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

by Sebastian Mallaby

  Druckenmiller refused to be lured so easily, but the two struck up a close relationship. Druckenmiller was as tall and broad shouldered as Soros was compact; he was as plainspoken as Soros was complex; he was as unflashy and middle American as Soros was exotic and middle European. But the two got along well. Soros, then in his late fifties, would pontificate; Druckenmiller, still in his midthirties, had his ego sufficiently in check to listen. And although they shared many views about the market, their funds were positioned differently. Druckenmiller had decided that a market break was coming, and he was short Wall Street; Quantum was short Japan but long the U.S. market. Indeed, Soros had recently added to his team of stock pickers, and Quantum was racking up eye-popping returns by loading up on the hot takeover stocks—the “garbitrage” stocks, as the wags of Wall Street called them. By riding the market wave, Soros’s team was up some 60 percent by the end of September. Everything was going wonderfully.

  On October 14 Soros published an article in the Financial Times reaffirming his view that the crash would arrive in Tokyo. That Wednesday morning, he headed off to Harvard’s Kennedy School to give a talk on boom-bust theory. After delivering his lecture, he emerged to find that Wall Street had sold off. The newswires were reporting that Congress might raise taxes associated with corporate mergers, a move that could silence one engine of the bull market.40 The Dow Jones Industrial Average dropped 3.8 percent that day, a move that should have caught Soros’s attention. He knew that the market was far from equilibrium; he knew that booms can be quickly followed by sharp busts. As he ruefully confessed later, “That’s when I should have been in the office and getting the hell out of the market.”41

  On Thursday stocks continued to head down; and on Friday they dove precipitously. After the markets closed that day, Soros received a visit from his new confidant. The three-day sell-off had convinced Druckenmiller that the Dow had given up enough ground; according to his charts, prices had fallen to a point from which they would probably bounce upward. That Friday afternoon, Druckenmiller had switched from a short to a long position.42

  Soros listened to his friend and spread a raft of charts in front of him. These had been prepared by Paul Tudor Jones, the other admirer of Alchemy, whom Soros also spoke with frequently. Druckenmiller examined the patterns and sensed a panic rising in his gut. Jones’s charts appeared to show that he had committed a disastrous error. The lines on the paper illustrated the stock market’s historical tendency to accelerate downward whenever an upward sloping parabolic curve had been broken, and they suggested a parallel between the market of 1987 and the market of 1929. Maybe a collapse was coming.43

  The next morning Druckenmiller visited Jack Dreyfus, the patriarch of the Dreyfus family of mutual funds, where Druckenmiller was working. Dreyfus had instructed his secretary to keep charts not just of the broad market indices but of individual stocks. “We went over all these individual charts and I knew I was cooked,” Druckenmiller recalled later. “What I saw wasn’t a bunch of stocks that were necessarily down a lot. They had just broken out,” he said, meaning that they had broken out of a congestion point and would now accelerate downward. “Stock after stock after stock had just made a clean break right there…. Clearly I had misread the situation.” 44 By focusing on the broad market, Druckenmiller had missed the alarming action in individual shares—and there is an old saying among chart watchers that soldiers lead generals. Druckenmiller was scared to death for the rest of the weekend. On Monday he bailed out of his positions as quickly as he could, and by late morning he had flipped 180 degrees. After a harrowing few hours, he was again short the market.

  That day, October 19, went down in history as Black Monday. The Dow Jones index lost 22.6 percent of its value, the largest drop since the venerable index had been launched ninety-one years earlier. By flipping his position so rapidly, Druckenmiller escaped the worst of the chaos, but the same was not true of Soros. He did his best to bail out of the market, but he was running more money than Druckenmiller; and the garbitrage stocks that had been riding high just days earlier were hard to unload in a panic. Around lunchtime, when Druckenmiller had completed his reversal but Soros was still desperately selling, the market descended into pandemonium. “People didn’t believe their stocks could go down that fast,” one Wall Streeter recalled later. She steadied herself by looking out of her window at a hot dog stand. So long as hot dogs were selling, the world could not be ending.45

