Further Praise for Inside the House of Money from Fund Investors

“Drobny has done a great job of capturing the inner workings of macro trading by interviewing some of the most interesting people in the fi eld today. This book is a treat and a must-read if you want to understand how the market’s best manage their portfolios.” —Mark Taborsky, Vice President, External Management Harvard Management Company

“Inside the House of Money provides a unique insight into the business. For those who think hedge funds are mysterious, here they will fi nd them transparent. Readers will be fascinated to see that there are so many ways to make money from an idea.” —Bernard Sabrier, Chairman, Unigestion

“With its behind-the-scenes perspective and macro focus, this book is an entertaining, educational read, and also fi lls a substantial gap in hedge fund literature.” —Jim Berens, Cofounder and Managing Director, Pacifi c Alternative Asset Management Company (PAAMCO)

“An exciting, fast-paced insider’s look at the elite, often mysterious world of high fi nance. This book is the real deal. An absolute must-read forevery endowment, foundation, or offi cer considering investing with hedge funds.” —Michael Barry, Chief Investment Offi cer, University of Maryland Endowment

INSIDE THE HOUSE OF MONEY

Top Hedge Fund Traders on Profi ting in the Global Markets Revised and Updated STEVEN DROBNY

Foreword by Niall Ferguson Cover Design: Michael J. Freeland Cover Photograph: © Getty Images

Copyright © 2006, 2009, 2014 by Steven Drobny. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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10 9 8 7 6 5 4 3 2 1 The social objective of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. —John Maynard Keynes

Once we realize that imperfect understanding is the human condition, there is no shame in being wrong, only in failing to correct our mistakes. —George Soros

The things you own end up owning you. —Tyler Durden

CONTENTS

Foreword by Niall Ferguson ix Preface xi Preface to the 2009 Edition xv Preface to the 2006 Edition xvii

1. Introduction to Hedge Funds: Joseph G. Nicholas (HFR Group) 1

2. The History of Global Macro Hedge Funds 5

3. The Future of Global Macro Hedge Funds 31

4. The Family Offi ce Manager: Jim Leitner (Falcon Management) 35

5. The Prop : Christian Siva-Jothy (SemperMacro) 85

6. The Treasurer: Dr. John Porter (Barclays Capital) 117

7. The Central Banker: Dr. Sushil Wadhwani (Wadhwani Asset Management) 145

8. The Dot-Commer: Peter Thiel (Clarium Capital) 165

9. The Floor Trader: Yra Harris (Praxis Trading) 183

10. The Pioneer: Jim Rogers 201

11. The Specialist: Dwight Anderson (Ospraie Management) 225

vii viii CONTENTS

12. The Stock Operator: Scott Bessent (Bessent Capital) 253

13. The Emerging Market Specialist: Marko Dimitrijevic´ (Everest Capital) 273

14. The Fixed Income Specialists: David Gorton and Rob Standing (London Diversifi ed Fund Management) 293

15. The Currency Specialist: Anonymous 309 Conclusion 325 Appendix: A Note to Investors about Global Macro 327

Acknowledgments 329 Bibliography 331 Index 335 FOREWORD

fi rst met Steven Drobny in Barcelona in 2004. He had invited me to give I a keynote address at a global macro hedge fund conference he was organizing. At that time, I had only the haziest notion of what a global macro hedge fund was, but I accepted—not realizing that the keynote at such an event was essen- tially a form of entertainment. No doubt I gave some spiel about the impending demise of the American empire or the unsustainable nature of the U.S. current account defi cit or the impending liquidity crisis that would be triggered by some geopolitical crisis or other. The other conference participants—nearly all managers of macro hedge funds—listened more or less politely, but made little secret of their skepticism when it came to questions afterward. Given that the next four years were going to witness one of the greatest fi nancial upswings of all time, they had good reason to be dubious. The real business of the conference was not my after-dinner speech, of course, but the peer-to-peer sessions conducted the next day. As I listened with growing fascination, a succession of hedge fund managers stood up and explained with great precision how inordinately large sums of money could be made out of complex transactions, the like of which I had never heard. What was a “swap”? A “steepener”? And what on earth was the “Swissie” everyone kept talking about? Having spent almost the entirety of my professional career in universities—apart from a one-year fellowship at the Bank of England—I had for many years complacently assumed that academics were the smart- est people on the planet. Not well paid, to be sure, but otherwise rewarded by the pleasures and pains of scholarship. Yet I had always worried about the gap between the grand theories I and my colleagues discussed in the groves of academe and the rough-and-tumble world of practice. For years I had called myself an economic historian, with pretensions to understanding the world of fi nance. After a day at the conference I realized that I understood next to nothing.

