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

by Sebastian Mallaby

  In this game of wits and bluff, loud flamboyance could be helpful. Jones happily described himself as “a cowboy in the purest sense,” and he approached the markets with the violent passion of the boxer he had been in college.6 He would scream huge orders down the phone to his brokers on various exchange floors, frequently reversing his instructions in the course of one call, knowing that the crazier he sounded the more he would keep rivals off balance. He would vary his methods to suit his purpose: Sometimes he would place small orders with multiple brokers in an attempt to stay under the radar; sometimes he would ambush the market, guns blazing, knowing that the shock appearance of a big buyer could send other traders scrambling to buy also. Perhaps because Jones wielded notoriety as a trading weapon, he was willing to publicize this style. In 1986 and 1987 he allowed a documentary film team to follow him around, capturing his trading tantrums.7

  In one early sequence of the film, Jones is sitting calmly at his desk just before the market opens. He’s wearing a white shirt, a conservative tie, and a signet ring; it’s a preppy look, almost an accountant’s look, rounded off by large glasses and brown hair combed into a tidy parting.

  “Eight minutes to go,” Jones drawls lazily, his Memphis childhood resonant in his voice.

  “I’m getting ready,” he continues, his voice picking up the pace a bit.

  “Getting a little drums along the Mohawk,” he says, louder, jiggling his legs with nervous energy.

  And then the accountant suddenly explodes. “Doing a little tom-tomming on the market!” he roars, leaping up like a warrior possessed, pumping his fists and waving at the speakerphone.

  “Offer three thousand at seventy!” he yells at the speaker, waving his hands around as though ordering the execution of a captured enemy. He sits down for a second and then springs up again. “Danny, don’t offer that! Sell five forty market! Sell five forty market!”

  The broker’s voice echoes through the speakerphone, confirming the order. Jones punches the air urgently. “Yeah! March! Go!” he yells, and squadrons of traders fan out across the pit to do his bidding.

  A little while into the documentary, Jones puts on a multimillion-dollar bet and then embarks on a strange ritual. He takes off his preppy shoes and switches into sneakers.

  “These tennis shoes, the future of this country hangs on them,” he says gravely to the camera. “They’ve been good for a point rally in bonds and about a thirty-dollar rally in stocks every time I put them on,” he continues, sitting back in his leather office chair in his button-down shirt and conservative tie and the incongruous shiny white footwear.

  “I wait till I get the max and then I put these suckers on,” he says, trying hard to thicken his young voice, like a prep schooler imitating an action hero. “I bought these at a charity auction. They are Bruce Willis’s. The man is a stud.”

  Then, on top of one of his trading screens, Jones erects an inflatable Godzilla.

  WHAT WAS THE INTELLECTUAL PROCESS BEHIND THESE bizarre antics? The answer is subtle, because Jones’s explanations of his own success were not always convincing.8 They began with his twentysomething chief economist, Peter Borish, who compensated for youth by wearing old-fashioned suspenders and was fond of expounding on the eerie parallels between the 1980s and the 1920s. Borish had plotted the stock charts of the two periods one on top of the other, and—surprise!—they both rose in a vertiginous line, convincing Borish and his boss that a spectacular 1929-scale crash was coming. In one remarkably candid interview, Borish admitted to fudging his results; he had juggled with the starting points for the two lines until he got the fit he wanted.9 On this quasi-quantitative foundation, Jones built up a house of anecdote. Wall Street’s exorbitant pay packets signaled that a correction must be due. Banks’ capital was thinly stretched. A van Gogh painting had just sold for ten times its preauction estimate. In the 1987 documentary, Jones looks calmly into the camera and predicts a bloodcurdling collapse. “It’s going to be total rock and roll,” he says, and his eyes look positively gleeful.