  On Monday evening Soros reassessed the situation. Wall Street had hit him hard, but his short position in Japan had paid off as the Nikkei stock index fell, cushioning his losses. There were rumors that the extraordinary collapse in New York had been caused by a newfangled instrument known as “portfolio insurance,” which promised investors protection against a market fall. The insurance worked by selling futures as the market weakened, putting a floor under an investor’s potential loss; but when thousands of insurance policies triggered futures selling in a weak market, the result was a meltdown unprecedented in history. If this account was right, there was an obvious message for Soros. A market collapse triggered by program trading rather than by fundamental factors was more likely to be corrected soon. Perhaps a rebound was coming.

  On Tuesday morning, sure enough, the market rallied. Soros seized the opportunity to pile back into the market. But his Japanese positions were hit by extraordinary bad luck. He had established his short position on the Nikkei index by selling futures in Hong Kong, where the market was more liquid. But when stocks collapsed on Black Monday, the masters of the Hong Kong futures exchange decided to staunch losses by closing it down, and when Wall Street began to rally on Tuesday, portending a rally the next day in Japan, Soros could not get out of his short position. On Wednesday the Nikkei leaped 9.3 percent, its biggest one-day gain since 1949. Soros could do nothing.46

  A few minutes before the markets closed in New York that Wednesday, Soros spoke again with Druckenmiller. The Dow had by now rallied strongly for two days, and Druckenmiller thought another turn was coming. He had studied the history of crashes, and he had seen a pattern: A sharp fall in the market was usually followed by a wild two-day rally, but then the market would collapse back to its low again.47 That Wednesday afternoon, Druckenmiller told Soros that he was short the market.

  Soros was not persuaded. He had consulted other confidants, and was convinced that Black Monday had been a freak. It was a bad dream caused by portfolio insurance.48

  Druckenmiller was an early riser and he woke up on Thursday morning nervous as a goat.49 The market had closed strongly the previous evening, and Soros might prove right that the historical pattern would not hold because of the anomaly of portfolio insurance. But when he checked in on the action in London, he saw that stocks were getting killed. If New York took its cue from London, Druckenmiller’s short positions would come good and Soros would be in trouble.

  Around 8:00 A.M., Druckenmiller got a call from the futures desk at Salomon Brothers.

  “There’s an elephant in the marketplace and the futures could open under two hundred,” the broker informed him. This was a bombshell. The futures had closed at 258 the night before; an instant fall to 200, under the pressure of this elephant trader’s selling, would represent a drop of almost a quarter. Druckenmiller figured that he might as well position himself for this drama in case it really did occur. He placed an order with the broker to close his short positions if the futures contracts fell to 195. At that rock-bottom level, Druckenmiller would be happy to take profits.

  The market opened, and the elephant crashed down upon it. The futures fell to 200 and below, and Druckenmiller’s orders with Salomon were all filled, yielding a 25 percent return on a position he had held only since the previous evening. By about ten o’clock in the morning, the elephant’s selling had been completed and the market stabilized, and Druckenmiller reckoned it was time for yet another flip in his position. Remembering the conversation of the previous afternoon, Druckenmiller picked up the phone and call
ed Soros.

  “George, I just wanted you to know I was negative last night but I think maybe this is the bottom,” he told him. “Some crazy person just sold the hell out of this thing. Like, really recklessly.”

  Soros sounded calm, detached. “Right now I’m licking my wounds,” he said. “I’ll come back and fight another day.”50

  It was not until that weekend that Druckenmiller realized what had happened. He picked up the newest edition of Barron’s and read that the elephant in the market had been none other than Soros.51

  The full story, which Barron’s reported partially, was connected to the trouble in Japan. After its huge leap on Wednesday, Tokyo had risen again on Thursday. Soros wanted out of his short position in the futures market, but there was no way he could sell until the Hong Kong authorities reopened the exchange; meanwhile, he was bleeding money. Coming on top of the losses in the New York market on Monday, Quantum risked the sudden evaporation of confidence that can destroy any leveraged fund. Once your lenders sense you are in trouble, they start calling in their loans; the calls force you to sell stocks into a weak market, setting off a death spiral.52 When Soros saw the London market fall early on Thursday, portending another sell-off in New York, he decided it was time to jump for the sidelines. He had been too slow to get out of the market on Monday, and he did not want to let that happen twice in a week.