ix x FOREWORD

What most impressed me about the global macro managers was the way they proceeded from theoretical insights derived from conventional eco- nomics, to empirical research, to the conception of a particular transaction, to the execution of the transaction—to the result itself. Here was a disci- pline generally lacking in many fi elds of social science and the humanities. Within a year at the outside, and more commonly a month, it would be clear if the trade had worked. Money would have been made or lost. So impressed was I by what I saw in Barcelona that I made a mental note to attend more such events and, if possible, to get a little closer to the busi- ness of hedge fund management. I could think of few better ways to learn about the relationship between economic theory and fi nancial practice. Steven Drobny’s book makes an invaluable contribution by document- ing what has been a quite extraordinary fi nancial revolution. The rise of hedge funds stands out as one of the decisive structural changes witnessed in fi nancial markets over the past 15 or 20 years. Future historians will thank Drobny—not least because hedge fund managers like the ones featured in these pages are rarely the kind of people who write their own memoirs. Although written in 2004–2006, long before the great subprime crisis begat the credit crunch and (perhaps) the recession of 2008–2009, Inside the House of Money repays rereading today. Many of the managers interviewed here anticipated the coming crisis, sensing that the explosion of leverage in the United States and the widening of the U.S. current account defi cit were unsustainable trends. If anyone had an incentive to anticipate the great struc- tural shifts of our time—not least the relative decline of the United States and the rise of East Asia and South Asia—it was the macro hedge funds. With Western economies staring recession in the face, and many tradi- tional fi nancial institutions teetering on the brink not just of liquidity but of solvency, we are living through the most turbulent economic time in liv- ing memory. Volatility is back with a vengeance. The smartest of the Macro Funds saw this coming and were so well positioned that they actually made money from it. Anyone who wants to follow their example would benefi t from the insights that Steven Drobny has gathered here. Niall Ferguson William Ziegler Professor of Business Administration at Harvard Business School; Laurence A. Tisch Professor of History at Harvard University; Author of Numerous Books, Including The House of Rothschild and The Cash Nexus Cambridge, Massachusetts July 2008 PREFACE

hen I fi rst started writing this book in 2004, there was virtually no W information on the topic of global macro as an investment strategy, save a few chapters here and there in well-dated books. After enough inves- tor calls, meetings, and e-mails asking where to fi nd information on global macro, I started to put pen to paper, and this book evolved quite organi- cally out of those initial notes. I set out to defi ne global macro as a strategy, but it became a real education and adventure for me, as I found myself charting a new course. Fast-forward to today—nearly a decade later—and everyone is talking about global macro. Not only does every bank have a macro strategist, but they also have a China macro strategist, a Fixed Income macro strate- gist, an Emerging Markets macro strategist, and so on. A variety of global macro research newsletters, blogs, and touts have also been spawned, more often than not preaching doom and gloom. Even CNBC, which was for- merly preoccupied with discussions about tech stocks or the Dow Jones Industrial Average, now regularly opines about the U.S. dollar, LIBOR, European interest rates, Greek equities, Chinese currency values, Hong Kong housing prices, commodity spreads, and credit default swaps. Macro has gone mainstream, but global macro as an investment strategy is far more nuanced than just talking about macro instruments. And as more and more macro tourists enter the fray, it seems as if the art of global macro investing has been lost in the noise. And the art of global macro is embedded in a manager’s investment and risk management processes. Almost every investment decision comprises an implicit macro bet. When a long/ equity manager shorts the Hong Kong dollar, he does not instantly become a global macro manager. When a global equity investor calls for yield curve steepening or a merger arbi- trage manager buys credit default swaps on Germany, they should not be considered global macro managers.

xi xii PREFACE

Implementing global macro as a strategy is far more complex than put- ting on an occasional hedge or opportunistic trade. It is a diffi cult strategy to understand because, unlike, say, long/short equity, a manager can express trades in a myriad of diff erent ways. The range of instruments and markets available to a global macro manager means that fi ve diff erent managers can have exactly the same view but generate fi ve completely diff erent profi t- and-loss (P&L) streams, depending on how they express a trade. Likewise, a currency specialist and an equity specialist and a rates specialist might all be categorized as global macro hedge funds, yet each has a very diff erent approach to the market and ultimate trade expression, given where and how they are most comfortable expressing risk. This breadth and complex- ity are what make macro so challenging. Other hedge fund strategies are easier to understand, as they typically employ a much narrower range of instruments. Furthermore, most other strategies tend to have an embedded equity , which hurt them in 2008 but (if they survived) has provided a signifi cant tailwind ever since. A long/ short equity hedge fund is either long or short an individual stock, but is almost always net long. How this justifi es a 2/20 fee structure is beyond me, but that discussion is for another day (or book). In 2006, when this book was originally published, there was a signifi - cant amount of skepticism about the eff ectiveness of global macro as an investment strategy. Attention to deep out-of-the money tail risk events and rigorous risk management were for the faint of heart and nonbeliev- ers. Suddenly, in 2008, when portfolios lost a third or more of their value, all investors started asking fundamental questions about how to more eff ectively manage risk and avoid large drawdowns. As incorporating a global macro view became increasingly important, the classic macroeconomic textbooks became irrelevant as central banks around the world went unconventional and governments loosened up the rules by implementing unorthodox policies to address the global crisis. The powers that be broke the glass and threw out the rulebook. As a result, there is no playbook for navigating today’s markets. For this reason, these dated interviews with global macro managers are even more relevant today than when they were fi rst published. Policy has been dominating markets, whether in Japan, Europe, or Latin America. Under- standing how diff erent macro managers interpret global events, prioritize trading themes, express trades in their portfolios, and, most important, manage their risk under extreme scenarios is immensely important. PREFACE xiii

