WSO Book Club MMTG Part 2

As promised, here is the second content thread for "More Money Than God: Hedge Funds and the Making of a New Eliteby Sebastian Mallaby. The discussion threads will be subdivided as follows:

Week 1 (01/08): Chapter I - IV (A.W. Jones, Michael Steinhardt, Paul Samuelson, Quantum Fund)

Week 2 (01/15): Chapter V - VIII (Tiger, Paul Tudor Jones, Stanley Druckenmiller, 1994 bond crisis) YOU ARE HERE

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 V: Julian Robertson founded Tiger Global, which was a slight evolution from the Alfred Winslow Jones model discussed earlier. Robertson picked individual stocks, took them either long or short, and tried to hedge out market risk. He also delved into currencies, commodities, and bonds such that he was often making more macroeconomic bets than many of his predecessors (this is a common theme in these chapters). He differed by keeping a very tight control of the portfolio himself, as he trusted himself more than other people, rejecting the multi-manager model pioneered by A.W. Jones. Explanations of why Tiger's success were largely elusive, with possible answers including their flexibility to go long or short, use of derivatives (which were unavailable to A.W. Jones), and a vast Rolodex of equity research analysts and company insiders who could yield great insights. Robertson's Tiger was not only successful on his own; his proteges started the "Tiger Cub" funds which are still some of the most prominent hedge funds today.

Chapter VI: Paul Tudor Jones grew up interacting with people on the floor of the cotton exchanges in New Orleans, where he learned many of trading insights and discovered that what matters most in a market is the reaction to the news rather than the news itself. His Tudor Investment Corporation quickly became known as one that punched above its weight and one that could move markets quickly. Jones used a variety of unpredictable tactics like screaming and placing orders with multiple brokers to shock and awe the markets into moving his way. Jones credited much of his success to the Elliott Wave Theory, which he believed allowed him to correctly play the October 1987 flash crash, allowing him to fare better than all of the "Big Three" like Steinhardt, Soros, and Robertson. 

One of Jones' most prescient calls was when he declared that Japan's equity markets would fall substantially. At that time, Japanese investment funds were expected to make at least 8% each year, otherwise they would face ostracism from virtually all investors. The Japanese stock market had performed poorly in January, so Jones argued that the investment funds would take a risk-off approach and pile into bonds, which were paying more than 8% and would guarantee that the hurdle would be met. In this way, Jones predicted that Japanese equity traders would flee stocks and buy bonds. This ultimately played out exactly as Jones said.

Chapter VII: After the Berlin Wall fell and East and West Germany unified, there was a strong inflationary environment, which led the German central bank, the Bundesbank, to clearly signal that they would combat that inflation. This gave the Quantum Fund a clear opportunity to bet on rising interest rates, which led to exceptional performance. But there was one complication: at the same time Germany was inflating from reunification, much of Europe was in a recession, a time when central banks generally lower interest rates. This meant that for European currencies like the Italian lira and the British pound sterling, investors would sell these currencies and buy the higher yielding German mark, which would put downward pressure on the lira and pound. Quantum realized this and began betting against the pound and the lira. Quantum played out this trade in Finland and Italy, making large amounts of money in the process, but the most famous trade of them all would occur against the British pound.

Despite interest rate hikes by the Bank of England and attempts to support sterling by buying it, the hedge funds had much larger war chests at their disposal and overcame these efforts. The British pound fell 14% against the German mark, yielding enormous gains to the highly leveraged funds. Word leaked that Quantum had made large amounts of money on this trade, leading to negative publicity for the fund. To avoid this, the fund committed to being much more secretive, and a similar sized gain in the Swedish krona went largely unnoticed (to this day).

Chapter VIII: Michael Steinhardt (from the earlier chapter) pioneered the concept of a shadowbank, an investment fund that operates much like a commercial bank by taking and lending money. He accomplished this by borrowing from banks like Goldman Sachs and lending money by buying bonds. He did this with much fewer regulations than a typical bank, including much lower capital adequacy ratios. In this way, he could leverage his capital 100:1, far greater than any typical bank. He used this leveraged power to make much money in the European currency markets, making bets on interest rate moves that were clearly telegraphed by central bankers.