  “I don’t understand what’s going on,” he said. “We’ve just got to move to cash. There’ll be another day to play.” Then he gave the order to his trader, Joe Orofino, to get out of the market by selling S&P futures on the Chicago Mercantile Exchange; and Orofino placed the sell order with brokers at Shearson Lehman Hutton. Quantum’s entire $1 billion position was to be dumped, and quickly. But it was impossible to sell that size of position without moving the market. Traders in the futures pit began to sell frantically as soon as the Soros fire sale started, and investors such as Druckenmiller understood that they could allow the market to crash through the floor before taking profits on short positions. “When they saw an order like that they made the market very, very low,” Soros later recalled, ruefully. 53

  Soros’s decision to go to cash that day was perhaps the worst call of his career, costing his fund about $200 million.54 It capped a cataclysmic run: In roughly a week, Quantum had gone from being up 60 percent for the year to being some 10 percent down; $840 million had vanished.55 The episode demonstrated a weakness in hedge funds that would haunt the industry in later years: The larger the funds grew, the harder it became to jump in and out of markets without disrupting prices and damaging themselves in the process. If Quantum had been smaller, Soros might have bailed out on Monday as swiftly as Druckenmiller had; and he could have sold his position on Thursday without causing prices to crater. Soros’s trading style assumed the ability to turn on a dime, and when that assumption proved wrong, Soros was in trouble.

  THE SCALE OF THE CRASH DESTROYED THE CONFIDENCE of many money managers. Proud figures retreated into the fetal position: “I was so depressed that fall that I did not want to go on,” Michael Steinhardt recalled later; “my confidence was shaken. I felt alone.”56 Soros experienced only a mild echo of those sentiments. He was tired of running Quantum, as he had confided to Druckenmiller even before the crash; the option of quitting was always somewhere in his consciousness. But his nerve was not in doubt, not in 1987 nor, indeed, at any time, and within the community of Soros fans, the manner of his recovery after the crash ranks among his greatest accomplishments. A week or two after Black Monday, Soros spotted an opportunity to short the dollar, and he put on a gutsy, leveraged position as though nothing untoward had happened. The dollar duly fell, and the gamble paid off. Quantum ended 1987 up 13 percent, despite having languished in the red only two months earlier.

  In the wake of Black Monday, there had been inevitable sniggers. An anonymous source chortled to the Times of London, “It took 20 years to make George Soros a genius; four days to make him a jerk.”57 An item in Forbes recalled Soros’s unfortunate bullishness in the Fortune cover story of just weeks earlier. “If George Soros, the rich, immensely conceited and famous Hungarian-born money manager, appears beside a gushing headline on the cover of a business magazine, sell your stocks,” it sneered.58 The reports of Quantum’s setback quickly spread to eastern Europe, where there were fears that it would put an end to Soros’s philanthropy in the region; Soros flew to Hungary to reassure the prime minister that his giving would continue. But by the end of 1987, the rumors of Soros’s financial death had been shown up as premature. Financial World listed Soros as the second-highest earner on Wall Street. The top dog was none other than Paul Tudor Jones, chartist and Patton aficionado.

  The Lazarus act of 1987, coming on top of the killing during the Plaza accord two years earlier, cemented Soros’s status as an investment folk hero. But it had a wider influence as well, for Soros’s example did much to create what came to be known as the “macro” hedge fund, at least in its modern incarnation. From 1924 until his death in 1946, John Maynard Keynes invested the endowment, the College Chest, of King’s College, Cambridge, in the global markets, and although the term “hedge fund” did not yet exist, he employed many of the devices that modern macro managers would recognize. He speculated in currencies, bonds, and equities, and he did it on a global scale; he went both long and short, and he magnified returns with leverage. After World War II, stable inflation, regulated interest rates, and immobile currencies caused Keynes’s tradition of macro investing to die out—ironically Keynes himself had helped to negotiate the fixing of exchange rates at the Bretton Woods conference. After the Bretton Woods system unraveled in the 1970s, macro investing began to stir again. But at first it did so tentatively.

