When Genius Failed: The Rise and Fall of Long Term Capital Management. Roger Lowenstein

let Hilibrand keep the trade he had. Eventually, it was profitable, but it reminded Salomon’s managers that while Hilibrand was critiquing various departments as being so much extra baggage, Arbitrage felt free to call on Salomon’s capital whenever it was down. The executives could never agree on just how much capital Arbitrage was tying up or how much risk its trades entailed, matters on which the dogmatic Hilibrand lectured them for hours. In short, how much—if, sometime, the Slinky did not bounce back—could Arbitrage potentially lose? Neither Buffett nor Munger ever felt quite comfortable with the mathematical tenor of Hilibrand’s replies.¹⁶ Buffett agreed to take J.M. back—but not, as Hilibrand wanted, to trust him with the entire firm.

      Of course, there was no way Meriwether would settle for such a qualified homecoming. The Mozer scandal had ended any hope that J.M. would take his place at the top of Salomon, but it had sown the seeds of a greater drama. Now forty-five, with hair that dipped in a wavy, boyish arc toward impenetrable eyes, J.M. broke off talks with Salomon. He laid plans for a new and independent arbitrage fund, perhaps a hedge fund, and he proceeded to raid the Arbitrage Group that he had, so lovingly, assembled.

* In practical terms, those who go short sell a security they have borrowed. They must return the security later—by which time, they believe, the price will have declined. The principle of buying cheap and selling dear still holds. Short sellers merely reverse the order: sell dear, then buy cheap.

* The Securities and Exchange Commission filed a civil complaint charging that Meriwether had failed to properly supervise Mozer. Without admitting or denying guilt, Meriwether settled the case, agreeing to a three-month suspension from the securities industry and a $50,000 fine.

       2 HEDGE FUND

      I love a hedge, sir. —HENRY FIELDING, 1736

      Prophesy as much as you like, but always hedge. –OLIVER WENDELL HOLMES, 1861

      BY THE EARLY 1990s, as Meriwether began to resuscitate his career, investing had entered a golden age. More Americans owned investments than ever before, and stock prices were rising to astonishing heights. Time and again, the market indexes soared past once unthinkable barriers. Time and again, new records were set and old standards eclipsed. Investors were giddy, but they were far from complacent. It was a golden age, but also a nervous one. Americans filled their empty moments by gazing anxiously at luminescent monitors that registered the market’s latest move. Stock screens were everywhere—in gyms, at airports, in singles bars. Pundits repeatedly prophesied a correction or a crash; though always wrong, they were hard to ignore. Investors were greedy but wary, too. People who had gotten rich beyond their wildest dreams wanted a place to reinvest, but one that would not unduly suffer if—or when—the stock market finally crashed.

      And there were plenty of rich people about. Thanks in large part to the stock market boom, no fewer than 6 million people around the world counted themselves as dollar millionaires, with a total of $17 trillion in assets.¹ For these lucky 6 million, at least, investing in hedge funds had a special allure.

      As far as securities law is concerned, there is no such thing as a hedge fund. In practice, the term refers to a limited partnership, at least a small number of which have operated since the 1920s. Benjamin Graham, known as the father of value investing, ran what was perhaps the first. Unlike mutual funds, their more common cousins, these partnerships operate in Wall Street’s shadows; they are private and largely unregulated investment pools for the rich. They need not register with the Securities and Exchange Commission, though some must make limited filings to another Washington agency, the Commodity Futures Trading Commission. For the most part, they keep the contents of their portfolios hidden. They can borrow as much as they choose (or as much as their bankers will lend them—which often amounts to the same thing). And, unlike mutual funds, they can concentrate their portfolios with no thought to diversification. In fact, hedge funds are free to sample any or all of the more exotic species of investment flora, such as options, derivatives, short sales, extremely high leverage, and so forth.

      In return for such freedom, hedge funds must limit access to a select few investors; indeed, they operate like private clubs. By law, funds can sign up no more than ninety-nine investors, people, or institutions each worth at least $1 million, or up to five hundred investors, assuming that each has a portfolio of at least $5 million. The implicit logic is that if a fund is open to only a small group of millionaires and institutions, agencies such as the SEC need not trouble to monitor it. Presumably, millionaires know what they are doing; if not, their losses are nobody’s business but their own.

      Until recently, hedge fund managers were complete unknowns. But in the 1980s and ’90s, a few large operators gained notoriety, most notably the émigré currency speculator George Soros. In 1992, Soros’s Quantum Fund became celebrated for “breaking” the Bank of England and forcing it to devalue the pound (which he had relentlessly sold short), a coup that netted him a $1 billion profit. A few years later, Soros was blamed—perhaps unjustifiably—for forcing sharp devaluations in Southeast Asian currencies. Thanks to Soros and a few other high-profile managers, such as Julian Robertson and Michael Steinhardt, hedge fund operators acquired an image of daring buccaneers capable of roiling markets. Steinhardt bragged that he and his fellows were one of the few remaining bastions of frontier capitalism.² The popular image was of swashbuckling risk takers who captured outsized profits or suffered horrendous losses; the 1998 Webster’s College Dictionary defined hedge funds as those that use “high-risk speculative methods.”

      Despite their bravura image, however, most hedge funds are rather tame; indeed, that is their true appeal. The term “hedge fund” is a colloquialism derived from the expression “to hedge one’s bets,” meaning to limit the possibility of loss on a speculation by betting on the other side. This usage evolved from the notion of the common garden hedge as a boundary or limit and was used by Shakespeare (“England hedg’d in with the maine”³). No one had thought to apply the term to an investment fund until Alfred Winslow Jones, the true predecessor of Meriwether, organized a partnership in 1949.⁴ Though such partnerships had long been in existence, Jones, an Australian-born Fortune writer, was the first to run a balanced, or hedged, portfolio. Fearing that his stocks would fall during general market slumps, Jones decided to neutralize the market factor by hedging—that is, by going both long and short. Like most investors, he bought stocks he deemed to be cheap, but he also sold short seemingly overpriced stocks. At least in theory, Jones’s portfolio was “market neutral.” Any event—war, impeachment, a change in the weather—that moved the market either up or down would simply elevate one half of Jones’s portfolio and depress the other half. His net return would depend only on his ability to single out the relative best and worst.

      This is a conservative approach, likely to make less but also to lose less, which appealed to the nervous investor of the 1990s. Eschewing the daring of Soros, most modern hedge funds boasted of their steadiness as much as of their profits. Over time, they expected to make handsome returns but not to track the broader market blip for blip. Ideally, they would make as much as or more than generalized stock funds yet hold their own when the averages suffered.

      At a time when Americans compared investment returns as obsessively as they once had soaring home prices, these hedge funds—though dimly understood—attained a mysterious cachet, for they had seemingly found a route to riches while circumventing the usual risks. People at barbecues talked of nothing but their mutual funds, but a mutual fund was so—common! For people of means, for people who summered in the Hamptons and decorated their homes with Warhols, for patrons of the arts and charity dinners, investing in a hedge