Rather than simply own stocks and be exposed to the whims of the market, though, Jones tried to “hedge,” or protect, his portfolio by betting against some shares while holding others. If the market tumbled, Jones figured, his bearish investments would help insulate his portfolio and he could still profit. If Jones got excited about the outlook of General Motors, for example, he might buy 100 shares of the automaker, and offset them with a negative stance against 100 shares of rival Ford Motor. Jones entered his bearish investments by borrowing shares from brokers and selling them, hoping they fell in price and could be replaced at a lower level, a tactic called a short sale. Borrow and sell 100 shares of Ford at $20, pocket $2,000. Then watch Ford drop to $15, buy 100 shares for $1,500, and hand the stock back to your broker to replace the shares you’d borrowed. The $500 difference is your profit.
By both borrowing money and selling short, Jones married two speculative tools to create a potentially conservative portfolio. And by limiting himself to fewer than one hundred investors and accepting only wealthy clients, Jones avoided having to register with the government as an investment company. He charged clients a hefty 20 percent of any gains he produced, something mutual-fund managers couldn’t easily do because of legal restrictions.
The hedge-fund concept slowly caught on; Warren Buffett started one a few years later, though he shuttered it in 1969, wary of a looming bear market. In the early 1990s, a group of bold investors, including George Soros, Michael Steinhardt, and Julian Robertson, scored huge gains, highlighted by Soros’s 1992 wager that the value of the British pound would tumble, a move that earned $1 billion for his Quantum hedge fund. Like Jones, these investors accepted only wealthy clients, including pension plans, endowments, charities, and individuals. That enabled the funds to skirt various legal requirements, such as submitting to regular examinations by regulators. The hedge-fund honchos disclosed very little of what they were up to, even to their own clients, creating an air of mystery about them.
Each of the legendary hedge-fund managers suffered deep losses in the late 1990s or in 2000, however, much as Hall of Fame ballplayers often stumble in the latter years of their playing days, sending a message that even the “stars” couldn’t best the market forever. The 1998 collapse of mega–hedge fund Long-Term Capital Management, which lost 90 percent of its value over a matter of months, also put a damper on the industry, while cratering global markets. By the end of the 1990s, there were just 515 hedge funds in existence, managing less than $500 billion, a pittance of the trillions managed by traditional investment managers.
It took the bursting of the high-technology bubble in late 2000, and the resulting devastation suffered by investors who stuck with a conventional mix of stocks and bonds, to raise the popularity and profile of hedge funds. The stock market plunged between March 2000 and October 2002, led by the technology and Internet stocks that investors had become enamored with, as the Standard & Poor’s 500 fell 38 percent. The tech-laden Nasdaq Composite Index dropped a full 75 percent. But hedge funds overall managed to lose only 1 percent, thanks to bets against high-flying stocks and holdings of more resilient and exotic investments that others were wary of, such as Eastern European shares, convertible bonds, and troubled debt. By protecting their portfolios, and zigging as the market zagged, the funds seemed to have discovered the holy grail of investing: ample returns in any kind of market. Falling interest rates provided an added boost, making the money they borrowed—known in the business as leverage, or gearing—inexpensive. That enabled funds to boost the size of their holdings and amplify their gains.
Money rushed into hedge funds after 2002 as a rebound in global growth left pension plans, endowments, and individuals flush, eager to both multiply and retain their wealth. Leveraged-buyout firms, which borrowed their own money to make acquisitions, also became beneficiaries of an emerging era of easy money. Hedge funds charged clients steep fees, usually 2 percent or so of the value of their accounts and 20 percent or more of any gains achieved. But like an exclusive club in an upscale part of town, they found they could levy heavy fees and even turn away most potential customers, and still more investors came pounding on their doors, eager to hand over fistfuls of cash.
There were good reasons that hedge funds caught on. Just as Winston Churchill said democracy is the worst form of government except for all the others, hedge funds, for all their faults, beat the pants off of the competition. Mutual funds and most other traditional investment vehicles were decimated in the 2000–2002 period, some losing half or more of their value. Some mutual funds bought into the prevailing wisdom that technology shares were worth the rich valuations. Others were unable to bet against stocks or head to the sidelines as hedge funds did. Most mutual funds considered it a good year if they simply beat the market, even if it meant losing a third of their investors’ money, rather than half.
