Thread by @ReformedTrader

1/ More Money Than God: Hedge Funds and the Making of a New Elite (Sebastian Mallaby)

"Hedging and leverage could be applied to bonds, futures, swaps, and options. Jones had invented a platform for strategies more complex than he could dream of." (p. 9)

amazon.com/More-Money-Tha…

2/ "Hedge funds are the vehicles for loners and contrarians, for individualists whose ambitions are too big to fit into established financial institutions.

"Cliff Asness had been a rising star at Goldman Sachs but opted for the freedom and rewards of running his own shop.

3/ "Jim Simons, who emerged in the 2000s as the highest earner in the industry, would not have lasted at a mainstream bank: He took orders from nobody, seldom wore socks, and got fired from the Pentagon’s code-cracking center after denouncing his bosses’ Vietnam policy.

4/ "Ken Griffin of Citadel, the second highest earner in 2006, started out trading convertible bonds from his dorm room at Harvard; he was the boy genius made good, the financial version of the entreprenerds who forged tech companies such as Google.

5/ "George Soros's charities fostered independent voices in the emerging ex-communist nations.

"Paul Tudor Jones created one of the first “venture philanthropies” to fight poverty in NYC: It identified innovative charities, set benchmarks for progress, and paid for performance.

6/ "From the mid-1960s to the mid-1980s, the prevailing view was that hedge funds succeeded mainly by being lucky.

"As this critique anticipates, plenty of hedge funds have no real “edge” if you strip away the marketing hype." (p. 13)

Related reading:

https://twitter.com/ReformedTrader/status/1233573232881438720

7/ "The titans rack up glorious returns but cannot explain how they did it.

"Genius does not always understand itself—a lesson that is not confined to finance." (p. 14)

More on this:

Hedge Fund Market Wizards

https://twitter.com/ReformedTrader/status/1217655775650181122

Superstar Investors

https://twitter.com/ReformedTrader/status/1217884016797310976

8/ Tennis coach Vic Braden: “Of all the research that we’ve done with top players, we haven’t found a single one consistent in knowing/explaining exactly what he does. They give different answers at different times, or they have answers that simply are not meaningful.” (p. 13)

9/ "Before the 1987 crash, most money in hedge funds had come from rich individuals, who presumably had not heard academia’s message that it was impossible to beat the market. After the crash, most money in hedge funds came from endowments who wanted in on the action.

10/ "Fama and French showed that unglamorous “value” stocks were underpriced relative to overhyped “growth” stocks: capital was being provided too expensively to solid, workhorse firms and too cheaply to their flashier rivals: Opportunities were being squandered." (p. 16)

11/ "In 1994, the Fed announced a tiny 0.25% rate rise, and the bond market went into a mad spin. The turmoil spread from the U.S. to Japan, Europe, and the emerging world; several hedge funds sank, and for a few hours it even looked as though Bankers Trust might be dragged down.

12/ "But the typical hedge fund is more cautious in its use of leverage than the typical bank. The average hedge fund borrows only one or two times its investors’ capital, and even those that are considered highly leveraged generally borrow less than ten times.

13/ "Investment banks were leveraged 30:1 before the '08 crisis; commercial banks were even higher by some measures.

"The structure of hedge funds promotes paranoid discipline. Banks are establishment institutions with comfortable bosses; hedge funds tend to be scrappy upstarts.

14/ "Banks’ investment judgment is often warped by their pursuit of underwriting or advisory fees; hedge funds live and die by their performance.

"Capitalism works only when institutions are forced to absorb the consequences of the risks that they take on." (p. 22)

15/ "Jones believed that investors' emotions created trends in stock prices. A rise in the stock market generates optimism, which generates a further rise... a feedback loop creates a trend that can be followed. The trick is to bail out when psychology turns around." (p. 29)

16/ "The short seller performs a socially useful contrarian function: he can dampen bubbles as they emerge; by repurchasing the same stocks later as they fall, he can provide a soft landing. Far from fueling wild speculation, short sellers could moderate the market’s gyrations.

17/ "The stigman nonetheless persisted. Because of the prejudice against it, shorting faces tougher tax and regulatory treatment." (p. 34)

However, for some investors, adding short equity positions may create a net tax benefit:

https://twitter.com/ReformedTrader/status/1070444696516718593

18/ "Shorting only works as part of a hedging strategy once a further refinement is brought in. It was here that Jones was way ahead of his contemporaries.

"To understand a stock’s effect on a portfolio, the size of a holding had to be adjusted for its volatility.

19/ "Jones’s next innovation was to distinguish between the money that his fund made through stock picking and what it made through its market exposure Years later, this became commonplace (skill-driven returns as “alpha” and passive market exposure as “beta”)." (p. 35)

20/ "In the pre-computer age, figuring the volatility of stocks was a laborious business, and Jones and his small staff performed these measurements for two thousand firms at two-year intervals. But, more than Jones’s patience, it was the conceptual sophistication that stood out.

21/ "In a rough-and-ready way, his techniques anticipated the breakthroughs in financial academia of the 1950s and 1960s.

"In 1952, three years after Jones launched his fund, modern portfolio theory was born.

"Jones’s approach was more practical than that of Markowitz.

22/ "The 1952 paper was impossible to implement: Working out correlations for 1,000 stocks required half a million calculations.

"Sharpe used a single correlation between each stock and the market index. This was precisely what Jones’s velocity calculations were designed to do.

23/ "By the time Sharpe published his paper in 1963, Jones had been implementing its advice for more than a decade. Jones also anticipated the work of James Tobin, another Nobel Prize–winning father of modern portfolio theory." (p. 37)

24/ "If managers took a share of a hedge fund’s investment profits rather than a flat management fee, they could be taxed at the capital-gains rate: Given the personal tax rates of the times, that could mean handing 25% to Uncle Sam rather than 91%.

