The invisible hands: Hedge Funda off the record - rethinking real money

Au th or of Guns, Germs, and Steel and Collapse

STEVEN DROBNY

A u th o r of Inside the House of Money

4 m ^

y m

T h e crash o f 2 008 crushed “real m oney” investors (en￾d ow m ents, pensions, fo u n d atio n s, an d fam ily offices).

W orld m arkets— from real estate an d equities to co m ­

m odities an d credit— collapsed. Som e o f the w o rld ’s

m ost venerable financial in stitu tio n s disappeared, w hile

m any hedge fu n d , private equity, venture capital, an d

real asset m anagers suffered im m ense losses. Yet, th e

w orld has n o t en d ed , an d now, all investors m ust adapt

to th e new reality.

A nalyzing m oney m anagers w ho fared well in 2 0 0 8 —

eith er by p o stin g stro n g p erform ance or by preserving

capital— is a logical startin g p o in t. G lobal m acro hedge

funds are those m oney m anagers. Risk m an ag em en t is a

key differen tiato r d u rin g crises, an d global m acro hedge

fu n d m anagers an ch o r their investm ent processes in risk,

rath er th an targeting outsized returns.

In The Invisible Hands, Steven D ro b n y — co fo u n d er o f

D ro b n y G lobal A dvisors an d au th o r o f Inside the House

o f M oney— again reaches o u t to his professional netw ork

o f leading global m acro hedge fund m anagers to b etter

u n d erstan d how th eir risk m an ag em en t, investm ent, and

portfolio construction process enabled them to effectively

navigate th e crash o f 08. W ith this b ook as y our guide,

you’ll glean valuable insights from unparalleled access to

these w inners in order to adapt to the new financial reality

we all now face.

The Invisible H ands begins by addressing th e im p o rtan ce

o f “real m oney” m an ag em en t, ex am ining its evolution

an d raising im p o rta n t q u estio n s ab o u t how portfolios

are co n stru cted . In Part Tw o, th e experts o r “Invisible

H an d s”— ten an o n y m o u s global m acro hedge fu n d m a n ­

agers— discuss how they app ro ach m o n ey m anagem ent,

revealing how they m ade m oney o r avoided large losses

d u rin g th e crisis o f 20 0 8 , an d d etailin g how they w ould

address som e o f th e challenges faced by real m oney m a n ­

agers. Part T h ree in tro d u ces th e invisible h an d know n as

“T h e Pensioner,” w ho provides an inside look at th e real

m o n ey w orld.

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THE INVISIBLE HANDS

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THE INVISIBLE HANDS

Hedge Funds O ff the Record—

Rethinking Real Money

Steven Drobny

Foreword by Jared Diamond

WILEY

J o h n W iley & S o n s, Inc.

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Library’ o f Congress Cataloging-in-Publication Data

Drobny. Steven.

T he invisible hands : hedge funds off the record-rethinking real money

Steven Drobny: foreword by Jared Diamond,

p. cm.

Includes bibliographical references and index.

ISBN 978-0-470-60753-4 (cloth)

1. Hedge funds. 2. M utual funds. 3. Investment advisors. 4. Portfolio m anagement.

I. Title.

HG4530.D 743 2010

332.64'524-dc22

'M

Printed in the U nited States o f America.

Copyright © 2010 by Steven Drobny. All rights reserved.

10 9 8 7 6 5 4 3 2 1

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For the taxpayer.

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The w hole problem w ith the w orld is that fools and fanatics

are always so certain o f themselves, but wiser people so full o f

doubts.

— B ertrand Russell

Investors are the big gamblers. T hey make a bet, stay w ith it,

and if it goes the w rong way, they lose it all.

—-Jesse Liverm ore

O nly after disaster can we be resurrected.

— Tyler D urden

Argue for your lim itations and they’re yours.

