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

by Sebastian Mallaby

  Even as he built success upon success, Soros began to rethink his priorities. In 1980 he parted company with Jim Rogers, whom he blamed for driving younger employees out of the firm, frustrating Soros’s hopes of spreading his workload; and he began to look for new partners to whom he could delegate responsibility.14 The distraction of the search caused his investment performance to crater. After gaining more than 100 percent in 1980, the Quantum Fund was down 23 percent the following year, its first-ever loss, and Soros was hit by a wave of redemptions that halved his capital from $400 million to $200 million.15 By September 1981 a humiliated Soros had entrusted the remaining money to other investors. Like Michael Steinhardt three years earlier, he took a break from the markets.

  WHEN SOROS RETURNED TO FULL-TIME INVESTING IN 1984, it was with a new sense of balance. Before, he had been paranoid that if he ceased to be paranoid his performance would suffer. But during his midlife crisis, a psychoanalyst had helped him to slay some of his demons. He recognized his success and permitted himself to relax, knowing that doing so might kill the golden goose, but also knowing that not doing so would render the success pointless. His visceral identification with his fund ended; it was as though something physical had been excised from his body. He compared this change to a painful operation he had endured to extract a hard ball of calcium from his salivary gland. Once the stone was removed and exposed to the air, it crumbled to powder. “That is what happened to my hang-ups,” Soros recalled. “Somehow, they dissolved when they were brought to light.”16

  Soros replaced the signals from his aching back with a more cerebral process. Starting in August 1985, he kept a diary of his investment thinking, hoping that the discipline of recording his thoughts would sharpen his judgments. The resulting “real-time experiment” is dense, repetitive, and filled with complex ruminations about scenarios that never in the end materialize. But because it is free of the biases that afflict retrospective explanations of success, it is a true portrait of the speculator at work. Moreover, Soros’s journal happened to capture one of his greatest triumphs—a bet against the dollar that he described as “the killing of a lifetime.”

  Soros had come out of the stock-picking culture of Wall Street. But his preoccupation with reflexive feedback loops led him to think broadly about opportunities. Like Michael Marcus of Commodities Corporation, who abandoned his seat on the floor of the cotton exchange to become a generalist trader, Soros saw no point in knowing everything about a few stocks in the hope of anticipating small moves; the game was to know a little about a lot of things, so that you could spot the places where the big wave might be coming. By the 1980s, the post–Bretton Woods system of floating currencies had emerged as a natural playground. The value of the dollar was based on traders’ perceptions, which Soros naturally believed were flawed. And since these perceptions could reverse at any time, the dollar could move dramatically.

  This was not the conventional view of the way currency markets functioned. In the 1970s and into the 1980s, most economists believed that currency markets, like equity markets, tended toward an efficient equilibrium.17 If the dollar was overvalued, U.S. exports would be hurt and imports would be boosted. The resulting trade deficit would mean that foreigners did not need as many dollars to buy American goods as Americans needed other currencies to buy foreign goods; the relatively low demand for the dollar would drive its value down, cutting the trade deficit until the system reached equilibrium. In the traditional view, moreover, speculators were in no position to disrupt this process. If they anticipated the currency’s future path correctly, they merely accelerated its arrival at the equilibrium point. If they judged wrong, they would slow its correction—but the delay would not persist because the speculators would lose money.

  Soros could see that equilibrium theory failed to explain how currencies actually behaved in practice. Between 1982 and 1985, for example, the United States had run a growing trade deficit, implying a weak demand for dollars; but over this period, the dollar had strengthened. The reason was that speculative flows of capital had pushed the dollar up; and these speculative flows tended to be self-reinforcing. When hot capital flowed into the United States, the dollar rose; the rising dollar drew in yet more speculators, driving the exchange rate away from equilibrium.18 If speculators were the real force determining exchange rates, it followed that currencies would exhibit a perpetual boom-bust sequence. In the first stage of the sequence, speculators would develop a prevailing bias, and this bias would reinforce itself, driving the exchange rate further and further from the level needed to achieve trade equilibrium. The more out of line the exchange rate got, the more the speculators would feel themselves confirmed, and the more the imbalance in trade would keep growing. Eventually, the pressure of enormous trade imbalances would overwhelm the speculators’ bias. A reversal would occur, the speculators would swivel 180 degrees, and a new trend would take off in the opposite direction.19