The shadowbank idea proliferated, resulting in odd cases like the time Bruce Kovner bought $6.5 billion worth of the $12 billion of Treasuries sold at an auction, then letting short sellers borrow his Treasuries and then repurchasing them on the open market, allowing Kovner to secure $16 billion in Treasuries, more than the amount outstanding. He manufactured his own short squeeze and imposed great losses on the people who borrowed his Treasuries and sold them short, showing the inherent instability of the shadowbank concept.

Because of the high leverage of the shadowbanks, they were extremely sensitive to small changes in interest rates. When Alan Greenspan began pursuing uncertain monetary policies, the hedge fund shadowbanks freaked out and began dumping bonds, driving up interest rates, which baffled central bankers who at the time were expecting interest rates to go down. Similar shocks occurred in the Japanese markets and the mortgage markets, resulting in shadowbank blowouts at Steinhardt's firm and the collapse of Askin Capital, a fund which was making highly leveraged bets on the mortgage market, pioneering products like interest-only (IO) and principal-only mortgage backed securities.

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Comments (11)

Jan 15, 2022 - 11:44pm
Pierogi Equities, what's your opinion? Comment below:

hi kellycriterion, I was a bit slow with reading the chapters, I'll add my comments sometime tomorrow. Chapter VI on Tudor was really interesting, I really enjoyed learning how he essentially used behavioral finance to create his market situations, sometimes splitting up his orders discreetly or announcing a wild loud order.

Quant (ˈkwänt) n: An expert, someone who knows more and more about less and less until they know everything about nothing.

  • 2
Jan 16, 2022 - 3:12am
Zenith_0_1, what's your opinion? Comment below:

I thought it was very interesting to see Soros focus on building his political brand over profits later in his career. Arguably most of the wealthy today ignore image to accumulate capital which they can use to lobby governments and influence policy decisions on issues they care about. Also interesting to see the Open society work is where many of the rumors about Soros comes from.

Jan 17, 2022 - 3:48am
Efficiently Inefficient, what's your opinion? Comment below:

Thanks for the write up again. 

Another very interesting 4 chapters. Another couple quick thoughts from me - Feel free to agree / disagree on any. 

  • I find the macro discussion in chapter 7 very interesting for two reasons - 1. I am surprised that (even at the time) banks were willing to give these hedge funds so much leverage to speculate on things such as currencies. Would be interested to know what the margin requirements looked like on those trades. 2. I find these trades where people have limited risk but huge upside very interesting. Seems like a trade that is hard to replicate in straight equities but would be interested if there ever has been such a trade (maybe a restructuring case, I'm not sure)
  • On the point of being a sure thing, the shadow banking trade in the subsequent chapter seemed incredibly risky from the moment I read it. Interested to hear if anyone else was surprised by this and surprised that it became so popular. I guess that stuff happens when the market is that hot
  • I disagree with the poster above - I don't think that Soros cared more about political capital in the later years of his career. I think that he was just aware of how to use political capital as a resource to make more money / expand the network of powerful connections. From the book: "Shortly after the pound's devaluation, Soros saw Jean-Claude Trichet, the governor of the French central bank, and told him that, out of concern for the destabilizing effects of his own trading, he would not attack the franc. The claim to selflessness was a bit much, since Quantum had correctly calculated that the franc would hold and was about to make a killing on this prophecy."
  • Expanding on the above point, I do think that two things happened to Soros and Steinhardt for that matter: 1. They understood that there was more to life than just making "rich people richer" and 2. They better appreciated the broader impacts of impact of their actions on markets and society (i.e. leverage causing a sell off in the bond markets / effectively funnelling British taxpayer money into their pockets) 
  • Would be interesting to get more of Greenspan's perspectives in another book. I know he is controversial and also played a role in the GFC, but perhaps a Greenspan book could be a good read for another month

Again, thank you for organising and doing this. Thoroughly enjoying it from my end.

