THE HEDGE FUND INDUSTRY IS HEADED FOR A FALL, and it has no one to blame but itself. So says Richard Bookstaber, former head of risk management at Moore Capital Management, a $12.5 billion hedge fund firm based in New York and London. In his new book, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, published this month by John Wiley & Sons, Bookstaber argues that academic theory, computer advances and human error have conspired to increase risk, not lessen it. Bookstaber, 56, speaks from experience, having witnessed firsthand -- at Morgan Stanley in the 1980s and at Salomon Brothers in the ‘90s -- most of the major market meltdowns of the past 20 years. He peppers A Demon of Our Own Design with illuminating anecdotes, including how the decision in July 1998 by Jamie Dimon, co-CEO of Travelers Group’s Salomon Smith Barney subsidiary, to publicly announce his firm’s intention to close its arbitrage group effectively signed the death warrant for John Meriwether’s hedge fund, Long-Term Capital Management, which was invested in many of the same strategies and securities as the investment bank. Although managers may disagree with Bookstaber’s conclusion -- that hedge funds must cut back on leverage and complex investment strategies to prevent a market collapse -- they should enjoy this exclusive excerpt, which tells how two hedge fund titans, George Soros and Julian Robertson Jr., fell victim to the Internet bubble for very different reasons. -- Imogen Rose-Smith
In the bucket shop era of the early 1900s, stock operators manipulated prices and churned positions to attract hungry investors who were looking to make a killing. In the Internet era, the mechanism of a very narrow float was used to inflate stock prices and churn legitimate investors. In both cases, a high volume of trading was essential to move prices higher. In contrast, value-based market appreciation does not need much trading to elicit an increase in the market price. In fact, in the extreme case, envisioned by the efficient market paradigm, new information that creates a shift in value will lead all investors to revalue their positions, so that the price will change to a new equilibrium level without any trading.
The change in wealth with market appreciation can itself propel market prices, independent of any new information or any change in the view of a company’s fundamental value. When people have more money, they are willing to put more of it at risk, especially when it came from speculative investment in the first place. There is a wealth cycle that can drive price appreciation, as investor demand leads prices to be bid up and as investors put more and more of their wealth into the market. The smaller the quantity of stock available to meet this demand, the higher the price will go.
At the time of the first major run-up in Internet stocks in 1998, the float of such major Internet stocks as Amazon, Excite, and Yahoo! was around 10 percent of the total shares outstanding. Daily volume averaged over 10 percent of the float, compared with a volume-float ratio of 1 percent for the similar but more established companies like Intel, Microsoft and even AOL. In contrast, in a value-based market the float will not matter, because investors will not be willing to buy the stock at higher than fair value, and fair value will be determined by the total shares of the stock outstanding, not by the stock that happens to be in the market.
The warning signs for this cycle therefore were large price changes coupled with large flows, high volume-to-float ratios, high short interest relative to float, and -- a natural outgrowth of these factors -- high volatility. There were also disparities in correlation. The places where the winners were piling on their investments became hot spots -- sectors with high internal correlation but low correlation with the rest of the market.
The end of the Internet bubble arrived when the period of restrictions on trading IPO holdings passed and the float expanded beyond the point of the demands of the extreme Internet optimists. Up to October 1999 the amount of IPO issuance that had become unlocked amounted to less than $40 billion. Then, in the last quarter of 1999, the IPO unlock exploded, with more than $50 billion worth released in December alone.
In January 2000 another $65 billion worth of IPO shares were unlocked and came into the market, and nearly $100 billion worth was released in the following three months. There was now more stock looking for buyers than there were superoptimists ready to buy. The marginal share had to find a buyer who was not all that hyped up about Internet prospects, and the downward spiral began.
What is surprising in all of this is that the flood from unlocked IPO shares and the implications this would have on the minuscule float were public information. Anyone could know how much would be freed up and when it would come to market. Although this became a subject of research interest, the implications it might have for the Internet bubble led to little action at the time. This was not for lack of notice.
For a moment during the Internet bubble, Warren Buffett, a world-class investor, looked like Warren Befuddled. So did hedge fund masters such as Julian Robertson, whose Tiger Management fund was beaten to the ground by his doggedly rational addiction to value. George Soros, who broke the Bank of England, was broken the same way -- fighting the equity crowds clamoring to buy more stock. His book Irrational Exuberance (Princeton University Press, 2000) earned Robert Shiller notoriety for his call that we were in the middle of a bubble, but in fact many investment professionals recognized it for what it was, the chorus getting louder as the bubble swelled. However, it is one thing to say the market has run amuck; it is another thing to trade against it. One of the most surprising fallouts of the Internet bubble was the closing, in rapid succession, of both Robertson’s and Soros’ long-admired funds. Each took a different path in trading against the “insanity,” and each failed.
Robertson’s Tiger investment fund enjoyed a remarkable run, returning an average of more than 30 percent each year in its first 18 years. Even after stumbling badly in its last two years, with a drawdown of nearly 50 percent, it still returned 25 percent annually over the course of its existence. Robertson persisted in a strategy that made sense before the Internet boom and after the bubble burst, but was poison in between: value investing. He elected to ignore the bubble, during which he felt “earnings and price considerations take a backseat to mouse clicks and momentum,” and stay the course as his stocks dropped in attraction and in value. Unfortunately, he had little choice but to do so because he held positions that were so large as to be illiquid. The most prominent of these was a 25 percent stake in US Airways; the value of Tiger’s position dropped by two thirds from the time Robertson acquired his stake, and there was no way to sell the position off. Indeed, since his position had become so well known, even rumors that he might be thinking of selling his holdings would sink the stock price. (Two months after Robertson closed shop in March 2000, vindication for his keystone position came in for a landing. US Airways agreed to be bought by United Airlines, and its price nearly doubled overnight.)