25/ "Jones’s performance fee (termed a “performance reallocation” in order to distinguish it from an ordinary bonus that would attract normal income tax) was happily embraced by successive generations of hedge funds." (p. 39)

26/ "Future hedge-fund managers would prove trend surfing to be profitable. But Jones never turned a profit by following the charts.

"Through skill and a coincidence of temperament, Jones had instead devised a way of assembling stock pickers who beat the pants off Wall Street.

27/ "Separating skill from market movement allowed him to pinpoint each manager’s results precisely. Jones compensated brokers accordingly.

"The trustees at the old institutions were compensated by AUM rather than by a performance fee, and they reached decisions by committee.

28/ "Jones’s method broke the mold. It was each stock picker for himself; it substituted individualism for collectivism and adrenaline for complacency. He convened remarkably few investment meetings because he found committees intolerably tedious." (p. 41)

29/ "In the 1950s-60s, information did not reach everyone at once. The team with the most hustle would win.

"Dresher went to SEC offices to read company filings the moment they came out. He was alone: the rest of the Street waited for filings to arrive in a bundle in the mail.

30/ "Jones required his partners to have their own capital in the funds: their wealth as well as their income were riding on performance.

"In contrast, mutual-fund companies paid salesmen who brought investors' capital, leaving little money to reward excellent research." (p. 42)

31/ 1966: "Caught up in the bull market, the Jones men came to regard shorting as a sucker’s game and lost interest in protecting the fund against a fall in the S&P 500. Instead, they pushed the boundaries of leverage: Each manager was out to buy as many go-go stocks as possible.

32/ "Even the velocity calculations fell by the wayside. The Jones men did not like being told to buy less of a hot stock merely because it might be volatile.

"This was the sixties; they were young; the market belonged to their generation.

33/ "In 1950, only 1 in 25 American adults owned stocks; by the end of the 1950s, 1 in 8 did.

"They believed financial turmoil would never rear its head again. The Fed watched the economy, the SEC watched the market, and Keynesian budget policies had repealed the business cycle.

34/ "The more the market rose, the more Jones’s performance-tracking system rewarded managers who took the most risk. In May 1969, the stock market started to fall, shedding a quarter of its value over the next year." (p. 48)

More on the 1960s bubble:

https://twitter.com/ReformedTrader/status/1312461433053954048

35/ "Having stayed below 2% in the first half of the 1960s, inflation hit 5.5% in the spring of 1969, forcing the Fed to jam on the monetary brakes and squeeze the life out of the stock market. The bear market that followed was only the first shock.

36/ "In 1971, the Nixon administration was forced to acknowledge that inflation had eroded the real value of the dollar, and it responded by abandoning the gold standard. Suddenly, money could be worth one thing today, another tomorrow; the realization fueled further inflation.

37/ "Another round of monetary tightening followed, and the market crashed again in 1973–4.

"By September 30, 1970, the 28 largest hedge funds lost two-thirds of their capital YTD. Their claim to be hedged was a bald-faced lie; they had been borrowing and riding the bull market.

38/ "The crash of 1973–74 wiped out most of the remaining hedge funds. The SEC gave up on its campaign to regulate a sector that was now too small to bother with.

"Fred Mates, the top-performing mutual-fund manager of 1968, found himself working as a bartender." (p. 49)

39/ "It was one thing to pay a premium for a company with bright prospects, another to pay so much that uninterrupted, supersonic growth was extrapolated into the hereafter.

"At the start of 1969, Steinhardt's fund shorted enough story stocks to balance its long positions.

40/ "Unlike most hedge funds, it was actually hedging. When the S&P 500 fell by 9% that year, the firm preserved all but a sliver of its capital; the following year, when the S&P 500 dropped by another 9%, it actually made money.

41/ "The Nixon administration was covering up the truth about its failures in Vietnam; it was covering up inflation with an impractical wage-and-price-control program.

"America’s finest companies were covering up the truth about themselves with accounting shenanigans.

42/ “The research reports released in the early 1970s were so simplistic that we looked at them as nonsense. Deferred this, different tax rate that, capital gains put as operating earnings.”

"The market was trading at levels that reflected broad political/financial delusions.

43/ "So the fund went further in 1972 [with a net short position]. At first, the crash did not happen. The fund was down 2% YTD in September as the S&P 500 rose 9%. But then the payoff came: The S&P fell 2% in the year to September 1973 and a shocking 41% the following year.

44/ "Steinhardt, Fine, Berkowitz racked up gains of 12% and then 28% after fees, an extraordinary performance in a bear market while just about every other manager lost his shirt.

"Their success demonstrated the capacity for contrarianism that marked later hedge funds." (p. 53)

45/ "After 1973, the economy was plagued by stagflation, an ugly new term. The number of Americans owning stock fell by seven million over the course of the decade.

"A Business Week cover proclaimed “The Death of Equities.” " (p. 56)

More on this:

https://twitter.com/ReformedTrader/status/1308179536127827968

46/ On block trading: "An insurance company needs to sell a large block of stocks to pay storm-damage claims: The selling pressure drives down prices. A pension fund needs to buy a large block to employ a fresh inflow of cash from workers: The buying pressure drives up prices.

47/ "In the real world, liquidity is not be perfect. This is especially pronounced when the demand for large transactions jumps before market structures adapt.

"As the brokers’ prized customer, Steinhardt could expect some creative bending of the rules.

48/ " If the seller was a smart hedge fund rather than an insurer, the broker might avoid inviting Steinhardt to be the buyer, since the fund might be selling on bearish information. If the sale represented the first order in a series, the broker might issue a discreet warning.