Array
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Jan 17, 2022 - 12:29pm
Pierogi Equities, what's your opinion? Comment below:

Efficiently Inefficient

  • Would be interesting to get more of Greenspan's perspectives in another book. I know he is controversial and also played a role in the GFC, but perhaps a Greenspan book could be a good read for another month

his book Capitalism in America is worth a read

Quant (ˈkwänt) n: An expert, someone who knows more and more about less and less until they know everything about nothing.

  • 2
Jan 17, 2022 - 6:58pm
Efficiently Inefficient, what's your opinion? Comment below:

Has been sitting on my shelf for two years! Just need to force myself to read it

Array
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Jan 17, 2022 - 3:31pm
Pierogi Equities, what's your opinion? Comment below:

Though I've always heard so much about Soros' breaking of the BOE, the chapter I found the most interesting was ch.6 featuring Paul Tudor Jones. This weekend I also read Howard Marks' latest memo (https://www.oaktreecapital.com/insights/memo/selling-out), and I found some similarities with the importance but sheer difficulty of knowing when is the proper time to sell an investment. What I found most fascinating with PTJ's approach was that he figured out how people react to kinds of news, and then orchestrating situations in which to position himself appropriately. This is more direct and different from Oaktree's approach, but it was interesting to see this done at scale.

Soros' macro-focused approach was also great to see, particularly in the context of his focus on reflexivity and shorter term trades, rather than Ray Dalio's longer term outlook (at least of late). The impression I'm getting is that these great investors aren't only making their own views on certain investments, but instead are almost more focused on how other people will react on their timeline, and then positioning themselves appropriately.

I don't know if it's covered in this book, but Paul Singer's Elliott would be great to read about too.

Quant (ˈkwänt) n: An expert, someone who knows more and more about less and less until they know everything about nothing.

  • 7
Jan 17, 2022 - 4:20pm
kellycriterion, what's your opinion? Comment below:

In any market, in order for a transaction to clear, you have to have a buyer and seller agree on a price. To the extent that at day (T-1) you can buy at $100 and figure out that some bozo will be willing to buy that asset for $105 on day (T), that's all that matters really. If you can replicate that multiple times a year, that's your fund right there. Discounted cash flows are worthless in the sense that they provide no guarantee that a future buyer will buy the asset at a more favorable price; now obviously the reason everybody does a DCF is because they believe the buyers will come around once the undervalued fundamentals of the business become glaringly obvious, but that's a very indirect way of figuring out whether somebody's gonna buy this stuff. Wouldn't it be easier to just know?

Jan 17, 2022 - 7:59pm
Pierogi Equities, what's your opinion? Comment below:

Exactly, that's an excellent point. I'm not trying to shit on equity research, but it really does make you think how efficiently things are priced.

Going off of that, the book deals with professional money managers with sophisticated clients, but I try to think about how to apply concepts I read about like these. In this field, without devoting a lot of time to research or even to market psychology, of course there are those that believe that markets are efficiently priced and try to find academic support, but then there are cases where (just like this book) you hear of people beating the market or whatever index. This same thing happens when you hear your friends saying they made 100x on some bullshit crypto ass-coin or GME or whatever, very few of them might have an edge, but occasionally someone actually might. To take it a step further, you now hear about equity research analysts and traders looking at r/WallStreetBets and whatever else to see sentiment (if you can call it that) around certain equities and come up with ideas. When a new version of this book gets written, I wonder who'll be the names they list as the ones that really killed it by trying to front run people on the internet.

Quant (ˈkwänt) n: An expert, someone who knows more and more about less and less until they know everything about nothing.

  • 6
Jan 18, 2022 - 9:35pm
Pierogi Equities, what's your opinion? Comment below:

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Quant (ˈkwänt) n: An expert, someone who knows more and more about less and less until they know everything about nothing.

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