the bathroom. He showed up that same day at an administrative meeting as though nothing untoward had happened.48

  Unlike many traders, Kovner combined a feel for the markets with organizational talent. He hired several assistants to track numbers and compose charts, never paying any of them more than was absolutely necessary. He could get the best out of ordinary people: He employed an ex-librarian to monitor the relationship between interest rates and gold futures; whenever the relationship showed an unusual blip, the librarian had instructions to bet on normalcy’s return, a formula that generated handsome profits. Meanwhile, Kovner was adept at extracting financial concessions from Weymar, frequently raising the hackles of colleagues. Rather than paying for his assistants out of his own profits, Kovner would sometimes get the company’s central budget to cough up; rather than setting aside his own capital allocation to trade on their ideas, Kovner would persuade Weymar to allocate them extra money.49 In the judgment of Irwin Rosenblum, the chief financial officer, Bruce Kovner amassed a larger fortune at Commodities Corporation than anyone else at the company.50

  Kovner combined fundamental analysis with attention to the charts, confirming the shift away from the model-driven research with which Weymar had started.51 As with Michael Marcus, the charts sometimes came first: Indeed, Kovner once argued that the most profitable opportunities arise when you have no fundamental information.52 If a market is behaving normally, ticking up and down within a narrow band, a sudden breakout in the absence of any discernible reason is an opportunity to jump: It means that some insider somewhere knows information that the market has yet to understand, and if you follow that insider you will get in there before the information becomes public. One time Kovner and Marcus were betting against the dollar when it inexplicably strengthened. Assuming that insiders had caught wind of important news, the traders immediately bailed out, and that weekend President Carter announced a dollar support program. If the duo had waited for the official announcement—if they had traded on the fundamental data in the way that Weymar sought to do at first—they would have been annihilated.53

  In 1981 Kovner and an associate, Roy Lennox, hit on a strategy that later became a hedge-fund staple. They searched for currencies that cost a lot less in the future than in the present and bought them at the bargain forward rate. Most traders assumed that there was nothing to be gained from this behavior: If the forward rate was lower, that was because the currency was likely to depreciate. But Kovner and Lennox saw that this was wrong. A low forward rate usually reflected high interest rates: If Spanish banks were paying 7 percent interest to depositors, the peseta would be worth 7 percent more in the immediate “spot” market than in the one-year forwards—effectively, the discount in the forward market was compensating buyers for missing the chance to collect interest. Far from being a signal that a currency was likely to depreciate, a forward-market discount was a sign that a currency might rise, since the high interest rate was likely to drive inflation down and suck capital into the country. For the next decade or so, Kovner and Lennox bought currency forwards that were trading at a big discount and sold currency forwards that were trading at small ones. This “carry trade” raked in glorious profits until rivals caught on to it.54

  Kovner’s success forms a kind of epilogue to the heyday of Commodities Corporation. As word of the firm’s profits reached sharp ears on Wall Street, Weymar found himself facing a challenge. New York brokers approached his top traders, seeking to place their clients’ capital directly with the stars; they were effectively pressing the likes of Marcus and Kovner to begin hedge funds within the structure of Weymar’s company. Weymar at first resisted, but the traders had the upper hand; the boss had loaded up Commodities Corporation with such vast administrative overhead that traders were already tempted to go independent, and now Wall Street was offering them an alternative source of trading funds—plus a fat fee for accepting them.55 After some internal argument, the traders got their way, and pretty soon Kovner was managing millions of dollars of Wall Street cash. His army of trading assistants expanded to the point that he was running a state within a state. By the time Kovner broke off to start Caxton Corporation in 1983, he was already an independent hedge-fund mogul in everything but name. He was secretive, leveraged, and enviably successful.

  Meanwhile, a pair of younger futures traders was rising in his wake. Paul Tudor Jones and Louis Bacon, whom we will encounter later in this story, both received seed capital from Commodities Corporation; and in the early 1980s the two would arrive by helicopter from Manhattan to attend traders’ dinners in Princeton. Jones and Bacon both learned from Commodities Corporation, sharing ideas on trends and chart patterns and adopting its risk-control procedures; Bacon eventually hired Elaine Crocker, a senior administrative officer at Commodities Corporation, to be the president of his hedge fund, Moore Capital. But Bacon was too independent a figure to fit into Weymar’s company, and Jones turned down a job offer; he was happy to take seed money from Commodities Corporation, but he did not want to join it.56 The difficulty of bringing in star performers combined with Weymar’s big spending t
o create a crisis at the firm; and in 1984 an internal revolt forced Weymar to promise lower overhead and a return to “the simple life.”57 Though it soldiered on after that, Commodities Corporation never recaptured its old verve. The center of gravity shifted: from Weymar to a younger set, from the idyll in Princeton to a new generation of New York hedge funds.