  Two streams of investors helped to revive it. Equity types such as Michael Steinhardt realized that shifts in interest rates could drive the stock market, as we have seen; starting in the 1980s, they took the logical next step and bet directly on interest-rate movements by speculating in bonds, first in the United States and later internationally.59 Meanwhile, commodity investors such as Michael Marcus and Bruce Kovner started out trading cotton, gold, and so on; but as commodity markets created new contracts on currencies and interest rates, they began to surf these instruments. Until the publication of Soros’s Alchemy, however, the equity and commodity traditions remained separate. The equity investors came from a culture dominated by fundamental analysis. The commodity traders came from a culture dominated by charts and trend following. But Soros’s example had something for both tribes. The real-time experiment in Alchemy combined fundamental analysis with a belief in trends; it combined the language of economists with the instincts of a chart watcher. In this way, Soros managed to communicate with both halves of the hedge-fund house, reminding each that there was wisdom in the other.60 Within a few years, commodity people like Paul Tudor Jones and equity people like Stan Druckenmiller were regarded simply as “macro” investors.61

  FOR YEARS AFTER THE CRASH, THE EVENTS OF BLACK Monday were picked over for some deeper meaning. Modern financial engineering, which later blurred with hedge funds in the public mind, was blamed for the debacle. The engineers had created a destabilizing feedback loop: A fall in the market triggered insurance-based selling, which in turn triggered a further fall in the market and another insurance-based sell-off. Mark Rubinstein, a Berkeley economics professor and coinventor of portfolio insurance, descended into what he would later recognize as a clinical depression. He fretted that the weakening of American markets might tempt the Soviet Union to attack, making him personally responsible for a nuclear conflict.62

  Not for the first time, financial innovation was being blamed too eagerly. Soros had believed that portfolio insurance created Black Monday; but markets had crashed periodically throughout history, and foreign markets, in which there was far less portfolio insurance, also suffered precipitous falls. Even in the United States, the postmortems on the crash found that of the $39 billion worth of stock sold o
n October 19 via the futures and the cash markets, only about $6 billion worth of sales were triggered by portfolio insurers. Low-tech villains were just as important. Many investors had standing orders with brokers to sell if their positions fell, and these old-fashioned stop-loss policies may have accounted for at least as much selling as portfolio insurance. Besides, fears of a crash had been widespread in the run-up to the event, so there were psychological explanations for the mayhem too. A story in the Atlantic Monthly at the time was headlined “The 1929 Parallel,” and the Wall Street Journal ran a piece on the morning of Black Monday superimposing a graph of the market’s recent decline on a graph of the market of the 1920s.63 The tools of finance were, in the end, just tools. People bought portfolio insurance or put in stop-loss orders because of the skittish atmosphere of the moment. 64

  Whatever the role of portfolio insurance, the larger lesson of the crash was different. Wall Street’s gyrations administered a crippling blow to the efficient-market theories that Soros had long criticized. Over the course of a week, the value of corporate America had bounced around like a pachinko ball; there was nothing efficient about this, nor was there any sign of equilibrium. “The theory of reflexivity can explain such bubbles, while the efficient market hypothesis cannot,” Soros wrote later, and broadly, he was right.65 It was surely no coincidence that efficient-market thinking had originated on American university campuses in the 1950s and 1960s—the most stable enclaves within the most stable country in the most stable era in memory. Soros, who had survived the Holocaust, the war, and penury in London, had a different view of life; and after the wild ride of Black Monday, the academic consensus began to come around to him. The crash had been a humiliation for Soros in investing terms. But in intellectual terms it was a vindication.