Bad as it appeared, Tiger’s last year and a half was perhaps even worse than the 50 percent drawdown suggests. The fund may well have lost more money in the last 18 months of its existence than it had earned in all of the previous 18 years. It started in 1980 with less than $10 million in capital; by 1998, it had in excess of $22 billion of capital, the vast majority of this money coming from new investments. And it is from this height that it began its fall into oblivion, generating losses of some $10 billion from peak to closing. This is almost certainly more than all the dollars it earned for its investors previously, when the fund posted spectacular returns, but on a much smaller dollar base. This means that when all the chips are counted, one of the most stellar traders of all time may well have spent 20 years and acquired a personal fortune while on net losing money for his investors.
The same might also be said of the other luminary of the hedge fund universe. George Soros’ investment performance eclipsed even that of Robertson; his Quantum Fund generated average returns exceeding 30 percent over more than three decades. Soros made his largest gains in the macro markets of foreign currencies, where he was best known for a huge bet against the British pound that netted him nearly $2 billion. Like Robertson’s funds, at their peak Soros’ funds commanded more than $20 billion of capital.
While Robertson stuck to his value-investing guns, Stanley Druckenmiller, the manager for Soros’ Quantum Fund, didn’t fight the tape. The Internet bet pulled Druckenmiller out of a hole in 1999, moving the fund from negative territory to plus 35 percent for the year. But with large positions, it was impossible for the fund to navigate the shallow float of the Internet stocks, and when the market turned in March 2000, Druckenmiller could not climb out of the positions without sizable losses. In March the fund lost 12 percent; through April another 20 percent.
Robertson blamed his demise on “irrational markets.” Soros similarly professed bewilderment, saying that “historical measures of value no longer apply.” Robertson justified his direction, stating, “We are not smart enough to know when they will begin to perform, but we do know that they are value. Buying value has always been our strategy, and it’s our strategy now. And we do know that value will win out eventually.” Alas, too late for him.
In contrast to these two funds, yet another sage of the markets remains open for business: Warren Buffett. Like Robertson, he did not understand where the value was coming from for the Internet stocks, and like Robertson he elected to sidestep the party. But he differed from Robertson in the concentration and leverage that he put into play. Although his holding company, Berkshire Hathaway, dropped nearly 50 percent in value by early 2000, it could ride out the frenzy in part because it owned actual businesses -- furniture, newspapers, jewelry -- that had actual sales and profits.
If value is your religion, the Internet bubble left you with damnable choices. You could try to ride the bubble up and be quick enough to bail out before it burst, as Soros’ Quantum Fund attempted. Unfortunately, the success of that approach depended critically on the ability to move out of the positions when the market turned. The Quantum Fund was an elephant trying to ride a balloon. It couldn’t work. Quantum was too heavily invested in relatively thinly traded stocks -- at least stocks that became thinly traded when the market turned. A second approach was to keep the faith in value, ignore the bubble worshippers, and stay focused on the stocks that had underlying value. Characteristically, Robertson and Buffett chose that path, although there was a critical difference between the two. Buffett had no problems with redemptions, because his investors owned shares that they could sell, and did, at whatever the market would bear. Robertson needed to worry about redemptions, as some of his investors defected to Internet stocks. But his fatal mistake was to lever and take on illiquid positions; the combination was like a vise that squeezed his ability to adjust his positions and thus the fund’s staying power. Buffett, while having his reputation tarnished in the short term, remained intact.
Early on during the Internet mania I discussed the inflated valuations of many of these companies with Stan Shopkorn, a great equity trader who was vice chairman of Salomon in the early 1990s. He held positions in a number of them, and I asked him how he could be in these markets. “Well,” he said, “that’s what makes me a trader and you a risk manager.”
While Buffett kept away from a market he could not understand, Robertson traded the value stocks against it and Soros realized after the fact that “we went into the new economy but we overstayed our welcome.” In the midst of the bubble, one manager who had watched his investments in Internet IPOs grow 20-fold, ballooning to upwards of $500 million, asked me how he could escape with his profits. He was restricted and could not sell. He knew a day of reckoning would come, and that “in a year or less this crap is going to be worth zero.” Well, there wasn’t much he could do; before he could get out, the bubble burst.
When the cycle breaks, a large price decrease will accompany an imbalance to sell. The trick is knowing when that imbalance will occur. For an unpredictable period of time, the wealth feedback gives reconfirming signals that endure too long for many people to resist. They can’t remain on the sidelines watching everyone else get rich, or hold on to a short position going south. It is all in the timing. Even the tulip mania in 17th-century Holland lasted for more than two years, but when it ended, you didn’t want to be the one holding the tulips.
Excerpted with the permission of John Wiley & Sons, from A Demon of Our Own Design, copyright 2007 by Richard Bookstaber. This book is available at all bookstores and online booksellers, from the publisher’s Web site at www.wiley.com or by phone, at 1-800-225-5945.