Reams of academic data demonstrated that few mutual funds could best the market over the long haul. And while index funds were a cheaper and better-performing alternative, these investment vehicles only did well if the market rose. Once, Peter Lynch, Jeffrey Vinik, Mario Gabelli, and other savvy investors were content to manage mutual funds. But the hefty pay and flexible guidelines of the hedge-fund business allowed it to drain much of the talent from the mutual-fund pool by the early years of the new millennium—another reason for investors with the financial wherewithal to turn to hedge funds.
For years, it had been vaguely geeky for young people to obsess over complex investment strategies. Sure, big-money types always got the girls. But they didn’t really want to hear how you made it all. After 2000, however, running a hedge fund and spouting off about interest-only securities, capital-structure arbitrage, and attractive tracts of timberland became downright sexy. James Cramer, Suze Orman, and other financial commentators with a passion for money and markets emerged as matinee idols, while glossy magazines like Trader Monthly chronicled, and even deified, the exploits of Wall Street’s most successful investors.
Starting a hedge fund became the clear career choice of top college and business-school graduates. In close second place: working for a fund, at least long enough to gain enough experience to launch one’s own. Many snickered at joining investment banks and consulting firms, let alone businesses that actually made things, preferring to produce profits with computer keystrokes and brief, impassioned phone calls.
By the end of 2005, more than 2,200 hedge funds around the globe managed almost $1.5 trillion, surpassing even Internet companies as the signature vehicle for amassing fortune in modern times. Because many funds traded in a rapid-fire style, and borrowed money to expand their portfolios, they accounted for more than 20 percent of the trading of U.S. stocks, and 80 percent of some important bond and derivative markets.1
The impressive gains and huge fees helped usher in a Gilded Age 2.0 as funds racked up outsized profits, even by the standards of the investment business. Edward Lampert, a hedge-fund investor who gained control of retailer Kmart and then gobbled up even larger Sears, Roebuck, made $1 billion in 2004, dwarfing the combined $43 million that chief executives of Goldman Sachs, Microsoft, and General Electric made that year.2
The most successful hedge-fund managers enjoyed celebrity-billionaire status, shaking up the worlds of art, politics, and philanthropy. Kenneth Griffin married another hedge-fund trader, Anne Dias, at the Palace of Versailles and held a postceremony party at the Louvre, following a rehearsal dinner at the Musée d’Orsay. Steven Cohen spent $8 million for a preserved shark by Damien Hirst, part of a $1 billion art collection assembled in four years that included work from Keith Haring, Jackson Pollock, van Gogh, Gauguin, Andy Warhol, and Roy Lichtenstein. Whiz kid Eric Mindich, a thirty-something hotshot, raised millions for Democratic politicians and was a member of presidential candidate John Kerry’s inner circle.
Hedge-fund pros, a particularly philanthropic group that wasn’t shy about sharing that fact, established innovative charities, including the Robin Hood Foundation
, notable for black-tie fund-raisers attracting celebrities like Gwyneth Paltrow and Harvey Weinstein, and for creative efforts to revamp inner-city schools.
The hedge-fund ascension was part of a historic expansion in the financial sector. Markets became bigger and more vibrant, and companies found it more inexpensive to raise capital, resulting in a burst of growth around the globe, surging home ownership, and an improved quality of life.
But by 2005, a financial industry based on creating, trading, and managing shares and debts of businesses was growing at a faster pace than the economy itself, as if a kind of financial alchemy was at work. Finance companies earned about 15 percent of all U.S. profits in the 1970s and 1980s, a figure that surged past 25 percent by 2005. By the mid-2000s, more than 20 percent of Harvard University undergraduates entered the finance business, up from less than 5 percent in the 1960s.
One of the hottest businesses for financial firms: trading with hedge funds, lending them money, and helping even young, inexperienced investors like Michael Burry get into the game.