— R ichard Bach

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Contents

Foreword by Jared Diamond ix

Preface xv

PART O N E R E A L M O N E Y A N D T H E C R A SH

O F ‘08 1

Chapter 1 R ethink in g R eal M oney 3

Chapter 2 T h e R esearcher: Dr. A ndres D robny,

D rob n y G lobal A dvisors 33

Chapter 3 T he Fam ily O ffice M anager: Jim Leitner,

Falcon M anagem ent 53

PART T W O T H E IN V ISIBLE H A N D S 77

Chapter 4 T he H ou se 79

Chapter 5 T h e P hilosoph er 111

C hapter 6 T he B on d Trader 149

C hapter 7 T he P rofessor 169

v ii

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VIII CONTENTS

C hapter 8 T he C o m m o d ity Trader 205

C hapter 9 T he C o m m o d ity Investor 235

Chapter 10 T h e C o m m o d ity H ed ger 269

C hapter 11 T he E quity Trader 299

C hapter 12 T he Predator 327

C hapter 13 T he P lasticine M acro Trader 349

PART T H R E E FIN A L W O R D 385

C hapter 14 T h e P ensioner 387

Conclusion 411

Acknowledgments 415

Bibliography 419

A bout the A uthor 427

Index 429

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Foreword

Q

uestion: W hat is the difference between a Peruvian peasant tanner

and a Harvard or Yale endow m ent manager?

Answer: T he peasant is the one w ho understands risk-sensitive investing

and sound investment goals.

T hat question and answer illustrate why I, as a mere impractical

academic historian, find the practical world o f investment fascinating.

I got my first peek into the m ystery-w rapped w orld o f hedge funds

several years ago, w hen Steven Drobny invited me to give the opening

address at his annual conference for hedge fund managers. That initial

peek aroused my curiosity. It led me to return to his conference in the

following year as an observer, to m eet some o f Stevens colleagues and in￾vited managers, to read Steven’s previous book, Inside the House o f Money,

and to enjoy brunches with Steven from tim e to time, where we talk

about anything from hedge funds and raising children to fixing the world.

O ne reason why I became fascinated in the world o f investing was

the parallels that I saw betw een investing and history. T he issue o f risk

is acute in both o f those spheres. Endow m ent and hedge fund managers

ix

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X FOREWORD

evaluate upside and downside risk to the m oney they manage for other

people, and they make or lose m oney as a result o f those evaluations. T he

historical and m odern peoples w hom 1 study assess upside and downside

risk to their ow n resources that they manage, and they and their families

survive or die as a result o f those evaluations.

For example, in the M iddle Ages, the N orse on the island ot G reen￾land, descended from Viking settlers w ho colonized G reenland in the

year AD 984, made decisions each year about how many o f their cows

to cull in the fall. They knew the am ount o f hay that they had harvested

during the previous summer, and knew the length o f each individual

w inter (hence the dem and for hay to feed the cows over the w inter)

over many past decades, but did not know the length o f the particular

w inter lying ahead. If they still had hay left in the spring, that m eant that

they had culled a certain unnecessary quantity o f cows, and they could

have brought m ore cows through the winter, then produced m ore milk,

cheese, and meat as a result and been less hungry the following year.

If they instead found themselves running out o f hay during the w inter,

that m eant they had culled too few cows in the fill, m eaning they w ould

have to start sacrificing cows in the w inter, ending up w ith fewer cows

in the spring than if they had culled m ore cows already in the fall.

For about 376 years, the G reenland N orse made those annual deci￾sions about risk-sensitive investment in cow herds sufficiently well that

they flourished. But around year AD 1360 there was a particularlv cold

series o f winters for w hich their hay gamble proved to be a bad mis￾calculation, w ith the result that all their cows died during one w inter,

and all o f the thousand or so N orse o f G reenland’s W estern Settlem ent

starved to death in the late winter. H edge fund managers will u n d o u b t￾edly empathize w ith the dilemma that the N orse faced, and w ith their

tem ptation to be greedy and to invest in m any cows in their w inter herd.

But managers will be grateful, w hen their own risk calculations prove

to be in error, that they themselves lose only their investors' m onev and

don't lose their own lives.