As I write, the S&P is above its all-time highs, Japan is reawakening from a 20-year slumber, U.S. interest rates have bounced off historical lows, and commodity markets across the board have seen pressure. The world has changed. But it is always changing. Market practitioners always have to adapt to increasing complexity and new variables. Good risk management, however, is unchanging. One only has to reread Reminis- cences of a Stock Operator, fi rst published in 1923, to realize that nothing has changed. Sure, more advanced concepts can be incorporated into a port- folio, or a manager can employ more robust risk management systems, but the basic framework or approach to risk management is as simple today as it has always been. I believe chip stack management is the most important skill in money management, far more important than brains, information, or making the right call. And this is exactly where the best global macro managers excel. In rereading this book now, I still learn new things, picking up on nuances that become more relevant today given the diff erent macro envi- ronment. With hindsight, it is fascinating to read what managers were pre- dicting back in 2004–2005. Although almost all of them called the crash, as one manager noted: if you are right but too early, you are wrong. Certain words or concerns or specifi c trades take on new meaning now that we know what happened. Rereading this book is like watching a scary movie once the creepy music starts—you know something bad is just around the corner. Since this book came out, we have all been forced to take a crash course in crisis management. But only now, amidst the (relative) stability of the prevailing environment, can we more fully process the events of 2008, instead of scrambling and reacting in the moment. However, it is precisely when times are quiet that preparing for the next storm becomes para- mount. Extreme scenario testing is the best thing that a money manager can practice. It is also interesting to follow the careers of the managers interviewed in this book, now almost 10 years later. Some have closed their funds, while others have prospered. Peter Thiel, for example, has wound down his macro hedge fund to focus on his family offi ce, having monetized his early-stage investment in Facebook (which is one of the greatest macro trades of all time—a distressed equity call option with no expiry). And Scott Bessent has returned to Soros Fund Management, one of the largest players in the macro space, as the chief investment offi cer. xiv PREFACE

More than anything, macro is a framework, a prism through which to see the world, fi lter ideas, and ultimately express and manage risk in your portfolio, whether that portfolio happens to be run in a hedge fund struc- ture or not. And it cannot be ignored. Steven Drobny Malibu, California August 2013 PREFACE TO THE 2009 EDITION

he original version of this book came out in spring 2006, near the T tail end of what has been called “the great moderation,” a period of low volatility, low interest rates, fl at yield curves, and strong globalequity and property markets that made investors relatively complacent about risk. Since then, we have seen a dramatic unwinding of this paradigm as extreme volatility has been ushered back into the markets. Large and divergent interest rate movements have become common, and equity and housing markets have in many instances fallen sharply from elevated levels. Central banks and governments around the world have responded with creative li- quidity measures and bailouts, as well as monetary and fi scal stimuli. These actions have not come without costs. Commodity prices exploded and then sold off , further complicating the infl ation outlook for policy makers. Stability seems to have bred instability, as Hyman Minsky once observed. Leverage, built up during the low-volatility quiet period, fi nally unraveled under its own weight, helped by central banks that raised interest rates. Although many were left naked as the tide receded, particularly exposed is the web of complex derivatives (SIVs, CDOs, CLOs, etc.) and the fi nancial creativity in the home lending arena, which created so much credit around the world. It is now clear that home prices do not always go up, much to the chagrin of rating agencies, governments, banks, investors, and lever- aged homeowners globally. Once the easy money dried up, a lot of the manager predictions in this book came to fruition. In particular, we have seen the U.S. dollar fall, and oil rally to levels not seen since the 1970s, the housing boom turn into a bust, major equity markets around the world crash, credit spreads blow out, and volatility return from historically low levels. Arguably, excess credit was the main driver of the low-volatility period from 2003 to 2007, whereas the tightening of credit has led to many sharp

xv xvi PREFACE TO THE 2009 EDITION reversals in 2007 and 2008. As central banks again cut rates to bail out investors, the next leg of this cycle is upon us. But will this process lead to infl ation, hyperinfl ation, stagfl ation, or is defl ation unavoidable? Likewise, will the world turn Keynesian with continued government stimulus or take the pain the Austrian way? The adage that there is always a bull market somewhere might very well speak to an imminent increase in government intervention, regulation, and legal bills. Will the trend toward globalization be altered in the process and what will the investment impli- cations be as a result? Other important questions face investors: Will the emerging world decouple from the developed world? Can China, India, Brazil, Russia, and others continue their dramatic growth without the help of their biggest customers? Is the United States in for a Japan-style lost decade, a European-style muddle through, or another Great Depression? It became clear in 2008 that macro variables have emerged as the pre- dominant drivers of investment performance. Bottom up/micro focused equity, bond, and commodity investors have been decimated, while global macro managers, for the most part, have been able to preserve investor capital. As such, global macro portfolio managers are exceptionally well- positioned to navigate what could be a sustained period of choppy, volatile markets. The managers in this book off er a snapshot of a diverse selection of global macro substrategies. Enhanced knowledge of each should serve inves- tors well while trying to stay afl oat in these increasingly uncertain times. For the paperback version, I have added a “Part Two” to the chapter with Jim Leitner. I have also added an addendum to Peter Thiel’s chapter.

Steven Drobny Manhattan Beach, California June 2008 PREFACE TO THE 2006 EDITION

edge funds are everywhere today. The term hedge fund used to conjure Himages of speculators hunting for absolute returns in any market in the world, using any instrument or style to capture their prey. The man- agers of the original multibillion-dollar mega-funds, such as George Soros or Julian Robertson, became well-known fi gures because of their speculative prowess. Yet they were also accused of such modern ills as attacks on developed world central banks and capital fl ight in the third world. After the crash of 2000, hedge funds came into their own by proving to be a superior asset management vehicle. As most global investors were suff ering year after year of negative returns, hedge funds performed. This encouraged a wave of institutional money to fl ow into such alternative investment vehicles. At the same time, given the superior fl exibility and attractive compensation structure of hedge funds, the most talented fi nancial minds migrated over in what became a mass exodus from The City and Wall Street. As hedge funds have matured, they have become more of a business. The tremendous infl ow of capital has altered the freewheeling image of more than a decade ago. This shift has spawned a more formalized indus- try where managers often implement rather narrow, specifi c strategies and where investors in hedge funds no longer tolerate down years or even down months of performance. Competition has smoothed returns, both on the upside and the downside, and lower returns have led to questions about hedge fund fees. Amidst this evolution and change in the hedge fund business, one strat- egy has remained true to its original mandate of investing, seeking outsized returns from investments anywhere in the world, in any asset class and in any instrument: global macro.

