WSO Book Club MMTG Part 1
As promised, here is the first content thread for ": Hedge Funds and the Making of a New Elite" by . The discussion threads will be subdivided as follows:
Week 1 (01/08): Chapter I - IV (A.W. Jones, Michael Steinhardt, Paul Samuelson, Quantum Fund) YOU ARE HERE
Week 2 (01/15): Chapter V - VIII (Tiger, Paul Tudor Jones, Stanley Druckenmiller, 1994 bond crisis)
Week 3 (01/22): Chapter IX - XII (1998 Russian crisis, LTCM, Dot-Com Bubble, Tom Steyer)
Week 4 (01/29): Chapter XIII - XVI (RenTech, Amaranth, John Paulson, and the subprime crisis)
(PREFACE: Throughout this book title in particular, we will be discussing people who have had very particular opinions on the way the world should be run politically. These people have used lobbying, think tanks, and in some cases actually running for political office in order to advance their views. None of that is relevant for discussing this book, which is about the history of hedge funds and their strategies. Discussing the political ideas of these people in isolation of their hedge fund ideas is highly frowned upon, and will not be treated favorably. Don't make me regret picking this book.)
Without further ado, let's get into it!
Chapter I: Alfred Winslow Jones had some early flirtations with left-wing and anti-Nazi politics within Europe before settling on starting the first "hedged fund," an investment structure that he argued strictly outperformed the market for this reason:
Example: Imagine that you have two stock-pickers, A & B, each with equal skills and $100K in capital. A, the unhedged investor puts $80K into his stock picks and keeps $20K in cash. The second, hedged investor B borrows $100K, then puts $130K into long stocks and puts 70K in short positions, yielding a net market position of ($130K - $70K = $60K). This means that investor B is less exposed to the equities markets. The book then elaborates on the notion that Investor B outperforms Investor A in bull and bear markets despite taking on less equities risk.
The other innovation of Alfred Winslow Jones is being the father of the multi-manager structure at a time when bank trust departments were extremely conservative about stockpicking. Jones would allocate a certain amount of capital to different stock pickers, reward the good ones with more capital, and punish the bad ones with less money, a very common model to this day. He also had this system adjusted for market volatility, a concept he discovered decades before Markowitz, as a means of risk control, but the go-go conglomerate years of the 1960s weakened this part of the system. As a result, his multi-managers took on too much market risk and were less hedged than they needed to be, resulting in significant losses, but not before Jones had already made many fortunes for himself.
Chapter II: Michael Steinhardt was on the other side of the go-go era: he shorted instead. This positioned his firm very well throughout the 1970s. Their strategy was to do deep-dive data analyses on individual companies and find situations where their opinion was highly contrary to what the broader market believed, a strategy that served them well.
The second successful innovation was that of block. The efficient market hypothesis (EMH) presumes that there is perfect liquidity in the market, an assumption that is violated when a pension fund or other larger stockholder wants to sell a large chunk of stock all at once. To take advantage of this, Michael Steinhardt became the go-to person for major S&T desks who were representing the sellers of these blocks of stock. He would buy at a substantial discount and successfully position it on the market for more, making a spread on the difference. In extreme instances, one of Steinhardt's tactics was to buy a block at a discount, then resell it on the market for a price even higher than the going price, converting a bearish sale into a bullish indicator and making more profit for himself. At times, he worked off of insider information, which made some of his business practices dubious, but he did well for himself nonetheless.
Chapter III: Commodities Corporation, now a subsidiary of, was founded by Helmut Weymar, a PhD who had seen great success in predicting the price of cocoa for Nabisco, allowing them to buy low and sell high and secure their commodities at more favorable terms than other consumer brands. He had a very complicated, data driven model that even looked at weather conditions in Africa to attempt to prognosticate the price of cocoa.
For the first few years of Commodities Corporation's history, the firm used similarly complicated data models to project the price of every commodity they could get their hands on, but after poring over a new dataset, the firm realized that a momentum strategy was easier to implement and superior to their complex data models. They would buy what was going up and short was going down, trying to follow trends from their infancy to their grave. They enjoyed great success in doing this, although the latter years of Commodities Corporation that are covered in the book were characterized by mass departures, leading to the creation of other entities likeCorporation and ultimately Paul Tudor Jones' fund (although he was less of an employee).
Chapter IV: After fleeing Nazism, George Soros came into contact with Karl Popper's philosophies around falsification and how humans can never be entirely certain of anything. Soros used these philosophies to develop an idea that he called "reflexivity." Because reality is too complex for humans to understand, investors rely on guesses that only approximate reality. But these guesses then go on to influence the actual market (e.g. when people view a publicly traded firm favorably, the company can raise more equity on good terms, allowing them to fund innovation and ultimately perform well-- a self fulfilling prophecy). Because of this, investors are doubly uncertain; they are uncertain of the proper inputs of action and they are uncertain of the final outcomes of the inputs.
Soros' Quantum Fund made an investment in defense stocks because of a belief that Western governments would soon spend more money fighting the Soviet Union after lackluster performance against the Soviets in Egypt. He was correct, and quickly made money on that bet. He also believed that speculators had reflexively pumped up the value of the US dollar in a self-reinforcing loop, and that at some point this loop would reverse and crash. So he bet against the US dollar and won that as well. The chapter ends with Black Monday of 1987, and how the Quantum Fund was caught flat-footed and lost substantial amounts of money.
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