49/ "In the wake of Black Monday, the big block-trading desks pulled back from the business, resulting in a furious outcry. In December, blocks of 25,000 shares now disrupted prices as much as 100,000-share blocks had done before the crash. The market had grown unstable.

50/ "The rumor that an institution might sell a block of stock was enough to drive the price down.

"In an ironic twist, the SEC promised to investigate the troubling lack of block trading.

"The only thing worse than fast-trading hedge funds was a sudden dearth of them." (p. 71)

51/ "In famous congressional testimony in 1967, the great economist Paul Samuelson delivered his verdict on money management. Citing a recent dissertation by a PhD candidate at Yale, he suggested that randomly chosen stock portfolios beat professionally managed mutual funds.

52/ “Most portfolio decision makers should go out of business—take up plumbing, teach Greek, or help produce GNP by serving as corporate executives,” he wrote in 1974. “Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed.”

53/ "But Samuelson believed that a giant with genuinely fresh insights could beat the market. Of course, these exceptional investors would not rent themselves out cheaply to the Ford Foundation or to the local bank trust department.

54/ "In 1970, he became a founding backer of an investment start-up called Commodities Corporation, diversifying his portfolio around the same time with an investment in Warren Buffett. Commodities Corporation was among the first boutiques created by hard-core “quants.”

55/ "The founding traders included MIT's Paul Cootner, who was ironically famous for his contribution to EMH.

"Commodities Corporation was not about salesmanship and relationships and looking like a market insider; it was about beating the market with computer models." (p. 73)

56/ "Followed the corn trade debacle, they developed fresh respect for price trends. EMH holds that trends do not exist: The random-walk consensus was so dominant that, through the 1970s and much of the 1980s, it was hard to get alternative views published in academic journals.

57/ "Trend-following seemed disarmingly simple: Buy things that have just gone up on the theory that they will continue to go up; short things that have just gone down on the theory that they will continue to go down.

"Even Paul Samuelson was won over to the new approach.

58/ "Samuelson stumped up a fresh chunk of capital to be invested, even though trend following had little standing within academia." (p. 81)

Today, trend following has much more academic support but is still not widely practiced by retail money managers:

https://twitter.com/ReformedTrader/status/1229159665658814469

59/ "Following Nixon’s abandonment of the dollar-gold link, Chicago’s Mercantile Exchange began trading futures in seven free-floating currencies in May 1972. Investor psychology could be counted upon to generate the same waves in currency markets as existed in commodities.

60/ "At the start of the decade, Nixon imposed price controls that turned out to be functionally equivalent to the misguided currency controls of later years: they proved not to be sustainable and created a bonanza for speculators.

61/ "By fixing plywood at $110 per thousand square feet, the Nixon administration was putting up traffic cones in the path of an invading tank: The U.S. was in the midst of a construction boom, and demand for plywood was booming; builders were willing to buy planks for much more.

62/ "Plywood warehouses shipped supplies to Canada and back again to get around Nixon’s controls, or they were performing “added-value services” such as shaving a sliver off their planks and then charging $150 per thousand square feet for them.

63/ "Builders started to buy wood in the futures market, where prices were not regulated. Marcus bought plywood futures by the truckload. Their value virtually doubled. When Nixon’s price controls were abandoned at the start of 1973, Marcus made even more money.

64/ "In 1974 alone, the coffee price went up by a quarter, rice went up by two-thirds, and white sugar doubled. Then food commodities turned around into an equally tradable downward trend: Sugar lost 67% of its peak value, cotton and rubber lost 40%, and cocoa fell more than 25%.

65/ "When the Carter administration tried to stimulate the economy, the boost to inflation caused the dollar to drop by a third against the yen and the deutsche mark, and the big moves gave surfers of the new currency-futures markets ample opportunity." (p. 86)

66/ "By the end of the 1970s, trend surfing was delivering returns of 50%+ to Commodities Corporation.

"In 1980 alone, profits came to an astronomical $42 million. Even after $13 million in bonuses for 140 employees, Weymar’s quiet firm outearned 58 of the Fortune 500 companies.

67/ "The phenomenon was first and foremost a triumph of flexibility. In moving beyond econometric analysis to focus on trends, Weymar had demonstrated a pragmatism that crops up repeatedly in the history of hedge funds—and indeed in business history generally.

68/ "Innovation is often ascribed to big theories fomented in universities and research parks. But it often depends less on grand academic breakthroughs than on humble trial and error—on a willingness to go with what works, never mind the theory that may underlie it." (p. 87)

69/ "In the inflationary 1970s, farmers and food companies were buying and selling futures because they needed to shed risk, not because they had a sophisticated view on the direction of prices; speculators who did have such a view were bound to have the upper hand.

70/ "The exchanges imposed limits on the number of contracts a speculator could buy, limiting the supply of “insurance.” Commodities Corp. pocketed the higher premiums created by this artificial scarcity. It also got around the restrictions through off-exchange trades." (p. 88)

71/ "Kovner had a nerveless temperament. One time, he took a hit on a silver position, suffering the sort of loss that would have left most traders vomiting in the bathroom. He showed up that same day at an administrative meeting as though nothing untoward had happened." (p. 91)

72/ "Kovner and Lennox bought currency forwards that were trading at a big discount and sold currency forwards that were trading at small ones. This “carry trade” raked in glorious profits until rivals caught on." (p. 93)

Related research:

https://twitter.com/ReformedTrader/status/1188911052253040640

73/ "Popper contented that human beings can only grope at truth through trial and error. It suggested that all political dogmas were flawed: The Nazism and communism inflicted upon Hungary by outside powers each claimed an intellectual certainty to which neither was entitled.

74/ "As Popper suggested, the details of a listed company were too complex for the human mind to understand, so investors relied on shortcuts that approximated reality. But Soros was also conscious that those shortcuts had the power to change reality as well ("reflexivity").