xvii xviii PREFACE TO THE 2006 EDITION

Global macro investing is still a relatively unknown and misunderstood area of money management but increasingly of interest. Given that my fi rm, Drobny Global Asset Management, advises investors on global macro hedge funds I am often asked the question, “What is global macro?” The classic defi nition—a discretionary investment style that leverages long and short positions in any asset class (equities, fi xed income, cur- rencies, and commodities), in any instrument (cash or derivatives), in any market around the world with the goal of profi ting from macroeconomic trends—often fails to satisfy. What I think people are really asking is, “How does one defi ne what the top global macro money managers actually do?” That’s a trickier question. Global macro is the most diffi cult of the hedge fund strategies to defi ne, simply because there is no defi nition. Just as the term hedge fund can be used to describe a wide variety of investing styles, so too global macro does not mean just one thing. Global macro has no mandate, is not easily broken down into numbers or formulas, and style drift is built into the strategy as managers often move in and out of various investing disciplines depending on market conditions. Even professional hedge fund investors struggle at times to decipher what global macro man- agers actually do. To help my inquisitors, I searched for books and research papers on the topic to recommend but found very little of value. This is surprising given the tremendous growth of assets and sophistication in the hedge fund busi- ness over the past few years and the fact that the public still associate hedge funds with the doyen of global macro, George Soros. Another reason the lack of literature on global macro is odd is that global macro variables infl uence all investment strategies. When a mutual fund increases its cash position, an endowment allocates to real estate, or an equity long/short hedge fund goes net long stocks, they are all making implicit global macro calls—even if they are not aware of it. Their invest- ment decisions are subject to changes in the world economy, the U.S. dol- lar, global equities, global interest rates, global growth, geopolitical issues, energy prices, and a multitude of variables of which they may never have heard. As such, an understanding of the global macro picture would seem of the utmost importance to the wider investment community. This book attempts to fi ll the gap in the literature. With the dearth of quality information out there about global macro, the next logical step was to speak directly to the smartest global macro managers I knew. With the PREFACE TO THE 2006 EDITION xix benefi t of the access aff orded through my business, I was able to draw on a host of resources to do just that. The original plan for these discussions with practitioners was simply to discover what global macro means to them, but the conversations proved to be much deeper. I learned how the best minds in the business think about risk, portfolio construction, history, politics, central bankers, global- ization, trading, competition, investors, hiring, the evolution of the hedge fund business, and a variety of other details. As a result, a more involved research project developed. After these initial discussions, I set out to speak with a broader selection of today’s top global macro hedge fund managers. In search of the widest possible variety of views, I interviewed managers who have diff erent prod- uct specialties, diverse backgrounds, and varied mandates. I chose to focus on fundamental discretionary managers rather than those who depend solely on technical patterns or computer-driven trading models, because fundamental discretionary managers rely on their own judgment above and beyond any analytical tools they may employ. As it turns out, there is no simple way to defi ne what the top global macro managers actually do. Rather, global macro is an approach to mar- kets in the way that science is an approach to the unknown. As in science, many diff erent approaches can be used to tackle a question and, while many fail, several wildly diff erent paths can lead to success. It is in the course of the development and testing of market hypotheses where the art or the genius lies. Although global macro funds tend to be idiosyncratic, I found that all global macro managers begin with a broad top-down approach to the world before drilling down into the fi ne details. It is in the process of drilling down where they diff erentiate themselves, ending in a wide variety of specialties. In a sense, global macro is evolving into global micro, whereby today’s managers derive their investment edge through having the latitude to express their micro expertise in various specialties and markets. I found other similarities among the managers in that they all love what they do, are incredibly hardworking, and are extremely smart. Yet despite their intelligence and strong opinions, they all seemed open-minded and fl exible when it came to being challenged by the market or their col- leagues. This fl exibility and willingness to admit that they could be wrong is, in a sense, how good hedge fund managers limit their downside risk and xx PREFACE TO THE 2006 EDITION cut off the left side of the return distribution. When it comes down to it¸ no matter the specifi c style of the manager, the goal of all global macro hedge fund managers is to produce superior risk-adjusted absolute returns for their investors and themselves. In the end, this book does not answer the question, “What is global macro?” Instead, it off ers an inside look at how some of today’s best and the brightest practitioners think about their area of expertise. Hopefully, this book will simultaneously help to demystify what today’s global macro managers actually do and show why there are so few who truly excel in this endeavor. If you learn as much from reading these interviews as I did conducting them, I will consider this research project a success. I begin with a word from Joseph G. Nicholas, founder and chairman of HFR Group, who off ers a professional investor’s perspective of global macro. Next, I briefl y highlight some of the key historical events in global macro to off er background and perspective which should prove helpful while reading the interviews. I attempt to show the evolution of global macro from its origins with John Maynard Keynes to George Soros, and then on to the future where increased competition and specialization are leading today’s global macro manager into the realm of global micro. Finally, we go “inside the house of money” via a collection of 12 inter- views with top global macro practitioners, each of whom off ers a unique perspective on global markets. The interviews were conducted all over the world between October 2004 and July 2005.