A nother reason why I was fascinated w ith w hat I learned about

the world o f investments was the parallels betw een investm ent m anagers

and m odern farm ing peoples. For instance, studies o f m odern Peruvian

peasants resolved a mystery that long puzzled medieval historian', and

that should have puzzled college investment managers. Each medieval

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Fo re w o rd xi

peasant family didn’t cultivate one large plot o f ground; instead, they

cultivated up to several dozen little strips o f land scattered in several

different directions from their hut, despite the obvious inefficiency o f

wasting time on traveling and carrying supplies betw een strips, as well

as the waste o f land inevitably left uncultivated at boundaries betw een

adjacent strips belonging to different peasants. A possible explanation

for the peasants’ apparently irrationally stupid behavior was that they

were practicing the virtue o f diversification praised by m odern financial

managers: d o n ’t put all your eggs in one basket but instead diversify your

portfolio. In any given year, all the strips in a single field may fail because

o f pest infestation, local climate, or thieves. You (the peasant family) are

less likely to starve if you plant different scattered strips.

T hat idea o f diversification is plausible, but only recently did eco￾nomic historians and agronomists discover how sophisticated are the

underlying calculations perform ed unconsciously by peasants. M odern

Peruvian peasants scatter their strips o f land as did medieval English peas￾ants. Any individual Peruvian peasant owns betw een 9 and 26 different

strips, whose yields o f potatoes and other crops vary from year to year

independently o f each other and partly unpredictably. T he peasants can’t

store significant quantities o f potatoes from one year to the next; their

food needs have to be satisfied by the current year’s harvest. In analogy to

the medieval N orse farm ers’ need for hay, the m odern Peruvian peasants

must succeed in obtaining a certain m inim um potato harvest am ounting

to about 680,000 calories in every single year, otherwise they and their

families end up starving. For 20 different peasants ow ning a total o f 488

strips, the anthropologist Carol Goland measured the potato yields in

successive years, then used those measured years to calculate the yield

that each peasant w ould have harvested each year by cultivating only 1,

or 2, or 3 . . . etc. strips, w ith total area held constant but with yield per

acre equal to the value for each possible com bination o f the 1, 2, 3 etc.

actual strips. She also measured the calories invested in travel betw een

1, 2, 3 . . . strips, in order to obtain the net calories remaining to the

peasant for each com bination.

Four interesting conclusions em erged from G oland’s study. First,

the long-term time-averaged potato harvest decreased with subdivision

o f the peasant's land, in agreem ent with the expectations o f horrified

western agronomists w ho urged the peasants to consolidate their strips.

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xii FOREWORD

and for several reasons including wasted travel time. Second, the year-to￾year variance in potato harvest decreased with increasing subdivision o f

the peasant’s land, as expected from the principle "don't put all your eggs

in one basket " But, because o f that variance, the third conclusion was

that the frequency o f the years with a harvest so low as to cause starvation

was highest for a single strip and decreased with subdivision to reach zero

at a certain num ber o f strips varying betw een 4 and 13, depending on

the particular peasant's land. Finally, each individual peasant planted 2 or

3 strips m ore than the num ber required to reduce the risk o f starvation

to zero.

In short, the peasants do not aim at m axim izing long-term tim e￾averaged yield, even though that is an appropriate goal for investors

not spending their earnings and just investing to pay for luxuries on

a rainy day in the distant future. Instead, the peasants only maxim ize

long-term yield insofar as that is consistent w ith their overriding goal

o f elim inating their risk o f starving in any given year, and throw ing in a

small safety m argin for that calculation. It seems to m e that the Harvard

and Yale endow m ent managers are in a position analogous to that of

the peasants, and w ould have done better to set a goal o f m axim izing

yield only above a certain minim al level. As a Harvard graduate myself,

I receive my college's periodic mailings, the tone o f w hich has recently

changed from pride in Harvard's wisdom to tales o f woe. Harvard, like

Peruvian peasants, uses endow m ent incom e for current needs: in fact, as

it turns out. a considerable fraction o f college expenses is paid from the

endow m ent each year. As a result. Harvard has had to impose a hiring

freeze, and recently it had to cancel its plan tor a new science campus.