75/ "The trick was to focus neither on the course of earnings nor on the psychology of investors’ appetites. Rather, he homed in on the feedback between the two, predicting that each would drive the other forward until extreme overvaluation led to an inevitable crash." (p. 97)

76/ "In the mature phase, all the speculators have already climbed aboard. There are hardly any buyers left, so it takes only a few sellers to create a U-turn.

"The buyout mania neatly fitted Soros’s ideas on reflexivity. The takeovers were feeding on themselves." (p. 102)

77/ "When stocks collapsed on Black Monday, the masters of the Hong Kong futures exchange decided to staunch losses by closing it down. When Wall Street began to rally on Tuesday, portending a rally the next day in Japan, Soros could not get out of his short position." (p. 111)

78/ "In roughly a week, Quantum had gone from being up 60% for the year to being 10% down. This weakness in hedge funds would haunt the industry in later years: The larger they grew, the harder it became to jump in and out of markets without disrupting prices." (p. 113)

79/ "Of the $39 billion worth of stock sold on October 19, only $6 billion were triggered by portfolio insurers.

"EMH had originated in American universities in the 1950s-60s—the most stable enclaves within the most stable country in the most stable era in memory.

80/ "Soros, who had survived the Holocaust, WWII, and penury, had a different view of life. After Black Monday, the academic consensus began to come around to him.

"Even in the early 1960s, Mandelbrot had argued that the tails might be fatter than the normal bell curve assumed.

81/ "Eugene Fama, the father of EMH, confirmed Mandelbrot’s assertion. If price changes had been normally distributed, jumps greater than 5σ should have shown up in daily price data about once every 7000 years. Instead, they cropped up once every three to four years.

82/ "Having made this discovery, Fama and his colleagues buried it. It was too awkward to live with; it rendered the statistical tools of financial economics useless.

"In terms of the normal distribution, the Oct. 19 plunge had a probability of one in 10^160.

83/ "The crash would not have been anticipated to occur even given twenty billion years, the upper end of the expected duration of the universe, or even if it were to be reopened for further sessions of twenty billion years following each of twenty successive big bangs." (p. 118)

84/ "In 1988, Richard Thaler of UChicago began to publish regular features that pointed out instances in which human choices appeared to violate economists’ expectations of rational beings. To Soros, it was another victory." (p. 120)

More on this:

https://twitter.com/ReformedTrader/status/1317876706414227457

85/ More on Soros's alpha (mostly from trend following in various asset classes):

https://twitter.com/ReformedTrader/status/1217890653897551872

86/ "Buffett argued that, contrary to EMH, stock-picking success is not randomly distributed. Clusters of excellence spring from specific investment approaches. To demonstrate his point, Buffett laid out the records of managers from the Ben Graham's tradition." (p. 122)

87/ "Brokers issued ten buy recommendations for every sell. No analyst wanted to issue a sell for fear of losing his relationship with companies he covered: investment bankers at his firm coveted advisory fees from those companies." (p. 128)

More on this:

https://twitter.com/ReformedTrader/status/1200838874743705600

88/ "If Robertson’s achievement had stood by itself, it might have been possible to dismiss him as a lucky coin flipper. But the success of Tiger’s numerous offshoots suggests otherwise. Whatever the source of Robertson’s edge, it was profitable—and transferable." (p. 129)

89/ "Robertson would sit in a manager’s office and ask about the company’s return on equity, but managers cared more about sales than profits; they were running companies for the sake of the employees rather than shareholders." (p. 137)

Related research:

https://twitter.com/ReformedTrader/status/1182288454601699331

90/ "Japan cut rates aggressively to offset the effect of the strong yen. The flood of cheap capital drove up the cost of Japanese assets and plenty of foreign assets too: Japanese money became the key buyer for everything from California golf courses to impressionist paintings.

91/ "In 1987, Nippon Telegraph and Telephone was floated on the Tokyo stock market at the fantastical P/E ratio of 250.

"Over the next two years, the Nikkei stock index gained an astonishing 63%, proof that there are few things more costly than tilting against a bubble.

92/ "At the start of 1990, the Tokyo market fell 4% in a matter of days. At last, Jones had his trend signal.

"Japanese savers expected fund managers to return 8%/year, so managers would respond to a market reversal by rushing into bonds, where they could lock in 8% risk-free.

93/ "If the market had fallen in December, fund managers above the 8% hurdle might not have minded. A fall in January was different: there were fifty weeks left in the year, enough to secure 8% in bonds. The stampede out of equities could push the market off a precipice." (p.154)

94/ "Cotton farmers invariably clung to part of their harvest for weeks, hoping prices would rise. But at the end of the year, they had to unload crops or suffer adverse tax consequences. Jones recognized a seasonal pattern: sell orders in December and a recovery in January.

95/ "It took nearly a year for a calf to gestate inside its mother’s belly, so the supply of cattle responded only sluggishly to rising prices; as a result, supply could take months to catch up with demand, and upward trends in cattle futures tended to be durable.

96/ "Stocks in the Dow index tended to do well on the closing Friday of each quarter, as that was when arbitrage traders bought back stocks that they had sold short to hedge expiring futures contracts." (p. 157)

More on return seasonalities:

https://twitter.com/ReformedTrader/status/1206391561807745030

97/ "Central banks could be a gift to a trader. Their intentions were often evident—the Bundesbank, for example, made no secret of its determination to fight inflation. This fact alone would be sufficient to create a trend that Druckenmiller could ride profitably." (p. 167)

98/ "German unification created inflationary pressure, pushing the Bundesbank to raise rates. This, with low recessionary rates elsewhere, caused money to flow into marks. The Italian lira and British pound traded near the bottom of the ERM band—and threatened to break out.