Steven Drobny Manhattan Beach, California January 2006 CHAPTER 1

INTRODUCTION TO GLOBAL MACRO HEDGE FUNDS

Joseph G. Nicholas Founder and Chairman of HFR Group

he global macro approach to investing attempts to generate outsized T positive returns by making leveraged bets on price movements in equity, currency, interest rate, and commodity markets. The macro part of the name derives from managers’ attempts to use macroeconomic prin- ciples to identify dislocations in asset prices, while the global part suggests that such dislocations are sought anywhere in the world. The global macro hedge fund strategy has the widest mandate of all hedge fund strategies whereby managers have the ability to take positions in any market or instrument. Managers usually look to take positions that have limited downside risk and potentially large rewards, opting for either a concentrated risk-taking approach or a more diversifi ed portfolio style of money management. Global macro trades are classifi ed as either outright directional, where a manager bets on discrete price movements, such as long U.S. dollar index or short Japanese bonds, or relative value, where two similar assets are paired

1 2 INSIDE THE HOUSE OF MONEY on the long and short sides to exploit a perceived relative mispricing, such as long emerging European equities versus short U.S. equities, or long 29- year German Bunds versus short 30-year German Bunds. A macro trad- er’s approach to fi nding profi table trades is classifi ed as either discretionary, meaning managers’ subjective opinions of market conditions lead them to the trade, or systematic, meaning a quantitative or rule-based approach is taken. Profi ts are derived from correctly anticipating price trends and capturing spread moves. Generally, macro traders look for unusual price fl uctuations that can be referred to as far-from-equilibrium conditions. If prices are believed to fall on a bell curve, it is only when prices move more than one standard deviation away from the mean that macro traders deem that market to present an opportunity. This usually happens when market participants’ perceptions diff er widely from the actual state of underly- ing economic fundamentals, at which point a persistent price trend or spread move can develop. By correctly identifying when and where the market has swung furthest from equilibrium, a macro trader can profi t by investing in that situation and then getting out once the imbalance has been corrected. Traditionally, timing is everything for macro traders. Because macro traders can produce signifi cantly large gains or losses due to their use of leverage, they are often portrayed in the media as pure speculators. Many macro traders would argue that global macroeconomic issues and variables infl uence all investing strategies. In that sense, macro traders can utilize their wide mandate to their advantage by moving from market to market and opportunity to opportunity in order to generate the outsized returns expected from their investor base. Some global macro manag- ers believe that profi ts can and should be derived from other, seemingly unrelated investment approaches such as equity long/short, investing in , and various strategies. Macro traders recog- nize that other investment styles can be profi table in some macro envi- ronments but not others. While many specialist strategies present liquidity issues for other, more limited investing styles in charge of substantial assets, macro managers can take advantage of these occasional opportunities by seamlessly moving capital into a variety of diff erent investment styles when warranted. The famous global macro manager George Soros once said, “I don’t play the game by a particular set of rules; I look for changes in the rules of the game.” INTRODUCTION TO GLOBAL MACRO HEDGE FUNDS 3

SUMMARY

Global macro traders are not limited to particular markets or products but are instead free of certain constraints that limit other hedge fund strategies. This allows for effi cient allocation of risk capital globally to opportunities where the risk versus reward trade-off is particularly com- pelling. Whereas signifi cant can prove an issue for some more focused investing styles, it is not a particular hindrance to global macro hedge funds given their fl exibility and the depth and liquidity in the markets they trade. Although macro traders are often considered risky speculators due to the large swings in gains and losses that can occur from their leveraged directional bets, when viewed as a group, global macro hedge fund managers have produced superior risk- adjusted returns over time. From January 1990 to December 2005, global macro hedge funds have posted an average annualized return of 15.62 percent, with an annualized standard deviation of 8.25 percent. Macro funds returned

HFRI Macro Index Growth of $1,000

$10,000

$9,000

$8,000

$7,000

$6,000

$5,000

$4,000

$3,000

$2,000

$1,000

$0 Initial 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

HFRI Macro Index S&P 500 w/ dividends

FIGURE 1.1 Comparison of HFRI Macro Index with S&P 500 Source: HFR. 4 INSIDE THE HOUSE OF MONEY over 500 basis points more than the return generated by the S&P 500 index for the same period with more than 600 basis points less volatility. Global macro hedge funds also exhibit a low correlation to the general equity market. Since 1990, macro funds have returned a positive per- formance in 15 out of 16 years, with only 1994 posting a loss of 4.31 percent. (See Figure 1.1.) In light of the correlation, volatility, and return characteristics, global macro hedge fund strategies are a welcome addition to any portfolio. CHAPTER 2

THE HISTORY OF GLOBAL MACRO HEDGE FUNDS

he path to today’s style of global macro investing was paved by John T Maynard Keynes a century ago. For an economist, Keynes was a renais- sance man. Not only was he the father of modern macroeconomic theory but he also advised world governments, was involved in the Bloomsbury intellectual circle, and helped design the architecture of today’s global mac- roeconomic infrastructure by way of the World Bank and International Monetary Fund. At the same time, he was also a successful investor, using his own macroeconomic principles as an edge to extract profi t from the markets. Some say he was the fi rst of the modern global macro money managers. In the words of Keynes’ biographer Robert Skidelsky, “[Keynes] was an economist; he was an investor; he was a patron of the arts and a lover of ballet. He was a speculator. He was also confi dant of prime ministers. He had a civil service career. So he lived a very full life in all those ways.” Keynes speculated with his personal account, invested on behalf of vari- ous investment and trusts and even ran a college endowment, each of which had diff erent goals, time horizons, and product mandates. Upon his death, he left a substantial personal fortune primarily a result of his fi nancial market activities. Evidence of Keynes’ investing acumen can be found in the returns of the King’s College Cambridge endowment, the College Chest, for which he had total discretion as the First Bursar. A publicly available track record shows he returned an average of 13.2 percent per annum from 1928 to 1945, a time when the broad UK equity index lost an average of 0.5 percent per annum.

