The Taming of the Shrewd
"I am very happy to pull my money out of the market," says George Soros, a hedge-fund investor who won fame and notoriety in equal measure by helping to force sterling out of Europe's exchange-rate mechanism in 1992, and was blamed by some South-East Asian countries for contributing to their crises in 1997. Regulators and politicians around the world have long fretted about the malign effects of big hedge funds on financial markets, especially after the near-collapse in 1998 of Long-Term Capital Management, another big hedge fund, threatened to damage the world's financial system hugely.
These worries were perhaps overdone. In March Julian Robertson, a man almost as famous (and as self-important) as Mr Soros, closed down Tiger, the hedge fund that he ran. Now Mr Soros, after a lifetime in the markets, has made his biggest, and possibly last, investment decision: that he does not understand what is going on. His two biggest funds, Quantum and Quota, have, in effect, been shut down; and the two men who ran those funds—respectively Stanley Druckenmiller and Nicholas Roditi—will retire.
This might be dismissed as nothing more than a few rich people quitting at a time when the markets are unusually volatile, with reputations that can go nowhere but down and wealth beyond the dreams of avarice. But their decisions carry greater significance. One by one, some of America's most accomplished investors are stepping aside. Last weekend Warren Buffett told shareholders in Berkshire Hathaway, his investment company, that share valuations were too high and that Berkshire's exposure to equities, which has already been cut sharply, would be reduced still further. And now the most famous and one of the most successful financiers of the age has all but quit.
All are leaving a market which, they think, has become irrational, in which trusted ways of valuing shares no longer work, and relationships between assets and economic variables no longer apply. "The stockmarket is now crazy-insane, unbelievably dangerous," says Mr Druckenmiller.
That said, there are important differences between these investors. Messrs Buffett and Robertson have long made clear their refusal to touch "new-economy" shares. Mr Buffett likens investing in Internet stocks to a "chain letter", in which early participants get rich at the expense of later ones. But Messrs Soros and Druckenmiller did not eschew tech shares completely. In part this is because Mr Druckenmiller is a half-believer in the new economy. But it is also because they were burned when they tried to bet against such stocks. Having lost $700m in March 1999 by selling tech shares short, and similar amounts the year before, they started to dabble instead. Quantum invested heavily in Qualcomm, Veritas and a number of other technology shares in the second half of last year, turning round what would otherwise have been a rotten 1999.
But when Nasdaq plunged in March and April, Quantum suffered such heavy losses that Messrs Soros and Druckenmiller decided to call it a day. "Being the last in, we felt it incumbent to be the first out," says Mr Soros. Although his funds lost some $2.5 billion in high-tech shares, Mr Druckenmiller reckons that buying was still a good strategy: Quantum kept half the original $5 billion profits that it had made—more, by far, than it made betting against the Bank of England.
Now, however, the two men do not want to punt either way. Yes, tech stocks, in particular, are absurdly overvalued. But then they also were last year. Mr Soros says that, in these circumstances, "it is too dangerous and crazy to short. You could have shorted the market in March of 1929 and lost everything." If you cannot go long and cannot go short, the only other place to go is away.
Mr Druckenmiller had considered quitting ever since his record began to deteriorate badly after 1996. Certainly, Quantum's recent results have not lived up to previous glories. Its returns have lagged the S&P 500 by over six percentage points a year for the past six years. A failure to read the markets correctly in February proved the last straw. When he saw Mr Robertson announce his retirement he was, he says, "jealous".
The closure of Quantum and Tiger, at one time the world's two biggest hedge funds, should calm the nerves of those politicians who think that hedge funds are a danger to world markets and should be reined in. America's Congress has been considering a bill that would force the big funds to disclose more about themselves—a move backed by the Financial Stability Forum, an international committee of the great and the good. The committee even considered whether hedge funds, unregulated for now, should be brought under the regulatory umbrella. Although the French and Germans were in favour, the committee rejected such a move, at least for now. But hedge funds are clearly less scary than they used to be.
Regulators might still be interested to hear what Mr Druckenmiller has to say about risk-management models, especially the ubiquitous value-at-risk (VAR) models, which purport to show how much an institution might lose. Quantum was forced by its bankers to use such models after their near-death experience with LTCM. "VAR is extremely dangerous. People look at their computer models and think they are safe. Much better to have no models and watch your own net worth every day." Watching it crumble is what told him to get out.
Will Quantum and Tiger take their particular style of hedge fund, with its big, aggressive bets on all manner of financial assets, with them into retirement? Of the big funds, only Moore Capital, with $12 billion of assets, and Tudor Investments, with $2 billion, are left.
Mr Soros does not rule out the possibility that opportunities remain for others. If the hedge funds had only got it right, the euro's slide would have been an attractive bet. Still, there may be reasons why they did not. Both his funds and Tiger started life as equity hedge funds. As they got bigger, they migrated into other investments in which they had less expertise. The likes of Tudor and Moore Capital, on the other hand, started in the futures markets and have long punted on all manner of things. Moreover, these two seem better able to delegate responsibility to those who know what they are doing: Tiger, at least, was run by what one insider calls a "back-seat driver", making it less able to retain talented staff.
Still, unlike other sorts of hedge fund, "macro" funds have in general had a dismal time lately (see chart). Many have been wrong-footed. Tiger famously lost some $2 billion in September 1998, when the yen rose sharply and unexpectedly. And last year many were caught out by the rises in the prices of oil, of American Treasuries and of the yen, and by the fall in the euro.
Worse, financial markets have become less liquid (partly because banks, their counterparties, are less willing to take risks), making bets more expensive. And as they have got bigger, managers gripe, those with whom they deal often try to do the same trades as they do, queering their pitch. The upshot is that macro funds are far less keen to take big punts. All in all, says Nicola Meaden, who runs TASS, a research firm, "the era of the classic macro hedge fund is drawing to a close."
For all the railings against them by regulators, that would be a bad thing. Without the willingness of hedge funds to take risks and bet against irrational trends, the markets would be more volatile, not less. Have no fear. Investors, hedge funds included, wisely get out of a market when it gets too bubbly to call, but when good opportunities arise they'll be back.
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Carl
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