99/ "If the Bank of England raised rates to protect the pound’s position within the exchange-rate mechanism, the instant hit to mortgage payers would dent consumption at a time when Britain was already in recession.

100/ "Ever since the hyperinflation that had fueled Hitler’s rise, the Germans had prized monetary stability.

"Their instinct would be to refuse to cut rates so long as reunification costs were causing budget deficits. The pressure on sterling would grow ever greater." (p. 169)

101/ "Speculative selling overpowered the Finnish central bank, forcing the government to abandon its peg to the ECU.

"There was a run against Sweden, which managed to attract capital back into the country by raising overnight interest rates to the extraordinary level of 75%.

102/ "Italian rates stood at 15%: ordinarily enough to keep capital in the country, but the vast growth of currency markets had changed the game.

"By September 11, the lira broke through the bottom of the ERM band. Italy then negotiated the formal devaluation of its currency.

103/ "Britain announced it was borrowing 10 billion ECUs to defend sterling. That day, the pound had experienced a sharp rise. To Soros and Druckenmiller, this was faintly amusing: The amount that Britain had borrowed was equal to the amount that Quantum alone aspired to sell.

104/ "Sterling’s small rise confirmed the speculators’ premise. Bets against currencies anchored by shaky pegs could be leveraged aggressively: the worst that could happen was that they would move against you slightly.

"Sure enough, the pound took a beating the next day.

105/ "As Lamont recounts in his memoir, the thought that Britain would be forced out of Europe’s monetary system the next day “simply did not cross my mind.”

"By 8:40 A.M., the Bank of England had purchased a total of £1 billion, but sterling still refused to budge.

106/ "It continued to buy pounds because it was obliged to do so by the rules of the ERM. But it no longer aspired to lift the currency; it was merely providing liquidity to hedge funds.

"When the announcement of the dramatic 200bps hike came, the pound did not respond at all.

107/ "Major insisted on another interest-rate hike—this time of 300 bps—as a last-ditch effort to save sterling. Again there was no effect on sterling’s value.

"That evening, Lamont announced Britain’s exit from the exchange-rate mechanism. The markets had won." (p. 183)

108/ "During the first half of September, the Bank of England spent $27 billion of reserves to defend sterling. After the pound left the ERM, it fell 14% against the deutsche mark.

"British taxpayers could be said to have lost $3.8 billion on their purchases of sterling.

109/ "Governments and central banks were not profit-motivated. Major bought sterling from Druckenmiller at a price both knew to be absurd.

"Major did this for a reason that appears nowhere in textbooks: He wanted to force political rivals to share responsibility for devaluation.

110/ "Governments had bottled up currency movements until a power greater than themselves blew the cork into their faces.

"As happens after every financial crisis, the first instinct was to vilify the markets rather than to learn the awkward lessons that they teach." (p. 186)

111/ Related reading (thread):

"By the 1980s, the governments of continental Europe were fed up with floating exchange rates. For countries like Germany and France, which traded heavily across a common border, the typical 20% volatility was damaging."

https://twitter.com/ReformedTrader/status/1281778164729962497

112/ "In 1990-91, the U.S. economy was in recession following the S&L crisis, and the Fed kept short-term rates low.

"Steinhardt borrowed short and lent long, just like any bank would do, but bypassed the tedious business of hiring tellers and credit officers." (p. 191)

113/ "Traders bought Spanish and Italian bonds, realizing capital gains as interest rates came down... an opportunity that governments had invited them to take. European statesmen had made no secret of plans for monetary union, nor about the resulting convergence in rates.

114/ "Short sellers tried to get out; but they couldn’t buy back the paper because Steinhardt and Kovner had cornered the Treasury market. (The victims included Goldman Sachs, Salomon Brothers, and Bear Stearns; it was hardly a case of the sharks eating the innocents.)

115/ "If the Fed wanted to stimulate the economy, it was helpful that hedge funds chased long bond rates downward. But this could be dangerous too: if the Fed held rates down until Main Street began to feel the benefits, Wall Street could inflate a giant bond bubble." (p. 194)

116/ "When a shock hit the markets and brokers issued margin calls, hedge funds had to sell out in a rush—and at exactly the same time as others were rushing to sell also. Everybody scrambled to sell to everybody else. The liquidity was gone. Nobody was buying." (p. 199)

117/ "Financial traders face political risks. On May 15, Thai authorities forbade all banks from lending baht to anyone outside the country. Short sellers could no longer borrow baht in order to sell them unless they secured the loans offshore at punitive interest rates.

118/ "(Tiger had financed positions by borrowing baht short-term, figuring that it could roll the loans.)

"Capital exited in other ways. Foreigners who had lent dollars demanded repayment, so Thai businesses dumped baht as they scrambled to meet their obligations." (p. 225)

119/ "In two weeks, the South Korean won dipped by 4% against the dollar, and the stock market weakened. But nobody imagined that the central bank had already chewed through two thirds of its reserves or that Korea was in the midst of a full-blown banking-cum-currency crisis.

120/ "Only a month earlier, the IMF had concluded that South Korea was immune from the turmoil elsewhere in the region.

"The official and widely believed numbers on the dollar debts of South Korean companies understated their real liabilities by a whopping $60 billion." (p. 231)

121/ "Soros had seen the inevitability of devaluation, but instead of shorting the ruble knowing that politicians would do nothing to save it, he had attempted to make politicians behave differently. As a result of the default and devaluation, Soros's funds lost 15%." (p. 240)

122/ More on the Russian default and devaluation

It happened in 1918, too:

https://twitter.com/ReformedTrader/status/1132659398713626625

Thread on various currency crises (Drobny):

https://twitter.com/ReformedTrader/status/1284867368078856197

Thread from Hedge Fund Market Wizards:

https://twitter.com/ReformedTrader/status/1209553682393468928

In relation to LTCM:

https://twitter.com/ReformedTrader/status/1282539664981684229

123/ "Market anomalies occur when investor behavior is distorted by tax rules, regulation, or the needs of institutions.