  In the summer of 1985, the challenge that preoccupied Soros was how to judge the timing of the dollar’s reversal. When he began keeping his diary, on August 16, he suspected that the moment might be close at hand. President Reagan had reshuffled his administration at the start of his second term, and the new team appeared determined to bring the dollar down in order to reduce the U.S. trade deficit. The fundamentals, insofar as they were relevant, pointed the same way. Interest rates were falling, making it unrewarding for speculators to hold dollars. If the combination of political action and low interest rates could persuade even a few speculators to abandon the greenback, the upward trend in the currency could suddenly reverse. In the mature phase of a cycle, all the speculators who want to ride the dollar have already climbed aboard. There are hardly any buyers left, so it takes only a few sellers to make the market perform a U-turn.

  Soros agonized about whether the turn was imminent. If U.S. growth accelerated, interest rates would rise, making a dollar reversal less likely. On the other hand, if banks entered a cycle of credit contraction, in which falling collateral values and reduced lending fed back on themselves, the trouble in the banking sector could slow the economy sharply and push interest rates downward. “Who am I to judge?” Soros wondered; but then he added, “The only competitive edge I have is the theory of reflexivity.” The theory led him to weight the risk of a self-reinforcing banking mess especially heavily and so inclined him to bet against the dollar; besides, certain technical indicators pointed in the same direction.20 Having digested arguments from the quasi science of economics, the quasi philosophy of reflexivity, and the quasi psychology of the charts, Soros arrived at an investment conclusion. It was time to short the dollar.

  Despite his inner doubts, Soros plunged decisively. As of August 16, Quantum owned $720 million worth of the main currencies against which the dollar would fall—yen, German marks, and sterling—an exposure that exceeded all the equity in the fund by a margin of $73 million. His appetite for risk was startling: “As a general rule, I try not to exceed 100 percent of the Fund’s equity capital in any one market,” he remarked breezily in his diary, “but I tend to adjust my definition of what constitutes a market to suit my current thinking.”21 The idea that a hedge fund should actually be hedged had been casually discarded.

  Three weeks later, on September 9, Soros’s second diary entry reported that his experiment had begun badly. The dollar had been buoyed by a batch of bullish U.S. economic indicators, and the currency bet had cost Quantum $20 million. Soros embarked on another bout of soul-searching. He continued to focus on the weak banking system, and the charts whispered that his luck might turn: The German mark appeared to be following a pattern that suggested a sharp rise might be coming. Then Soros brought a further dimension into his analysis. Putting himself in the shoes of the monetary authorities, he argued that interest rates were likely to stay low, even if the economy proved stronger than expected. The Federal Reserve would be reluctant to raise interest rates because of its responsibility as the regulator of the banks; the la
st thing that wobbly lenders need is more expensive capital. Moreover, the Fed would have room not to raise interest rates because Reagan’s reshuffled administration was determined to rein in the budget deficit, relieving inflationary pressure. Weighing his options that September, Soros resolved to stick with his losing bet against the dollar, but to abandon half of it if the market moved further against him.

  Soros’s investment decisions were often balanced on a knife edge. The truth is that markets are at least somewhat efficient, so most information is already in the price; the art of speculation is to develop one insight that others have overlooked and then trade big on that small advantage. Soros would often pick through the evidence, formulate a thesis, but then turn on a dime; a stray remark from a lunch guest could tip the balance of the argument, and Soros would leap up and instruct a trader to get out of his positions.22 Soros’s decision to hold on to his dollar shorts in that second week of September was one of those close calls. If he had blinked after his initial loss, his life story would have turned out differently.23

  But Soros did not blink. Less than two weeks after his second diary entry, on September 22, 1985, Treasury secretary James Baker assembled his counterparts from France, West Germany, Japan, and Britain at the Plaza Hotel in New York. Together the five powers promised coordinated intervention in currency markets to push the dollar downward. The news of the Plaza accord delivered Soros an overnight profit of $30 million. The yen rose more than 7 percent against the dollar the next day, its largest one-day jump in history.