  Jones may have been happy for the world to think that Borish had invented some kind of crystal ball; it could only help to strike fear into his rivals. Given his performance in the mid-1980s, the rivals might well have believed anything he said: In 1985 Jones had returned 136 percent, and in 1986 he was on his way to returning 99 percent. But the truth was that Borish’s examination of the 1920s was incidental to Jones’s success, even though a crash did come in October 1987. Most players on Wall Street expected the market to break sooner or later; the hard thing was to put a date on it. Borish predicted that the crash would arrive in the spring of 1988—in other words, his forecast was no better than the others that littered the investment business.10

  Jones’s other efforts to explain his own success were scarcely more credible. Like Tony Cilluffo, the eccentric autodidact who had powered Steinhardt’s 1970s success, Jones was taken with Kondratiev wave theory, which held that the world moves in predictable twenty-four-year cycles. Kondratiev’s teachings had helped Cilluffo to anticipate the crash of 1973, which presumably meant that the next cataclysm was not due until 1997; yet in 1987 Jones nonetheless believed that the theory reinforced the case that “total rock and roll” was imminent. Jones was even more enamored of Elliott wave analysis, as expounded by an investment guru named Robert Prechter. The guru asserted with great confidence that stocks would experience one last upward explosion before plunging at least 90 percent: It would be the greatest crash since the bursting of the South Sea bubble in England in 1720. Jones told one interviewer, apparently in all sincerity, “I attribute a lot of my own success to the Elliott Wave approach.”11 But Prechter’s predictions of disaster were wildly overblown, and even Jones agreed that Prechter had no way of pinpointing when the crash would happen.12

  The truth was that Jones’s trading profits came from agile short-term moves, not from understanding multidecade supercycles whose existence was dubious. Like the traders at Commodities Corporation, Jones was adept at riding market waves; he would get up on his surfboard when a swell seemed to be coming, ready to jump off quickly if the market turned against him. “When you take an initial position, you have no idea if you are right,” he once confessed, undermining the notion that any long-range analysis could explain his success. Rather, as he explained in his more candid moments, his method was “to write a script for the market,” setting out how it might behave; and then to test the hypothesis repeatedly with low-risk bets, hoping to catch the moment when his script became reality.13 Years later, Jones described the mental gymnastics that went into writing these scripts. “Every evening I would close my eyes in a quiet place in my apartment. I would picture myself in the pit. I would visualize the opening and walk myself through the day and imagine the different emotional states that the market would go through. I used to repeat that exercise every day. Then when you get there, you are ready for it. You have been there before. You are in a mental state to take advantage of emotional extremes because you have already lived through them.”14

  The crash of 1987 demonstrated the power of this sort of preparation. The moment the S&P 500 started to head down on Friday, October 16, Jones sensed that the expected market break might at last be coming. It didn’t matter that Borish’s crude comparison with the 1920s had suggested that the crash was several months off; Jones never took that stuff too literally. What did matter was that Jones visualized the possiblity of a crash; he understood that once the market started falling, the chances of a really monster fall were significant. Investors had been anticipating a day of reckoning for months; their confidence could crack decisively. Portfolio insurance added to the danger of a downward lurch: Falling stocks would trigger selling by portfolio insurers, which would cause stocks to fall more. Because of the way the market was positioned, betting on its decline was irresistible. If the early fall on Friday petered out into nothing, Jones might lose modestly by going short; he would simply close his position and await the next opportunity. But
if investor skittishness and portfolio insurance caused the market to crater, the payoff could be enormous. The balance of risk and reward was overwhelmingly attractive.15

  By Friday evening, Jones had sold armfuls of S&P 500 futures. He took off for his hunting lodge in a remote part of Virginia, together with Louis Bacon, the fellow trader and Commodities Corporation seedling, and some friends from Europe. When the weekend was over, there were too many guests to fit on the private plane that was returning to New York. Jones, ever chivalrous, offered the last seats to his friends. He would stay back in Virginia.