MICHAEL BURRY had graduated medical school and was almost finished with his residency at Stanford University Medical School in 2000 when he got the hedge-fund bug. Though he had no formal financial education and started his firm in the living room of his boyhood home in suburban San Jose, investment banks eagerly courted him.
Alison Sanger, a broker at Bank of America, flew to meet Burry and sat with him on a living-room couch, near an imposing drum set, as she described what her bank could offer his new firm. Red shag carpeting served as Burry’s trading floor. A worn, yellowing chart on a nearby closet door tracked the progressive heights of Burry and his brothers in their youth, rather than any commodity or stock price. Burry, wearing jeans and a T-shirt, asked Sanger if she could recommend a good book about how to run a hedge fund, betraying his obvious ignorance. Despite that, Sanger signed him up as a client.
“Our model at the time was to embrace start-up funds, and it was clear he was a really smart guy,” she explains.
Hedge funds became part of the public consciousness. In an episode of the soap opera All My Children, Ryan told Kendall, “Love isn’t like a hedge fund, you know … you can’t have all your money in one investment, and if it looks a little shaky, you can’t just buy something that looks a little safer.” (Perhaps it was another sign of the times that the show’s hedge-fund reference was the only snippet of the overwrought dialogue that made much sense.) Designer Kenneth Cole even offered a leather loafer called the Hedge Fund, available in black or brown at $119.98.3
Things soon turned a bit giddy, as investors threw money at traders with impressive credentials. When Eric Mindich left Goldman Sachs to start a hedge fund in late 2004, he shared few details of how he would operate, acknowledged that he hadn’t actually managed money for several years, and said investors would have to fork over a minimum of $5 million and tie up their cash for as long as four and a half years to gain access to his fund. He raised more than $3 billion in a matter of months, leaving a trail of investors frustrated that they couldn’t get in.4
Both Mindich and Burry scored results that topped the market, and the industry powered ahead. But traders with more questionable abilities soon got into the game, and they seemed to enjoy the lifestyle as much as the inherent investment possibilities of operating a hedge fund. In 2004, Bret Grebow, a twenty-eight-year-old fund manager, bought a new $160,000 Lamborghini Gallardo as a treat and regularly traveled with his girlfriend between his New York office and a home in Highland Beach, Florida, on a private jet, paying as much as $10,000 for the three-hour flight.
“It’s fantastic,” Mr. Grebow said at the time, on the heels of a year of 40 percent gains. “They’ve got my favorite cereal, Cookie Crisp, waiting for me, and Jack Daniel’s on ice.”5 (Grebow eventually pled guilty to defrauding investors of more than $7 million while helping to operate a Ponzi scheme that bilked clients without actually trading on their behalf.)
A 2006 survey of almost three hundred hedge-fund professionals found they on average had spent $376,000 on jewelry, $271,000 on watches, and $124,000 on “traditional” spa services over the previous twelve months. The term traditional was used to distinguish between full-body massages, mud baths, seaweed wraps and the like, and more exotic treatments. The survey reported anecdotal evidence that some hedge-fund managers were shelling out tens of thousands of dollars to professionals to guide them through the Play of Seven Knives, an elaborate exercise starting with a long, luxuriant bath, graduating to a full massage with a variety of rare oils, and escalating to a series of cuts inflicted by a sharp, specialized knife aimed at eliciting extraordinary sexual and painful sensations.6
Not only could hedge funds charge their clients more than most businesses, but their claim of 20 percent of trading gains was treated as capital gains income by the U.S. government and taxed at a rate of 15 percent, the same rate paid on wage income by Americans earning less than $31,850.
For the hedge-fund honchos, it really wasn’t about the money and the resulting delights. Well, not entirely. For the men running hedge funds and private-equity firms—and they almost always were men—the money became something of a measuring stick. All day and into the night, computer screens an arms-length away provided minute-by-minute accounts of their performance, a referendum on their value as investors, and affirmation of their very self-worth.
AS THE HEDGE-FUND celebrations grew more intense in 2005, the revelers hardly noticed forty-nine-year-old John Paulson, alone in the corner, amused and a bit befuddled by the festivities. Paulson had a respectable track record and a blue-chip pedigree. But it was little wonder that he found himself an afterthought in this overcharged world.