"French insurance companies needed to buy particular maturities of bonds—not because they were bargain, but to match the maturities of promises to customers.

124/ "French insurers and American banks fulfilled their imperative at a better price than they would otherwise have, and LTCM itself reaped fabulous profits.

"In 1995, LTCM's return on assets, at 2.45%, was modest; leverage turned it into a 42.8% return on capital." (p. 248)

125/ In the decade after LTCM's failure, "there were calls for VaR calculations to be supplemented with stress tests; LTCM had done that. There were calls for financial institutions to pay attention to liquidity risks; LTCM had done that.

126/ "Yet LTCM failed anyway, not because its approach to calculating risk was simplistic, but because getting the calculations right is extraordinarily difficult.

"The real lesson was that all attempts to be precise about risk are unavoidably brittle." (p. 253)

127/ Due to crowding, "a shock that forced the other arbitrageurs to sell would cause LTCM’s portfolio to collapse precipitously.

"LTCM trades that were unknown to Wall Street bounced back after the post-Russia Friday shock; it was the known trades that kept bleeding money.

128/ "August 1998 was one of the most brutal months in the history of hedge funds. Meriwether and his partners lost 44% of their capital. They calculated that this loss should have occurred less than once in the lifetime of the universe. But it had happened anyway." (p. 261)

129/ "LTCM's position in futures on British government bonds might have been half of the open interest. It had a similarly outlandish position in Danish mortgages. Its portfolio of equity options was enormous. LTCM’s collapse might cause some markets to cease trading altogether.

130/ "There were rumors that Lehman Brothers was on the brink of bankruptcy; LTCM’s collapse might push it over.

"TV commentators speculated that the scheduled release of Clinton’s deposition on the Lewinsky scandal was rattling investors—a theory Fisher found grimly amusing.

131/ "Attacks on LTCM’s positions in equity options grew so extreme that option prices implied a crash every month.

"The bankers knew that coughing up the $4 billion was their least bad option; if they let LTCM go down, its massive portfolio would crash the markets." (p. 266)

132/ Related reading on LTCM:

https://twitter.com/ReformedTrader/status/1271108014498385920

133/ "In November 1998, the plodding bookseller Books-A-Million announced it was improving its Web site; within three days of this unremarkable news, its share price jumped tenfold. In March 1999, a startup called Priceline.com gained 425% on its first day of trading.

134/ "This untested Web site selling airline tickets was deemed to be worth more than United, Continental, and Northwest Airlines combined. (The airlines owned terminals, landing slots, and fleets of aircraft. Priceline owned software and a chunk of William Shatner.)" (p. 277)

135/ "By summer 1999, Robertson’s decision to ignore the tech boom was causing a crisis on Park Avenue. Tiger had lost 7.3% YTD; meanwhile, technology-heavy mutual funds were up by a quarter or more. Day traders at kitchen tables outperformed Robertson’s special-forces unit.

136/ "Druckenmiller had placed an unhedged, outright bet against the tech bubble, shorting $200 million of particularly overvalued startups. All of them shot up with a violence that made it impossible to escape: “They’d close at 100 and open at 140,” he remembered with a shudder.

137/ After switching from short to long, "Druckenmiller made more from surfing tech stocks in late 1999 than he had made from shorting sterling eight years earlier." (p. 281)

(He subsequently got out, then jumped in again near the top.)

138/ "On March 10, the NASDAQ turned. Many of the stocks Quantum held fell faster than the market did. VeriSign lost almost half its value in a month, plummeting so hard that it was difficult to escape. By pivoting one too many times, Druckenmiller had failed to escape." (p. 288)

139/ "Investment banks created a scramble by parceling out new issues cheaply to the lucky funds with access to initial offerings.

"Companies cooked their accounts, auditors turned a blind eye, and banks engaged in shameless hype about the tech companies they brought to market.

140/ "Chemdex earned a commission on every trade that the companies made through its network, but it booked the entire value of the goods exchanged as revenue. David Einhorn took a large short position in September 1999, when the company’s stock was trading at $26.

141/ "But in the bubble, even the most questionable accounting failed to faze investors. In February, the stock rose to a mind-bending $164.

"By late 2000, Chemdex had collapsed to $2 — too late to help Einhorn, who was forced out of his short before the bubble burst." (p. 284)

142/ "On March 10, 2000, the NASDAQ crested. The air whooshed out of one of history’s great bubbles.

"But the turn had come too late. By the time the NASDAQ began to fall, Robertson had made his decision to get out, and he was too beaten up to change it." (p. 287)

143/ "As a young analyst at Morgan Stanley, Steyer had been upset to discover that investment-bank advisers can be paid for being wrong; sounding convincing mattered more than actually being right, since the objective was simply to extract fees from the clients." (p. 294)

144/ "Pension funds, mutual funds, and other institutional investors were forced sellers of junk: Their rules forbade them to hold the bonds of companies in default, so they were compelled to concede bargains to nimble players such as Farallon." (p. 295)

145/ "Beating the market was only possible for people with a sort of obsessive passion. “Great investors tend to have a ‘screw loose,’ pursuing the game not for profit, but for sport,” Swensen wrote." (p. 296)

146/ "The way Morgan Stanley’s team tried to find anomalies in financial data was nothing like the way that a university computer-science team would have approached the challenge, and the techniques used to combine the anomalies into trading models were also different.