  Soros had been somewhat lucky. He had seen clearly ahead of time that the Reagan administration wanted to manage the dollar down, but he had no idea how this intention would play out and no foreknowledge of the Plaza meeting.24 What happened after Plaza, however, was nothing to do with luck—and everything to do with Soros’s emergence as a legend. Rather than cashing in his bet against the dollar and resting on his laurels, Soros piled on harder. The turn in the dollar had finally come. Everything he knew about reflexive feedback loops argued that the dollar’s initial fall was merely the beginning.

  The Plaza Hotel meeting ended on a Sunday in New York, but it was already Monday morning in Asia. Soros immediately called brokers in Hong Kong with orders to buy additional yen for his portfolio. The next day, when his firm’s own traders began taking profits in the small subportfolios they ran, Soros succumbed to a rare moment of fury. He charged out of his office, yelling at the traders to stop selling yen and telling them that he would assume their positions.25 The traders had wanted to throw their arms around success before it ran away.26 But as far as Soros was concerned, the top governments of the world had telegraphed that the dollar was headed down. Plaza had given the signal, so why shouldn’t he hog more yen positions?

  Over the next days, Soros continued buying. By the Friday after the Plaza meeting, he had added $209 million to his holdings of yen and German marks and had established an extra $107 million worth of short positions in the dollar.27 If there was a risk in this posture, it was that the Plaza communiqué would turn out to be a paper tiger; the declaration was suspiciously thin on actionable detail, and it depended on the uncertain commitment of governments to follow up with concrete measures. But more than any other New York fund manager, Soros had a web of political contacts in Washington, Tokyo, and Europe, and his network encouraged him to believe that Plaza was serious.28 By early December he had loaded up on another $500 million worth of yen and German marks, while adding almost $300 million to his short position in the dollar.29 “I have assumed maximum market exposure in all directions,” Soros recorded in his diary.30

  In December 1985 Soros concluded the first phase of his real-time experiment. He looked back on a period that had begun with a hypothesis that the dollar was ripe for reversal and that had culminated with the theory’s confirmation. His repeated conjectures about a collapse in the banking system had turned out to be a red herring; “the outstanding feature of my predictions is that I keep on expecting developments that do not materialize,” he admitted.31 But the errors had been dwarfed by one central success. Soros had understood that nothing more substantial than slippery perceptions had driven up the dollar, and therefore that a trigger could set off a sudden reversal. Because he had grasped the system’s instability, he had understood the Plaza accord’s meaning faster than others. Plaza was the trigger, and it didn’t even matter that the details of the new policy had yet to be filled in. A political jolt had kick-started a new trend, which would now feed on itself and become self-sustaining.

  The rewards from the Plaza trade were astonishing. In the four months from August, Soros’s fund jumped by 35 percent, yielding a profit of $230 million. Convinced that the act of writing his diary had contributed to his performance, Soros joked that his profit represented the highest honorarium ever received by an author.32 When the diary was published two years later, as part of Soros’s book The Alchemy of Finance, reviewers mocked its dense prose. But as one commentator said, financial alchemy certainly beat boiling up mercury with egg yolks.33