  4

  THE ALCHEMIST

  The London School of Economics was abuzz in 1949, when a young Hungarian named George Soros arrived there. The trauma of World War II was fresh; victims of Nazism, exiles from communism, and young leaders from Britain’s disintegrating empire found refuge together in London. There was a search for grand theories, for an understanding of how Europe had destroyed itself and how it could be rebuilt; the Labour government was refashioning Britain with its new welfare state, and Marshall aid was speeding reconstruction on the continent. In the LSE’s lecture halls, impassioned Marxists rubbed shoulders with the libertarian Friedrich Hayek; Keynesians and anti-Keynesians debated one another. It was in this era, as a historian of the school wrote, that “the myth of LSE was born.”1

  Soros had already endured much by the time he arrived at the university. Born to a well-to-do Jewish family in Budapest, he had survived the Nazi occupation by separating from his family, assuming a Christian identity, and hiding with various of his father’s acquaintances. He had seen corpses in the streets of his city, mangled figures with bound hands and crushed heads, and he had helped his family survive by hawking jewelry to black-market dealers. In 1947, when he was barely seventeen, Soros had left Hungary for a better future in London, bidding good-bye to his parents, whom he expected not to see again. He took jobs as a dishwasher, a house painter, a busboy; a headwaiter told him that, provided he worked hard, he might one day end up as his assistant. The summer before Soros began his studies at LSE, he at last found a job he liked. He was a lifeguard at a swimming pool with not many swimmers. He read Adam Smith, Thomas Hobbes, and Niccolò Machiavelli.

  The LSE luminary who inspired Soros the most was Karl Popper, a philosopher who had fled his native Austria to escape Nazism—and who, in an entirely unintended way, stamped his ideas on the young man who was to become the most famous of all hedge-fund managers. Popper’s central contention was that human beings cannot know the truth; the best they can do is to grope at it through trial and error. This notion had an obvious appeal to someone of Soros’s background. It suggested that all political dogmas were flawed: The Nazism and communism inflicted upon Hungary by outside powers each claimed an intellectual certainty to which neither was entitled. Popper’s masterwork, The Open Society and Its Enemies, created in Soros a lifelong desire to make his own contribution to philosophy. It pointed him toward a distinctive way of thinking about finance and inspired the name of the philanthropy he was to found, the Open Society Institute.

  Soros left LSE with mediocre grades and spent a while in dead-end jobs, at one point selling handbags in northern Wales. He escaped this version of his destiny by writing to all the investment banks in the City of London, inquiring about entry-level positions. Spurned by the establishment because of his lack of social ties, he eventually landed a job with a brokerage run by Hungarian émigrés; after learning the financial ropes, he found his way to New York in 1956, figuring he could stomach Wall Street for five years, long enough to put aside the savings he needed to support a life as an independent philosopher.2 But he soon found he was too good at the investing game to quit. By 1967 he was the head of research at Arnhold and S. Bleichroeder, a venerable Wall Street brokerage specializing in European stocks. And after getting to know the A. W. Jones segment managers by pitching ideas to them, he launched his own $4 million long/short stock-picking vehicle in 1969. He called it the Double Eagle Fund, and he managed it under the Bleichroeder umbrella.3

  By now Soros had melded Karl Popper’s ideas with his own knowledge of finance, arriving at a synthesis that he called “reflexivity.” As Popper’s writings suggested, the details of a listed company were too complex for the human mind to understand, so investors relied on guesses and shortcuts that approximated reality. But Soros was also conscious that those shortcuts had the power to change reality as well, since bullish guesses would drive a stock price up, allowing the company to raise capital cheaply and boosting its performance. Because of this feedback loop, certainty was doubly elusive: To begin with, people are incapable of perceiving reality clearly; but on top of that, reality itself is affected by these unclear perceptions, which themselves shift constantly. Soros had arrived at a conclusion that was at odds with the efficient-market view. Academic finance assumes, as a starting point, that rational investors can arrive at an objective valuation of a stock and that when all information is priced in, the market can be said to have attained an efficient equilibrium. To a disciple of Popper, this premise ignored the most elementary limits to cognition.4