147/ "There were no familiar terms to make sense of the recurring patterns Shaw found. They were so far from intuitive that he had no need for high-speed trading: He did not need to get orders to market faster than rivals, as he was confident that he would have none." (p. 320)

148/ "Data was swept for typing glitches and errors.

"Shaw’s faculty often found that anomalies in academia consisted of misreported numbers. If a series shows IBM at $60, then at $61, then at $16, that last number is not a buy signal for a mean-reversion strategy. It is a typo.

149/ "Shaw diversified; some of the new ventures paid off handsomely. But he was sometimes moving into fields that were already popular, running the risk of getting stuck in crowded trades. (Shaw got hurt in the bond turbulence that accompanied LTCM’s collapse in 1998.)" (p. 321)

150/ "At Tudor, Wadhwani trained a machine to approach markets in a manner that made sense for human traders.

"At D. E. Shaw, the approach often was to test hypotheses against data.

"In contrast, Brown and Mercer fed data to the computer first and let it come up with answers.

151/ Bob Mercer: “The signals that we have been trading without interruption for fifteen years make no intuitive sense. Otherwise, someone else would have found them.” " (p. 331)

More on Renaissance Technologies:

https://twitter.com/ReformedTrader/status/1193643537616666626

152/ 2006: "Too many people were making too much money too fast. Consultants staged workshops on how to open a hedge fund; a book called Hedge Funds for Dummies appeared. The frenzy recalled the leveraged-buyout boom in the 1980s or the dot-com mania in the 1990s." (p. 338)

153/ "Hunter held an astonishing 70% of the natural gas contracts for Nov 2006 delivery and 60% of the contracts for Jan 2007. So long as he added aggressively to the spread, his view was likely to be self-fulfilling - but he would have nobody to sell to if he needed to get out.

154/ "There was no mystery: You just had to check which pairs of contracts had widened.

"When Hunter unloaded, the glorious results of April were followed by horrifying losses. Amaranth was down by nearly four times more than the risk department had deemed possible." (p. 345)

155/ "Maounis repeated the marketing patter he knew by heart—Amaranth had a world-class equity team, a world-class credit team, a world-class quant team, a world-class commodities team, a world-class infrastructure. Then an e-mail arrived. There was trouble back at the office.

156/ "The fund had lost $560 million in a single day, as its spread position had collapsed to a third of its original size. At a tense meeting at Maounis’s home that evening, Amaranth’s top brass agreed they needed to raise capital immediately to meet margin calls." (p. 346)

157/ "Multistrategy funds have to contend with a mild version of the incentives that plague large banks and brokerages. Traders want bonuses; bonuses are won by betting big; and a firm’s central risk department seldom controls wizards who acquire an aura of invincibility.

158/ "Critics continued to worry that leveraged monsters could ignite systemic fires as LTCM had done. But Citadel’s lightning purchase of Amaranth’s portfolio revealed another side. Perhaps funds might occasionally ignite fires. But they could also be the firefighters." (p. 351)

159/ 2005: "Paulson wanted the thing that would blow up if the economy slowed even a little. The dream target would be in a cyclical industry, loaded up with too much debt (with the debt sliced into senior and junior bonds so that Paulson could short the junior ones).

160/ "Car companies, insurers, and home lenders had franchises, buildings, brands, and customer relationships. Even if they collapsed under their debts, they would probably still be worth something. Paulson wanted to short something that could be totally wiped out." (p. 358)

161/ "The mortgage-industrial complex argued that house prices would never fall across the country in a synchronized way. It had never happened before, so bonds backed by bundles of mortgages drawn from different states were regarded as relatively riskless.

162/ "Because Pellegrini was a newcomer, he was unburdened by this article of faith.

"After adjusting for inflation, there had been national slumps in both the 1980s and 1990s. The extraordinary run-up of the early 2000s could reasonably be followed by another downturn.

163/ "Even if prices merely went flat, homeowners would lack the collateral to refinance into larger mortgages.

"Appreciation was slowing from the Fed’s rate hikes, so the odds of flat prices had to be at least even, but the potential reward was 70-80 times the stake." (p. 358)

164/ "If hedge funds mostly recognized subprime assets for the garbage that they were, who did lead the buying? To a large extent, it was banks and investment banks—firms such as Citibank, UBS, and Merrill Lynch.

165/ "The U.S. government was forced to rescue Citibank. UBS got a lifeline from the Swiss government. Merrill sold itself to BofA.

"Whereas the failure of hedge funds had cost taxpayers nothing, bank failures imposed enormous burdens on government budgets and the world economy.

166/ "Banks sometimes run their books in a way that the capital requirements deem to be safe, even when it isn’t.

"Bonds backed by toxic mortgages were given AAA ratings, partly because the rating agencies were paid by the bond issuers, which dulled the incentive to be critical.

167/ "Regulation and ratings agencies thus became a substitute for analysis of the real risks.

"Proprietary trading desks coexisted alongside departments that advised on mergers, underwrote securities, and managed clients’ funds; the scramble for fees blurred investment choices.

168/ "Merrill Lynch sold $70 billion worth of subprime CDOs, earning a fee of 1.25% each time. Merrill’s bosses obsessed about their standing: The chief executive, Stan O’Neal, was prepared to finance home lenders at no profit in order to be first in line to buy their mortgages.

169/ "To feed their CDO production lines, Merrill and its rivals kept plenty of mortgage bonds on hand. When demand for CDOs collapsed in early 2007, the banks were stuck with billions of unsold inventory that they had to take onto their balance sheets." (p. 365)

170/ "To keep the sausage factory going, Bear bought up subsidiaries that made subprime loans directly to home buyers. Managers became less focused on what mortgages might be worth than on how to create lots of them.

"This pursuit of fee income helped to seal Bear’s fate.