5 6 INSIDE THE HOUSE OF MONEY

(See Figure 2.1.) This was quite a feat considering the 1929 stock mar- ket crash, the Great Depression, and World War II occurred over that time frame. But, like all great investors, Keynes fi rst had to learn some diffi cult les- sons. He was not immune to blowups in spite of his superior intellect and understanding of global markets. In the early 1900s, he successfully specu- lated in global currencies on margin before switching to the commodity markets. Then, during the commodity slump of 1929, his personal account was completely wiped out by a margin call. After the 1929 setback, his greatest successes came from investing globally in equities but he contin- ued to speculate in bonds and commodities. Skidelsky adds, “His investment philosophy. . .changed in line with his evolving economic theories. He learned a lot of his theory from his expe- rience as an investor and this theory in turn modifi ed his practice as an investor.” Keynes’ distaste of fl oating currencies (ironically his original vehicle of choice for speculating) eventually led him to participate in the construction of a global fi xed currency regime at Bretton Woods in 1945. The post-World

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FIGURE 2.1 King’s College Cambridge Chest Fund and the UK Broad Country Equity Index Source: Motley Fool. THE HISTORY OF GLOBAL MACRO HEDGE FUNDS 7

War II economic landscape, coupled with the ensuing Cold War–induced peace and the relative stability fostered by Bretton Woods, led to a boom in developed-country equity markets starting in 1945 and lasting until the early 1970s. During that time, there were few better opportunities in the global markets than buying and holding stocks. It wasn’t until the breakdown of the Bretton Woods Agreement in 1971, and the subsequent decline in the U.S. dollar, that the investment universe again off ered the opportunities that spawned the next generation of global macro managers.

POLITICIANS AND SPECULATORS Recent history is riddled with examples of politicians attempting to place blame on speculators for shortcomings in their own policies, and the breakdown of Bretton Woods was no exception. When the currency regime unraveled, President Nixon attempted to lay blame on speculators for “waging an all-out war on the dollar.” In truth, his own infl ationary policies are more often cited as the underlying problem, with speculators a mere symptom of the problem.

THE NEXT GENERATION OF GLOBAL MACRO MANAGERS

The next round of global macro managers emerged out of the break- down of the Bretton Woods fi xed currency regime, which untethered the world’s markets. With currencies freely fl oating, a new dimension was added to the investment decision landscape. Exchange rate vola- tility was introduced while new tradable products were rapidly being developed. Prior to the breakdown of Bretton Woods, most active trad- ing was done in the liquid equity and physical commodity markets. As such, two diff erent streams of global macro hedge fund managers emerged out of these two worlds in parallel.

The Equity Stream One stream of global macro hedge fund managers emerged out of the international equity trading and investing world. Until 1971, the existing hedge funds were primarily focused on equi- ties and modeled after the very fi rst hedge fund started by Alfred Winslow 8 INSIDE THE HOUSE OF MONEY

Jones in 1949. Jones’s original structure is roughly the same as most hedge funds today: It was domiciled off shore, largely unregulated, had less than 100 investors, was capitalized with a signifi cant amount of the manag- er’s money, and charged a performance fee of 20 percent. (Allegedly, the now standard 20 percent performance fee was modeled by Jones upon the example of another class of traders who demanded a profi t sharing arrangement that provided the proper incentive for taking risk: Fifteenth- century Venetian merchants would receive 20 percent of the profi ts from their patrons upon returning from a successful voyage.) The A.W. Jones & Co. trading strategy was designed to mitigate global macro infl uences on his stock picking. Jones would run an equally weighted “hedged” book of longs and shorts in an attempt to eliminate the eff ects of movements by the broader market (i.e., stock market beta). Once currencies became freely fl oating, though, a new element of risk was added to the equation for international equities. Whereas managers using the Jones model sought to neutralize global macro–induced moves, the global macro managers who emerged from the international equity arena sought to take advantage of these new opportunities. Foreign exchange risk was treated as a whole new tradable asset class, especially in the con- text of foreign equities where currency exposure became a major factor in performance attribution. Managers from this stream such as George Soros, Jim Rogers, Michael Steinhardt, and eventually Julian Robertson (Tiger Management) were all too willing to use currency movements as an additional opportunity set to be capitalized upon. They were already successful global long/short equity investors whose experience in global markets made the shift to currencies and foreign bonds seamless in the post–Bretton Woods world. In the early days of this new paradigm, these managers saw little in the way of compe- tition. Over time, though, as their superior returns attracted larger amounts of capital, the funds were increasingly forced to trade deeper, more liquid markets and thus move beyond their core competence of stock picking. At the same time, competition intensifi ed.