  “No,” somebody said. “We know you’ve got a big position.”16

  Jones got on the plane, and on the morning of Black Monday he was at his desk in Manhattan. If his guests had been less generous, he would have missed the largest one-day equity collapse in his lifetime. Stocks fell sharply in the morning, then went into a bloodcurdling dive, and Jones rode the cascade all the way down to the bottom. Frantic investors flooded brokers with phone calls, desperate to sell out of the market, and the only people who weren’t panicking were the ones who just turned numb in the face of the destruction. Some years later, Jones likened Wall Street’s reaction to the crash to his own crash with a boat. “I remember the time I got run over by a boat, and my backside was chewed up by the propeller. My first thought was, ‘Dammit, I just ruined my Sunday afternoon because I have to get stitched up.’ Because I was in shock, I didn’t even realize how badly cut up I was until I saw the faces of my friends.”17 The crash of 1987 paralyzed some people’s reactions in a similar fashion. But Jones had written a script for the market. He was mentally prepared for mayhem.

  Even as he rode the market down, Jones seized a second chance to profit. He had been thinking about how the Fed would respond to the collapse, writing a script for the markets as he always did, and he had reasoned that the authorities would seek to calm everybody’s nerves by pumping cash into the banks to make borrowing cheaper. Here, Jones figured, might be another asymmetrical bet: If the Fed did as he expected, the bond market would soar; but if the Fed did nothing, there was no reason to expect the market to go downward. When the bond market ticked up late on Black Monday, Jones took that as a signal that his script was coming true. He bought the largest bond position that he had ever owned, and soon it turned out to be his most profitable one.

  Jones’s double coup on Black Monday reportedly netted his Tudor Investment Corporation between $80 million and $100 million, contributing to the 200 percent return that he racked up that year. Not long afterward, Jones revealed a side of his personality that contrasted with the cowboy antics. He launched a charity, the Robin Hood Foundation, which tapped into the new hedge-fund wealth, channeling millions of dollars to New York’s poorest neighborhoods.

  JONES’S TRIUMPH ON BLACK MONDAY WAS NOT AN ISOLATED fluke. The late 1980s were a good time for others who came out of the Commodities Corporation tradition. The Big Three—Soros, Steinhardt, and Robertson—all lost heavily in the 1987 crash, but Bruce Kovner and Louis Bacon both fared well, though they made less money than Jones did. The Big Three and the junior three shared the expectation of a market reversal; they had discussed the prospect frequently among themselves, and Jones had even tried to persuade Julian Robertson to run a portfolio of stock shorts for him.18 But it was one thing to expect trouble and another to respond like lightning when it actually arrived: This is where the Commodities Corporation trio proved nimbler than the older group, which had come out of the equity tradition. A stock picker like Julian Robertson was wedded to his stocks: His Tigers had researched each of them exhaustively, and it hurt to unload them. But Jones, Kovner and Bacon had none of that baggage. Their hall mark was flexibility, and they could turn on a dime.19 They didn’t care about individual stocks. They traded the whole market.

  After the stock market crash, Kovner and Bacon both piled into bonds, profiting from the same script that Jones had followed.20 The next year and for the rest of the decade, they continued to thrive. Kovner reaped glorious rewards in currencies, building on the carry trade that he had developed at Commodities Corporation; in 1989 and 1990, he was reportedly the highest earner on Wall Street, thanks not least to bets on oil futures. Meanwhile, Louis Bacon did so well trading a small account as a broker at Shearson Lehman Hutton that he split off to found his own hedge fund, Moore Capital, in 1989. That year he was up 86 percent, and the following year he was up 29 percent, having correctly foreseen the effect of Iraq’s invasion of Kuwait on the equity and oil markets. The seed money Bacon had received from Commodities Corporation was now dwarfed by other cash. Paul Jones, who was unable to absorb all the money that was pressed on him, advised his clients to invest instead with Bacon.

  Meanwhile, Jones himself scored big in Tokyo. Like all the Wall Street cognoscenti, he had seen in the late 1980s that a bubble was forming. The Japanese authorities had cut interest rates aggressively after the Plaza accord, seeking to offset the effect of the strong yen on their economy. The resulting flood of cheap capital had driven up the cost of Japanese assets, and plenty of foreign assets too: Japanese money became the key buyer for everything from California golf courses to impressionist paintings. In 1987, the Japanese phone company Nippon Telegraph and Telephone was floated on the Tokyo stock market at the fantastical price-earnings ratio of 250. The market was overvalued on any sane measure, and yet it continued to head upward.