Born in December 1955, Paulson was the offspring of a group of risk-takers, some of whom had met their share of disappointment.
Paulson’s great-grandfather Percy Thorn Paulsen was a Norwegian captain of a Dutch merchant ship in the late 1890s that ran aground one summer off Guayaquil, Ecuador, on its way up the coast of South America. Reaching land, Paulsen and his crew waited several weeks for the ship to be repaired, using the time to explore the growing expatriate community in the port city. There, he met the daughter of the French ambassador to Ecuador, fell in love, and decided to settle. In 1924, a grandson was born named Alfred. Three years later, Alfred’s mother died while giving birth to another boy. The Paulsen boys were sent to a German boarding school in Quito. Alfred’s father soon suffered a massive heart attack, after a game of tennis, and passed away.
The boys, now orphans, moved in with their stepmother, but she had her own children to care for, so an aunt took them in. At sixteen, Alfred and his younger brother, Albert, fifteen, were ready to move on, traveling 3,500 miles northwest to Los Angeles. Alfred spent two years doing odd jobs before enlisting in the U.S. Army. Wounded while serving in Italy during World War II, he remained in Europe during the Allied occupation.
After the war, Alfred, by now using the surname of Paulson, returned to Los Angeles to attend UCLA. One day, in the school’s cafeteria, he noticed an attractive young woman, Jacqueline Boklan, a psychology major, and introduced himself. He was immediately taken with her.
Boklan’s grandparents had come to New York’s Lower East Side at the turn of the century, part of a wave of Jewish immigrants fleeing Lithuania and Romania in search of opportunity. Jacqueline was born in 1926, and after her father, Arthur, was hired to manage fixed-income sales for a bank, the Boklan family moved to Manhattan’s Upper West Side. They rented an apartment in the Turin, a stately building on 93rd Street and Central Park West, across from Central Park, and enjoyed a well-to-do lifestyle for several years, with servants and a nanny to care for Jacqueline.7
But Boklan lost his job during the Great Depression and spent the rest of his life unable to return the family to its former stature. In the early 1940s, searching for business opportunities, they moved to Los Angeles, where Jacqueline attended UCLA.
After Alfred Paulson wed Jacqu
eline, he was hired by the accounting firm Arthur Andersen to work in the firm’s New York office, and the family moved to Whitestone, a residential neighborhood in the borough of Queens, near the East River. John was the third of four children born to the couple. He grew up in the Le Havre apartment complex, a thirty-two-building, 1,021-apartment, twenty-seven-acre development featuring two pools, a clubhouse, a gym, and three tennis courts, built by Alfred Levitt, the younger brother of William Levitt, the real estate developer who created Levittown. The family later bought a modest home in nearby Beechhurst, while Jacqueline’s parents moved into a one-bedroom apartment in nearby Jackson Heights.
Visiting his grandson one day in 1961, Arthur Boklan brought him a pack of Charms candies. The next day, John decided to sell the candies to his kindergarten classmates, racing home to tell his grandfather about his first brush with capitalism. After they counted the proceeds, Arthur took his grandson to a local supermarket to show the six-year-old where to buy a pack of Charms for eight cents, trying to instill an appreciation of math and numbers in him. John broke up the pack and sold the candies individually for five cents each, a tactic that investor Warren Buffett employed in his own youth with packs of chewing gum. Paulson continued to build his savings with a variety of after-school jobs.
“I got a piggy bank and the goal was to fill it up, and that appealed to me,” John Paulson recalls. “I had an interest in working and having money in my pocket.”
One of Alfred Paulson’s clients, public-relations maven David Finn, who represented celebrities including Perry Como and Jack Lemmon, liked Alfred’s work and asked him to become the chief financial officer of his firm, Ruder Finn, Inc. The two became fast friends, playing tennis and socializing with their families. Alfred was affable, upbeat, and exceedingly modest, content to enjoy his family rather than claim a spotlight at the growing firm, Finn recalls. On the court, Alfred had an impressive tennis game but seemed to lack a true competitive spirit, preferring to play for enjoyment.
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