The Commodity Stream The other stream of global macro managers developed out of the physical commodity and futures trading world that was centered in the trading pits THE HISTORY OF GLOBAL MACRO HEDGE FUNDS 9 of Chicago. It developed independently although simultaneously with the equity stream. The biggest global macro names to emerge from the commodity world, however, did not come from the Chicago epicenter but instead learned their craft from the most forward thinking of commodity and futures trad- ing fi rms: Commodities Corporation of Princeton, New Jersey. The founder of Commodities Corporation (CC), Helmut Weymar, is said by many to be the father of the commodity stream of global macro. Weymar, an M.I.T. PhD and former star cocoa trader for Nabisco, founded CC along with his mentor and legendary trader Amos Hostetter, wheat speculator Frank Vannerson, and his former professor, Nobel Prize winner Paul Samuelson, with the goal of providing an ideal environment where traders could take risk without worrying about administration and other distractions. The management of CC had a solid understanding of risk tak- ing and off ered an incredibly open framework in which traders thrived. CC incubated or served as an important early source of funding for some of the best known global macro managers of all time, including (Caxton), (Tudor Investment Corporation), Louis Bacon (Moore Capital), Michael Marcus, Grenville Craig, Ed Seykota, Glen Olink, Morry Markowitz, and Willem Kooyker (Blenheim Capital), to name a few. Commodities Corporation was originally set up to take advantage of tradable physical commodities, and traders were siloed such that each focused exclusively on one . As world trade opened up in the 1970s and 1980s, global macroeconomic infl uences started to play a larger and more important role in determining the price movements in the commodity markets. Being accustomed to the sometimes extreme volatility, and having the knowledge of the macroeconomic infl uences on their specifi c markets, the fi rm easily moved into trading currency and fi nancial futures as those markets developed. For CC traders, as long as there was volatility, they were indiff erent to the underlying asset. Commodities Corporation traders involved in all products became known as “generalists.” While CC founder Hostetter had been trading stocks, bonds, and commodities since the 1930s, the fi rst successful general- ists to emerge at CC were plywood and cotton trader Michael Marcus and his young assistant Bruce Kovner. Kovner especially pushed CC toward a more global macro style of trading, which meant trading all products, any- time, anywhere. He also started another trend in the organization, namely, 10 INSIDE THE HOUSE OF MONEY leaving the fi rm to set up his own fund. Started with the blessing and initial capital from CC, Kovner’s fund, Caxton, is now one of the largest hedge fund management groups in the world as measured by assets under manage- ment. Likewise, several other CC alumni are managing some of the largest hedge fund complexes today. Many credit their success to lessons learned at CC about risk management, leverage, and trading. As a testament to its suc- cess, Commodities Corporation was purchased by in 1997 after evolving into more of a fund of hedge funds investment vehicle, with many allocations still out to original CC traders.

MAJOR GLOBAL MACRO MARKET EVENTS

For the purposes of this book, we are going to use the experiences of the global macro pioneers, such as Soros, Robertson, and Tudor Jones to dis- cuss some of the important episodes in the global macro arena over the past few decades, mainly because macro markets were dominated by these managers until 2000. What is interesting about these episodic moments in global macro his- tory is not what happened to the macro trading community, but rather that the lessons learned from these events served as the education for today’s generation of global macro managers. Today’s managers, many of whom are alumni of the original global macro fund managers, earned their stripes during the ensuing crises and events. While Keynes had his 1929 event to learn about the positive and negative eff ects of trading on leverage, which he subsequently incor- porated into his trading style and translated into future success, today’s managers had the 1987 stock market crash, the sterling crisis of 1992, the rout of 1994, the Asia crisis of 1997, the Russia/LTCM crisis of 1998, and fi nally the dot-com bust of 2000. (See Figure 2.2.) The ways that today’s managers look at markets, control risk, and manage their busi- nesses include lessons learned through these important events.

The Stock Market Crash of 1987 Although the U.S. stock market crash of October 1987 is now a mere blip on long-term stock market charts (see Figure 2.3), as indexes fully recovered only two years later, the intensity of Black Monday for traders who lived through it has certainly left its mark. Most notably, the notions of liquidity THE HISTORY OF GLOBAL MACRO HEDGE FUNDS 11

FIGURE 2.2 Major Global Macro Market Events since 1971 Source: DGA.

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FIGURE 2.3 S&P 500 Index, 1980–2005 Source: Bloomberg.

risk and fat tails were introduced to the wider investment community without mercy. Entire portfolios and money management businesses were obliterated on that day as margin calls went unfunded. Indeed, even so-called “portfolio insurance” hedges didn’t work as the futures and options markets became unhinged from the cash market. Yra Harris (Praxis Trading) explains in his interview later in this book what he saw that day on the fl oor of the Chicago Mercantile Exchange: 12 INSIDE THE HOUSE OF MONEY

FAT TAILS “Fat tails” are anomalies in normal distributions, whereby observed outcomes diff er from those suggested by the distribution. In other words, extreme occurrences can be more frequent than otherwise theoretically expected. Because markets are governed by human behavior, under- and overreactions to various data and indicators and the herding instincts of participants sometimes push prices to extremes, explaining the prevalence of such extreme but infrequent events in reality.

It was eerie and scary because you just didn’t know the extent of everything. People were clearly hurting badly but you just didn’t know how badly. I’ve traded through a lot of devaluations and debacles but I’ve never seen as many people pulled off the fl oor by clearinghouses as I did that day. The pit was practi- cally empty, which actually turned into a great opportunity to trade the S&Ps. I went into the S&P pit and starting making markets because nobody else was. Spreads were so unbelievably wide that it was pretty easy to make money just scalping around. Honestly, I couldn’t help it.