Naturally, Peruvian peasants did not perform the sophisticated statis￾tical analysis that Carol Goland perform ed retrospectively. Instead, they

arrived at their solution o f optim izing strip num bers to avoid starvation

on the basis o f long experience. They had observed some greedy but

lazy peasants w ith overconsolidated holdings w ho glutted themselves for

m any years, only to starve to death in a bad year. Likewise, thev observed

other peasants w ith overspread holdings w ho never starved but also never

glutted, while still others discovered a happy m edium o f strip num bers

that perm itted frequent modest gluts and never any starvation. Should

vou suspect that the peasants really did use a pocket calculator and a

friendly visiting m athematical modeler, birds such as sparrows, w hich

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Fo re w o rd xiii

certainly don’t have pocket calculators, also make similar risk-sensitive

decisions such that they are never starving.

Steven D robny’s latest book is about the Peruvian peasants o f the

hedge-fund world: that m inority o f managers w ho made m oney or at

least preserved capital during the A nnus horribilis o f 2008, while greedier

managers w ho had accumulated major gluts and perhaps even achieved

higher long-term time-averaged returns in previous happy years lost

disastrously or w ent bankrupt. Hence, anyone interested in the world

o f finance and m aking m oney will pour over this book to extract some

powerful lessons: W hat can I do to emulate those successful guys and

gals in order to make m oney or preserve capital, even under the worst

conditions, and becom e rich and famous?

But this book will also fascinate anyone interested in people. My

other interest in the hedge fund world is for that reason. W hen Steven

Drobny introduced me to his world o f colleagues and clients, 1 found

myself com paring them with the many creative scientists, architects,

composers, artists, and business people w hom 1 have interviewed. I

wondered: W hat makes these people tick? H ow did their childhood

experiences shape their adult professional success? Because a person’s

abilities change with age, do most hedge fund managers becom e washed

up by age 40, or does a 60-year-old m anager still have ways o f succeeding

in a world o f cutthroat young managers w ho need less sleep and w ho

received a m ore recent technological education? Are they managing

m oney in order to becom e rich, to stoke their ego, to acquire flashy cars

and superm odel dates, or to satisfy some other motivation?

W ith Steven D robny’s kind help, I interview ed some hedge fund

managers (including a couple that Steven interviewed for this book)

just for my ow n curiosity. I was struck by the fact that, although all

the managers were quite different from each other, each had a broader

life philosophy that he or she applied to the w orld o f hedge funds in

particular. Each had childhood experiences, things that their parents did

or didn’t do for them , that shaped them as future managers, although

their parents could have hardly anticipated that outcom e. All o f them

became managers partly for fun and curiosity. T hey want to understand

how the w orld works, and they want to keep testing their evolving

hypotheses about the world’s workings against reality. All are still active

in their 40s, 50s, and 60s. Yes, the 28-year-old whiz kids can get by with

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x iv FOREWORD

less sleep, while saddled with less knowledge about dated technologies,

and have been schooled in the latest technologies. But “older" managers

w hom I interviewed enjoyed the advantage o f having used their years

to try out m ore things, and having seen more ups and downs. T hey are

in the position o f the peasant w ho remembers that dry sum m er 17 years

ago, and w ho isn’t deceived by the recent runs o f wet sum m ers into

assuming that sum m er will always be wet. Some o f the managers w hom

I m et expect still to be managing m oney w hen they are 80 years old.

They fulfilled their own lifetime financial needs long ago, but they may

never fulfill their curiosity about how the world works, nor the fun they

derive from testing their ideas.

My own interviews were casual ones, by an interview er (i.e., me)

ignorant o f the subject matter. Steven D robny’s book consists o f 13 long

interviews, eleven anonymous and two o f nam ed managers. N o one is

better qualified than Steven to probe the subject matter, and to place

his interviewed managers in a broad context, both as investors and as

hum an beings. W hether you are curious about m oney or people, you

are certain to love this book.

Jared D iam ond

Professor o f Geography and Environm ent Health Sciences. U CLA

A uthor o f num erous books including Guns, Germs and Steel,

Collapse, The Third Chimpanzee, and W hy is Sex Fun?

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