  As with all bubbles, the challenge with Japan was not so much to see that it would crash but to anticipate the moment. Shorting the Tokyo market aggressively in the wake of NTT’s flotation would have been tantamount to suicide: Over the next two years, the Nikkei stock index gained an astonishing 63 percent, proof that there are few things more costly than tilting against a bubble. Jones of all people was not about to tilt early; so long as the bulls had momentum on their side, he was too much of a trend follower to risk betting against them.21 And so he bided his time, watching for the moment when the trend might turn. Then at the start of 1990, the Tokyo market fell nearly 4 percent in a matter of days. At last Jones had the signal that he had been waiting for.

  At a discussion organized by Barron’s in mid-January 1990, Jones rattled off the reasons why Tokyo was primed for a sharp fall.22 He began with the standard stock analyst’s observation: The market was trading at huge multiples to its earnings. But as with Wall Street in 1987, he focused with particular passion on the way that market players were positioned.23 In the Wall Street case, portfolio insurance had created a mechanism that would exacerbate a fall, creating an asymmetrical bet for speculators. In the Tokyo case, Japan’s financial culture created a similar asymmetry: Japanese savers expected their fund managers to show returns of 8 percent per year, and because of the importance attached to this hurdle, fund managers would respond to a reversal in the equity market by rushing defensively into bonds, where they could lock in 8 percent returns on a risk-free basis.24

  It made all the difference, Jones argued, that the Tokyo market had suffered its 4 percent correction at the beginning of the year. If the market had fallen in December after rising strongly in the previous months, fund managers who were still above the 8 percent hurdle might not have minded—particularly since holding bonds for the last couple of weeks of the year would have yielded too little income to bother with. But a fall in January was different. Fund managers were not sitting on a cushion created by earlier equity returns; and there were fifty weeks still left in the year, enough for the managers to secure their 8 percent target by taking refuge in the bond market. If the fund managers behaved in the defensive manner that Jones expected, the resulting stampede out of equities could push the stock market off a precipice.

  Jones’s script for Japan soon played out in reality. The Nikkei 225 index fell 7 percent in February and 13 percent in March; and by the end of the year it had lost two fifths of its value, crippling what had previously been the world’s biggest stock market. But Jones did not merely get the big call right. With almost uncanny accuracy,
he anticipated Tokyo’s fluctuations on the way to its final destination. Based on his knowledge of the patterns in previous bear markets, he predicted in January that the Nikkei’s fall would be followed by a weak rally; and when the Nikkei stabilized in the spring, he duly switched from a heavy short position to a mild long one.25 The maneuver underlined the difference between the flexible style of a commodities trader and the dogged persistence of a value investor such as Julian Robertson, who never traded in and out of his position. Sure enough, the Nikkei rose 8 percent in May and Jones profited again, even though he was firmly convinced that the rally was temporary.

  That month, May 1990, Jones sat for another interview with Barron’s. The magazine congratulated him on his January prediction that Tokyo was riding for a fall, and Jones modestly recalled that he had predicted a Japanese crash prematurely in 1988 and 1989—though the very essence of his skill was that he could predict such things without actually making losing bets on them. Then Jones reiterated his forecast that the market would experience rallies on the way down, diving precipitously each time after a bounce proved disappointing. His logic was that investors who had not sold out during the first leg of the crash would be desperately hoping to make their money back; but each time they experienced a rally that was too feeble to recover their losses, more of them would give up and sell out of the market. For the moment, Jones said, he was lightly long Japan, but he planned to be short again by late summer. Sure enough, Jones’s timing proved excellent: Tokyo’s market fell steeply from July through early October.26 That year, 1990, Jones estimated that he returned 80 percent to 90 percent on his portfolio, largely on the strength of his trading in Tokyo.