Global macro managers from the equity stream, including George Soros, got hurt in the 1987 crash. Just prior to the crash, Fortune maga- zine ran a cover story entitled, “Are Stocks Too High?” in which Soros disagreed with the notion. Days later, Soros lost $300 million as stocks collapsed (yet Soros Fund Management still ended the year up 14 percent). Meanwhile, Tiger Management posted its fi rst down year (–1.4 percent) only one year after an article, noting Tiger’s 43 percent average annual returns since inception in 1980, sparked the next wave of hedge fund launches. For global macro traders from the commodities stream, however, the 1987 crash served as a windfall event. Paul Tudor Jones in particular was elevated to star status when he famously caught the short side of the stock market and the long side of the bond market by identifying similarities between technical trading patterns in 1987 and the great crash of 1929. (See Figure 2.4.) Jones’s Tudor Investment Corporation returned 62 percent for the month in October 1987 and 200 percent for the year. THE HISTORY OF GLOBAL MACRO HEDGE FUNDS 13

The year 1987 also marked the introduction of a new Federal Reserve chairman in Alan Greenspan. Greenspan came into offi ce in August 1987 and his fi rst act a few weeks later was to raise the discount rate by 50 basis points. This unexpected tightening created volatility and uncertainty in the markets as traders adjusted to the style of a new Fed chairman. Some argue that Greenspan’s rate hike was actually the cause of the subsequent equity market meltdown a month-and-a-half later. Immediately after the stock market crash, Greenspan fl ooded the market with liquidity, initiating a process that came to be known as the “Greenspan put.” The Greenspan put is an implicit option that the Fed writes anytime equity markets stumble, in hopes of bailing out investors. Former Federal Reserve chairman William McChesney Martin famously observed that the job of a central banker is to “take away the punch bowl just when the party is getting started.” Alan Greenspan, on the other hand, seemed to interpret his role as needing to intervene only as the partygoers are stumbling home. As he has claimed, bubbles can only be clearly observed in hindsight, such that the role of a central

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FIGURE 2.4 Dow Jones Industrial Average: The Late 1920s versus the Late 1980s Source: Bloomberg. 14 INSIDE THE HOUSE OF MONEY banker is to soften the impact of the bubble’s bursting rather than to take away the fuel for the party.

Black Wednesday 1992 The term global macro fi rst entered the general public’s vocabulary on Black Wednesday, or September 16, 1992. Black Wednesday, as the sterling crisis is called, was the day the British government was forced to withdraw the pound sterling from the European Exchange Rate Mechanism (ERM)— a mere two years after joining—sending the currency into a free fall. The popular press credited global macro hedge fund manager George Soros with forcing the pound out of the ERM. As Scott Bessent (Bessent Capi- tal), head of the London offi ce of Soros Fund Management at the time, noted, “Interestingly, no one had ever heard of George Soros before this. I remember going to play tennis with him at his London house on the Saturday after it happened. It was as if he were a rock star with cameramen and paparazzi waiting out front.” The ERM was introduced in 1979 with the goals of reduc- ing exchange rate variability and achieving monetary stability within Europe in preparation for the Economic and Monetary Union (EMU) and ultimately the introduction of a single currency, the euro, which culminated in 1999. The process was seen as politically driven, attempt- ing to tie Germany’s fate to the rest of Europe and economically anchor the rest of Europe to the Bundesbank’s successful low interest rate, low infl ation policies. The United Kingdom tardily joined the ERM in 1990 at a central parity rate of 2.95 deutsche marks to the pound, which many believed to be too strong. To comply with ERM rules, the UK government was required to keep the pound in a trading band within 6 percent of the parity rate. An arguably artifi cially strong currency in the United King- dom soon led the country into a recession. Meanwhile, Germany was suff ering infl ationary eff ects from the integration of East and West Ger- many, which led to high interest rates. Despite a recession, the United Kingdom was forced to keep interest rates artifi cially high, in line with German rates, in order to maintain the currency regime. In Septem- ber 1992, as the sterling/mark exchange rate approached the lower end of the trading band, traders increasingly sold pounds against deutsche marks, forcing the Bank of England to intervene and buy an unlimited amount of pounds in accordance with ERM rules. Fears of a larger THE HISTORY OF GLOBAL MACRO HEDGE FUNDS 15 currency devaluation sent British companies scrambling to hedge their currency exposure by selling pounds, further compounding pressures on the system. In an eff ort to discourage speculation, UK Chancellor Norman Lamont raised interest rates from 10 percent to 12 percent, making the pound more expensive to borrow and more attractive to lend. However, this action only served to embolden traders and further frighten hedgers, all of whom continued selling pounds. Offi cial threats to raise rates to 15 per- cent fell on deaf ears. Traders knew that continually raising interest rates to defend a currency during a recession is an unsustainable policy. Finally, on the evening of September 16, 1992, Great Britain humbly announced that it would no longer defend the trading band and withdrew the pound from the ERM system. The pound fell approximately 15 percent against the deutsche mark over the next few weeks, providing a windfall for specula- tors and a loss to the UK Treasury (i.e., British taxpayers) estimated to be in excess of £3 billion. (See Figure 2.5.) It was reported at the time that Soros Fund Management made between $1 billion and $2 billion by shorting the pound, earning George Soros the moniker “the man who broke the Bank of England.” But he was certainly

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FIGURE 2.5 Sterling/Mark and UK Base Rates, 1992 Source: Bloomberg.