171/ "The bank hurriedly assigned unqualified executives to build out its asset-management business by launching internal hedge funds, and some of these funds loaded up on subprime debt. The Federal Reserve was later forced to absorb $29 billion of Bear’s toxic securities.

172/ "Like other hedge funds launched under the umbrella of large banks, the Bear funds were managed by people who were seeded within a large firm, not by entrepreneurs. They raised capital with the help of the parent bank’s network and brand, which lowered the barriers to entry.

173/ "Two were run by Ralph Cioffi, who had previously worked on Bear’s sales desk, peddling mortgage-backed securities. His plan for his hedge funds was to buy those same MBS and leverage them up by 35:1. This sort of risky bet made sense to a deep-pocketed, fee-hungry parent.

174/ "As a salesman, he had virtually no experience in controlling portfolio risk—indeed, some Bear executives argued that he should not be allowed to do so.

"Banks that jumped onto the hedge-fund bandwagon were less intent on risk management than on leveraging their brands.

175/ "In June 2007, Cioffi’s funds blew up. They had been marketed on the strength of the Bear Stearns brand, so now Bear felt obliged to rescue them—vindicating the view that deep-pocketed parents dull the incentive to be vigilant." (p. 367)

176/ "High-quality bonds that were supposed to be fine in a downturn were often the easiest to sell, so they were dumped first; when traders deleveraged indiscriminately, the logic of capital-structure arbitrage went out the window.

"Sowood was hemorrhaging money.

177/ "Griffin did what he had promised. He and his team worked through the night and bought Sowood’s entire trading book.

"One hedge fund had imploded, threatening to start a systemic fire. Another hedge fund had swooped in, acting as the fireman." (p. 371)

178/ More on 2007-8 crisis:

https://twitter.com/ReformedTrader/status/1256712405343563778

179/ 2007 quant quake: "All of the quants' value and momentum bets were fizzling at once. Somewhere out there in the trading universe, one or maybe several quants were liquidating their holdings, perhaps because they had lost money on their mortgage bets and needed to raise cash.

180/ "The price gap between growth stocks and value stocks had shown little sign of narrowing in the years leading up to 2007.

Cliff Asness: “We are fond of saying that if these strategies are truly horribly overcrowded, then someone has apparently forgotten to tell the prices.”

181/ "Marek Fludzinski tested virtually identical trading strategies to see if the presence of one would erode the other’s returns. (It did not.)

"Positions suddenly feel crowded in during turmoil, but this held for virtually all strategies, not just quantitative ones." (p. 377)

182/ "Lehman had marked down its $6.5 billion of CDOs by only $200 million—a suspiciously small shift, given the sharp slide in credit markets. It had informed investors it would book a loss on hard-to-value “Level Three” assets but turned around and reported a profit." (p. 382)

183/ "Tudor had tried to withdraw the remainder of its assets from Lehman the previous week, but the request had arrived a day late, so the firm had $100 million frozen in Lehman’s London operation.

"And once Lehman collapsed, the true risks in emerging markets were revealed.

184/ "The emerging-market loans immediately lost two-thirds of their value. They were utterly illiquid.

"Tudor was down 4% in 2008, even though Jones himself had seen the storm coming. He promised to narrow Tudor’s focus and stick to the liquid markets he knew best." (p. 392)

185/ "AIG's CDS writing was the crazy risk-taking you got when with an ambitious trading operation inside the bosom of a well-capitalized firm, imbuing the traders with a heady sense of invulnerability.

"The government was forced to rescue the firm, lending it $85 billion.

186/ "Griffin put Morgan Stanley’s chances of survival at 50%. The odds of Goldman then following were 95%. If Goldman failed, the odds of Citadel collapsing were almost 100%, since the forced selling by Morgan and Goldman would destroy the value of Citadel’s holdings.

187/ "If you put that sequence together, Citadel’s chances of survival clocked in at only around 55%. “That’s a pretty bad day—when you realize twenty years of your work now comes down to whether or not some firm that you have no influence over fails,” Griffin said later.

188/ "As a hedge fund, Citadel did not have access to emergency Fed lending. On the contrary, the government had kicked it in the teeth with the ban on short selling, which made it impossible to hedge new convertible positions. The demand for convertible bonds cratered.

189/ "Its main funds were down 20% for the month of September.

"But unlike banks, which borrowed on extremely short terms, Citadel had calculated how long it would take to sell each asset, then lined up loans with the same mix of maturities. It was not facing margin calls.

190/ "Because Citadel had back-office systems to track the precise value of everything it owned, banks were less aggressive in moving the marks against it. Besides, Citadel had sold plenty of assets to raise cash and prevent its leverage from spiraling upward.

191/ "By the end of the year, its flagship funds were down 55%.

"This is a model of how the financial sector should work. Investors were forced to take extraordinary losses. But the financial system was not destabilized, and taxpayers were not asked to throw Citadel a lifeline.

192/ "Careful liquidity management can substitute for the Fed’s safety net.

"So it turned out that an upstart Goldman imitator could be better for the financial system than the real Goldman—not to mention incomparably better than Bear Stearns or Lehman Brothers." (p. 402)

193/ "The larger the hedge fund, the more peremptory and arrogant the managers tended to be—and frequently it was the bigger funds that had the worst performance. The big alpha factories were stuck in losing positions when liquidity dried up." (p. 404)

194/ "If hedge funds’ 20% performance fees seem to invite excessive risk taking, bank performance fees were far larger. In recent years, investment banks distributed 50% of net revenues as salary and bonuses. Though the comparison is not perfect, it puts criticism in perspective.

195/ "Government insurance encourages more risk-taking, leading to increased insurance.

"Neither Obama nor any other leader knows how to prevent too-big-to-fail institutions from fleecing the public. The worst thing about the crisis is that it is likely to be repeated." (p. 409)