  THE PUBLICATION OF THE ALCHEMY OF FINANCE IN MAY 1987 confirmed Soros’s status as a celebrity. The diary struck a chord with several of the younger stars in the hedge-fund firmament, who saw in it an honest picture of a speculator wrestling anxiously with multiple imponderables. Paul Tudor Jones, the whiz-kid cotton trader who had received seed capital from Commodities Corporation and later built the wildly successful Tudor Investment Corporation, made Alchemy required reading among his employees.34 In a foreword to Alchemy, Jones declared that, having published, Soros should now beware; and he invoked a scene from the World War II movie Patton, in which the great American general savors victory over Field Marshal Erwin Rommel. Patton has prepared for battle by reading Rommel’s tactical writings, and in a climactic moment in the movie, he peers out from his command post and delivers Jones’s favorite line: “Rommel, you magnificent bastard. I read your book!”35

  Soros was having too much fun to fret about such warnings. At last he was becoming the kind of public intellectual he had admired at the LSE; and his expensively tailored figure, topped off with large glasses and a thick tangle of hair, began popping up on magazine covers. His Central European accent added to the exotic aura that surrounded him. Soros, said the profiles, had been a student of global investing years before most fund managers had discovered Tokyo on the map; he embraced futures, options, and forward currency contracts; he went long and short with equal facility. From his eerily quiet trading floor in Manhattan, he ruled over the markets of the world, hobnobbing with global financiers in five languages.36The Economist called him “the world’s most intriguing investor,” and a cover story in Fortune suggested he might rank ahead of Warren Buffett as “the most prescient investor of his generation.”37 But just as the flattering profile of Soros in Institutional Investor in 1981 had presaged that year’s humiliating 23 percent loss, so the adulation of 1987 presaged a calamity.

  The Fortune cover story appeared on September 28, 1987, and its title posed the question of the moment. “Are stocks too high?” the magazine asked; after the long bull market that had begun at the start of the decade, the stocks in Standard & Poor’s index of four hundred industrial companies sold at an average of three times book value, the highest level since World War II. Fortune introduced Soros as its first expert witness on the stock market’s level, and it explained that Soros was sanguine. The fact that trend followers had driven the market upward did not mean that the crash was coming soon: “Just because the market is overvalued does not mean it is not sustainable,” Soros declared delphically. For evidence to support his view, Soros pointed to Japan, where stocks had soared even higher above traditional valuations. Eventually a crash would come. But it would hit Tokyo before Wall Street.

  Soros was not alone in being bullish. The following week Salomon Brothers issued a research note promising that the bull market would continue into 1988, and the week after that, Byron Wien, a well-known Morgan Stanley stra
tegist and Soros friend, predicted “a new high before this cycle is over.” It was the era of the leveraged buyout, and debt-fueled takeovers were driving stock prices steadily higher; the lives of corporate raiders were the stuff of drooling magazine features. The mood of the moment was captured by a hitherto unknown financier named P. David Herrlinger, who announced a $6.8 billion offer for Dayton Hudson Corporation. Herrlinger appeared on his front lawn to tell reporters that his offer might or might not be a hoax—“It’s no more of a hoax than anything else,” he said—and the news of the apparent takeover sent Dayton Hudson stock into the stratosphere. But a hoax is what it was, and Herrlinger was soon removed to a hospital.38

  The buyout mania neatly fitted Soros’s ideas on reflexivity. The takeovers were feeding on themselves: As each acquisition was announced, the stock of every company in the sector jumped, and the prospects of returning acquired companies to the stock market at a profit grew rosier. The avalanche of loans to finance deals kept on coming; the spiral drove prices further and further from any approximation of fundamental value, just as the Soros theory predicted. Of course, sooner or later the takeover deals would collapse under the weight of their own debt, and the trend would reverse itself. But there seemed no strong evidence that the reversal would come soon. Soros continued to pursue his new avocation as Wall Street’s philosopher-in-chief, holding court to journalists and appearing on television shows.

  On October 5 Soros invited one of his new fans over to his office. The guest was Stanley Druckenmiller, the hottest mutual-fund manager on the Street, who had read Alchemy and expressed an interest in a meeting. Soros held forth grandly and offered Druckenmiller a job.39 He wanted a successor who could run Quantum, leaving him more time for philosophy and philanthropy. Money management was wearing on him.