MORE MONEY THAN GOD HEDGE FUNDS AND THE MAKING OF A NEW ELITE Sebastian Mallaby A Council on Foreign Relations Book THE PENGUIN PRESS New York 2010 More Money Than God ALSO BY SEBASTIAN MALLABY The World’s Banker: A Story of Failed States, Financial Crises, and the Wealth and Poverty of Nations After Apartheid: The Future of South Africa MORE MONEY THAN GOD HEDGE FUNDS AND THE MAKING OF A NEW ELITE Sebastian Mallaby A Council on Foreign Relations Book THE PENGUIN PRESS New York 2010 the penguin press Published by the Penguin Group Penguin Group (USA) Inc., 375 Hudson Street, New York, New York 10014, U.S.A. Penguin Group (Canada), 90 Eglinton Avenue East, Suite 700, Toronto, Ontario, Canada M4P 2Y3 (a division of Pearson Penguin Canada Inc. ) Penguin Books Ltd, 80 Strand, London WC2R 0RL, England Penguin Ireland, 25 St. Stephen’s Green, Dublin 2, Ireland (a division of Penguin Books Ltd) Penguin Books Australia Ltd, 250 Camberwell Road, Camberwell, Victoria 3124, Australia (a division of Pearson Australia Group Pty Ltd) Penguin Books India Pvt Ltd, 11 Community Centre, Panchsheel Park, New Delhi – 110 017, India Penguin Group (NZ), 67 Apollo Drive, Rosedale, North Shore 0632, New Zealand (a division of Pearson New Zealand Ltd) Penguin Books (South Africa) (Pty) Ltd, 24 Sturdee Avenue, Rosebank, Johannesburg 2196, South Africa Penguin Books Ltd, Registered Offi ces: 80 Strand, London WC2R 0RL, England First Published in 2010 by The Penguin Press, a member of Penguin Group (USA) Inc. Copyright © Sebastian Mallaby, 2010 All rights reserved The Council on Foreign Relations (CFR) is an independent, nonpartisan membership organization, think tank, and publisher dedicated to being a resource for its members, government officials, business executives, journalists, educators and students, civic and religious leaders, and other interested citizens in order to help them better understand the world and the foreign policy choices facing the United States and other countries. Founded in 1921, CFR carries out its mission by maintaining a diverse membership, with special programs to promote interest and develop expertise in the next generation of foreign policy leaders; convening meetings at its headquarters in New York and in Washington, DC, and other cities where senior government officials, members of Congress, global leaders, and prominent thinkers come together with CFR members to discuss and debate major international issues; supporting a Studies Program that fosters independent research, enabling CFR scholars to produce articles, reports, and books and hold roundtables that analyze foreign policy issues and make concrete policy recommendations; publishing Foreign Affairs, the preeminent journal on international affairs and U.S. foreign policy; sponsoring Independent Task Forces that produce reports with both findings and policy prescriptions on the most important foreign policy topics; and providing up- to-date information and analysis about world events and American foreign policy on its website, www.cfr.org. The Council on Foreign Relations takes no institutional position on policy issues and has no affiliation with the U.S. government. All statements of fact and expressions of opinion contained in its publications are the sole responsibility of the author or authors. Photograph credits appear on page 483. Library of Congress Cataloging-in-Publication Data Mallaby, Sebastian. More money than god : hedge funds and the making of a new elite / Sebastian Mallaby. p. cm. Includes bibliographical references and index. ISBN: 1-101-45714-7 1. Hedge funds. 2. Investment advisors. I. Title. HG4530.M249 2010 332.64'524— dc22 2009053253 designed by meighan cavanaugh Without limiting the rights under copyright reserved above, no part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior written permission of both the copyright owner and the above publisher of this book. The scanning, uploading, and distribution of this book via the Internet or via any other means without the permission of the publisher is illegal and punishable by law. Please purchase only authorized electronic editions and do not participate in or encourage electronic piracy of copyrightable materials. Your support of the author’s rights is appreciated. To my parents, Christopher and Pascale Contents Introduction : The Alpha Game 1 1. BIG DADDY 15 2. THE BLOCK TRADER 40 3. PAUL SAMUELSON’S SECRET 62 4. THE ALCHEMIST 83 5. TOP CAT 109 6. ROCK-AND-ROLL COWBOY 130 7. WHITE WEDNESDAY 147 8. HURRICANE GREENSPAN 172 9. SOROS VERSUS SOROS 193 10. THE ENEMY IS US 220 11. THE DOT-COM DOUBLE 248 12. THE YALE MEN 265 13. THE CODE BREAKERS 285 14. PREMONITIONS OF A CRISIS 307 15. RIDING THE STORM 323 16. “HOW COULD THEY DO THIS?” 348 CONCLUSION: SCARIER THAN WHAT? 373 Acknowledgments 392 Appendix I : Do the Tiger Funds Generate Alpha? 