  Even as his financial career took off in the 1960s, Soros continued to hide away in the study of his weekend home, struggling to express his philosophy on paper. His ideas affected the way that he invested too, despite later suggestions that Soros superimposed the theory of reflexivity on his investment success as an after-the-fact rationalization. In an investment note written in 1970, Soros explained the workings of real-estate investment trusts in explicitly reflexive terms. “The conventional method of security analysis is to try to predict the future course of earnings,” he began; but in the case of these investment trusts, future earnings would themselves depend on investors’ perceptions about them. If investors were bullish, they would pay a premium for a share in a successful trust, injecting it with cheap capital. The cheap capital would boost earnings, which would in turn reinforce the appearance of success, persuading other investors to buy into the trust at an even greater premium. The trick, Soros insisted, was to focus neither on the course of earnings nor on the psychology that drove investors’ appetite. Rather, Soros homed in on the feedback loop between the two, predicting that each would drive the other forward until the trusts were so completely overvalued that a crash was inevitable. Sure enough, the real-estate investment trusts followed the boom-bust sequence that Soros expected. His fund made a fortune as they went up and another as they crashed downward.5

  In 1973, Soros left Bleichroeder to set up his own company. He rented an office a block away from his co-op on Central Park West, bringing along his partner from Bleichroeder, an irascible, workaholic analyst named Jim Rogers. Interviewed years later in his Manhattan home, Rogers conducted the discussion while wincing and gasping on an exercise bike that was rigged up with a laptop and phone for maximum multitasking.6 Together with Rogers, Soros continued to look for moments when an unstable equilibrium might reverse. He saw, for example, that financial deregulation was changing the game in banking, transforming a dull sector of the stock market into a sexy one: He made a fortune from bank stocks. He spotted that the Arab-Israeli war of 1973 changed the game for the defense industry, since Soviet weaponry used by Egypt had performed well, demonstrating that the United States faced a greater challenge than previously imagined. Soros predicted that the Pentagon would soon persuade Congress to authorize some catch-up investments. He plunged into defense stocks.7

  When Soros sensed a game-changing moment, he was not afraid to bet the store on it. After he decided military spending would go up, he became the largest outside shareholder in the defense contractor Lockheed. He was willing to take the plunge without waiting for conclusive evidence that he was right. If he found an investment idea attractive on cursory examination, he figured that others would be seduced too; and since he believed that perfect cognition was impossible, there was no point in sweating the details. On a skiing vacation once in Switzerland, he bought the Financial Times at the bottom of the chairlift, read on the way up about the British government’s plan to bail out Rolls-Royce, and called his broker from the top of the mountain with an order to buy British government bonds.8 Let specialists obsess about minutiae. Soros’s motto was �
�Invest first, investigate later.”9

  By the start of 1981, Soros had achieved success beyond his wildest imaginings. His hedge fund, renamed the Soros Fund in 1973 and the Quantum Fund in 1978, had accumulated assets of $381 million, multiplying its initial capital almost a hundredfold despite the tough equity markets of the 1970s. The teenager who had eked out a precarious living in London, sometimes relying on charities for support, had accumulated a personal fortune worth $100 million and was himself becoming a philanthropist. In June 1981, a reverential magazine profile in Institutional Investor called Soros “the world’s greatest money manager.” Rivals expressed their admiration by echoing Ilie Nastase’s tribute to Bjorn Borg: “We’re playing tennis and he’s playing something else.”10

  Soros was not above celebrating his own brilliance. “I stood back and looked at myself with awe: I saw a perfectly honed machine,” he wrote, with no apparent irony.11 “I fancied myself as some kind of god or an economic reformer like Keynes (each with his General Theory),” he confessed on another occasion. “Or, even better, a scientist like Einstein (reflexivity sounds like relativity).”12 But the tragedy was that he was not happy. Success as an investor required a visceral as well as intellectual focus on markets, which could be so intense as to be physical. If there was trouble stirring in his portfolio, Soros would first know about it when his back seized up; believing that markets could turn against him at any time, Soros would defer to these physical signals and sell out his positions. The business of investing consumed all the time and energy he had. He thought of himself as a boxer in training who had to sacrifice all personal life for the sake of victory. He compared himself to a sick person with a parasitic fund swelling inexorably inside his body.13