WSO Book Club MMTG Part 2
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 vastand 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 learnedinsights 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 likemoney 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.