395 Appendix II: Performance of the Pioneers 400 Notes 408 Index 465 Photo Credits 483 Introduction: The Alpha Game he first hedge-fund manager, Alfred Winslow Jones, did not go to business school. He did not possess a PhD in quantitative finance. THe did not spend his formative years at Morgan Stanley, Gold- man Sachs, or any other incubator for masters of the universe. Instead, he took a job on a tramp steamer, studied at the Marxist Workers School in Berlin, and ran secret missions for a clandestine anti-Nazi group called the Leninist Organization. He married, divorced, and married again, honeymooning on the front lines of the civil war in Spain, traveling and drinking with Dorothy Parker and Ernest Hemingway. It was only at the advanced age of forty-eight that Jones raked together $100,000 to set up a “hedged fund,” generating extraordinary profits through the 1950s and 1960s. Almost by accident, Jones improvised an investment structure that has endured to this day. It will thrive for years to come, despite a cacophony of naysayers. Half a century after Jones created his hedge fund, a young man named Clifford Asness followed in his footsteps. Asness did attend a business school. He did acquire a PhD in quantitative finance. He did work for Goldman Sachs, and he was a master of the universe. Whereas Jones had launched his venture in his mature, starched-collar years, Asness rushed into the business at the grand old age of thirty-one, beating all records for 2 MORE MONEY THAN GOD a new start-up by raising an eye-popping $1 billion. Whereas Jones had been discreet about his methods and the riches that they brought, Asness was refreshingly open, tearing up his schedule to do TV interviews and confessing to the New York Times that “it doesn’t suck” to be worth mil- lions.1 By the eve of the subprime mortgage crash in 2007, Asness’s fi rm, AQR Capital Management, was running a remarkable $38 billion and Asness himself personified the new globe-changing finance. He was irrev- erent, impatient, and scarcely even bothered to pretend to be grown up. He had a collection of plastic superheroes in his offi ce.2 Asness freely recognized his debt to Jones’s improvisation. His hedge funds, like just about all hedge funds, embraced four features that Jones had combined to spectacular effect. To begin with, there was a perfor- mance fee: Jones kept one fifth of the fund’s investment profits for himself and his team, a formula that sharpened the incentives of his lieutenants. Next, Jones made a conscious effort to avoid regulatory red tape, pre- serving the flexibility to shape-shift from one investment method to the next as market opportunities mutated. But most important, from Asness’s perspective, were two ideas that had framed Jones’s investment portfolio. Jones had balanced purchases of promising shares with “short selling” of unpromising ones, meaning that he borrowed and sold them, betting that they would fall in value. By being “long” some stocks and “short” others, he insulated his fund at least partially from general market swings; and having hedged out market risk in this fashion, he felt safe in magnify- ing, or “leveraging,” his bets with borrowed money. As we will see in the next chapter, this combination of hedging and leverage had a magi- cal effect on Jones’s portfolio of stocks. But its true genius was the one that Asness emphasized later: The same combination could be applied to bonds, futures, swaps, and options—and indeed to any mixture of these instruments. More by luck than by design, Jones had invented a platform for strategies more complex than he himself could dream of. No definition of hedge funds is perfect, and not all the adventures recounted in this book involve hedging and leverage. When George Soros and Stan Druckenmiller broke the British pound, or when John Paulson shorted the mortgage bubble in the United States, there was no particular INTRODUCTION: THE ALPHA GAME 3 need to hedge—as we shall see later. When an intrepid commodities player negotiated the purchase of the Russian government’s entire stock of non- gold precious metals, leverage mattered less than the security around the armored train that was to bring the palladium from Siberia. But even when hedge funds are not using leverage and not actually hedging, the platform created by A. W. Jones has proved exceptionally congenial. The freedom to go long and short in any fi nancial instrument in any country allows hedge funds to seize opportunities wherever they exist. The ability to leverage allows hedge funds to size each bet to maximum effect. Perfor- mance fees create a powerful incentive to coin money. Ah yes, that money! At his death in 1913, J. Pierpont Morgan had accu- mulated a fortune of $1.4 billion in today’s dollars, earning the nickname “Jupiter” because of his godlike power over Wall Street.