Every hedge-fund manager talks of the risk-reward ratio. The reward was that you’d be the richest cat on Wall Street. The risk, on the other hand, was bottomless. And recently, the risk has been growing. “It feels like a top,” said one manager. Meaning, possibly, there’s nowhere to go but down. And down can be a long way.
“Let me take you into my hell,” says David Marcus.
Like many hedge-fund managers, Marcus began trading early. At 13, he sank his bar mitzvah money into the market. In college, he played options between classes, using advances against student loans. After college, Marcus went to work for mutual-fund king Michael Price. Eventually, he managed a $1 billion European fund for Price’s Franklin Mutual. “I discovered Sweden,” says Marcus. “I’d never seen stocks so cheap.”
As portfolio manager, Marcus had a ball. Swedes are polite, well behaved. In a jaunty tone, Marcus said whatever he wanted. One chairman, he noted, was “a bag of hot air.” Why shouldn’t he? In 1999, Marcus’s fund returned 47 percent. Barron’s labeled him a “European-stock ace.”
After Price sold the company, to Marcus’s mind, the new owners didn’t treat him like an ace. He earned over $1 million a year, much of it, though, in deferred compensation. Plus, he considered the alternative. If he’d been ahead 47 percent while running a $1 billion hedge fund, he’d have earned close to $90 million. I’d never have to work again, he thought.
So Marcus started a hedge fund. Perhaps the most challenging task for new hedge-fund managers is raising money. With money pouring in, though, the manager with good results may have the upper hand. “We have a manager that is no longer willing to wear shoes at investor meetings,” says Robert Schulman, CEO of Tremont Capital, which invests in hedge funds. Marcus raised $400 million in khaki pants and blue button-down shirts—that’s all he owns. He launched MarcStone (from Marcus and Flintstone) in 2000.
Marcus took big positions in several solid companies—he particularly liked a French construction company. Overall, though, he believed Europe was in for a tumble. He bet most of his money on a declining market. In his view, European telecommunication companies—in particular Marconi, which is British—were overpriced; some, Marcus believed, ought to be worth a big fat zero. He bet on them to go down, selling big short positions.
To sell short, you borrow the stock, sell it, and then later buy it back when, if all goes according to plan, the price is lower. Hedge funds claim they can make money whether the market is up or down. The short is why. Jim Chanos, who runs Kynikos Associates, shorted Enron at about 60. Others lost their shirts; Chanos rode it into the single digits, making money all the way.
The real trick, though, is the paired trade. To believe strongly in one thing and strongly against another, and have those things counterbalance, is a kind of hedgie bliss. It is what permits the manager to tell investors that he can hedge out the risk, which sounds magical and mostly isn’t true. As one extremely successful manager says, “I don’t know how you can really make money if you’re not willing to lose money.”
Still, at one point tourists made paired trading easy. The public, for instance, pushed the IPO for Palm through the roof, not noticing that its parent company, 3Com, owned 94 percent of Palm. Hedge managers bought 3Com and shorted Palm. Much of the risk was hedged out—by owning 3Com, you had a huge stake in Palm’s upside, and by shorting Palm, you also owned its downside. “We made a fortune on Palm,” says one manager.
Marcus didn’t have much experience with shorts. Mutual funds don’t short. If the market declines, they head to the sidelines—if they can lumber out of the way. “They’re fighting with one hand tied behind their backs,” says Carvin. Maybe so. But Marcus had done pretty well without shorts. As a hedge-fund manager, he spent lots of time worrying whether he’d calculated the hedge right.
Marcus figured that shorting the telecoms, hair-trigger stocks that should exaggerate market movements, would hedge against a collapse in his long positions, his buys. They should, if things worked right, crash faster than the broad market.
At hedge funds, market news comes at you constantly. They all watch CNBC all day. With TV commentators dizzily rattling off losses, a hedgie who bucks the market and makes money feels close to indomitable. “You’re a genius, you’ve got a big dick, you’re a superstar,” explains Carvin. For Marcus, March 2001 was a genius month, his best ever. Marconi was cut in half.
Over the years, Marcus’s weight had bulged. He was a Krispy Kreme guy. As a hedge manager, he’d broken 250 pounds. At five ten, he was by his own estimation a “fat pig.” Still, what a month! Marcus had a doughnut, and added to his short positions.
The spiral, sometimes called the death spiral, is what every hedge-fund manager fears. What’s striking is how innocuously it begins.
On April 18, 2001, in an unscheduled move, the Federal Reserve cut interest rates by a half-point. Stocks around the world shot up.
In one day, Marconi was up 9 percent, and it, Marcus reminded himself, was a piece of crap. Within a short time, his shorts had gone in his face, 25, 30 percent. Marcus’s long positions might have bailed him out by shooting up as well. Instead, they idled on their butts. “I made a basic hedge-fund mistake,” Marcus says glumly. The market took revenge, squeezing his shorts. By April 2001, Marcus was down 15 percent, close to $65 million.
Hedge-fund managers make investors a promise: I won’t take a bonus again until I earn back your losses. Many believe an unestablished fund simply can’t have a negative year. “One down year and you’re gone—poof—screwed,” says Carvin. Investors will hit the fax, redeem their money. One group of Marcus’s investors redeemed $45 million.
Once investors make for the exits, the death spiral accelerates. To return their cash, you have to sell into a market that’s against you, which further erodes your returns. Losing a lot of money is a crucible, and not just for the fund. As one manager said, “My very worth as a human being depended on my continually making money.” Confidence is a threshold-sensitive state. Cross the line, you might not return. Carvin knew two guys who, after big losses, were afraid to pull the trigger.
Marcus has four children. At home in New Jersey, he didn’t mention his losses—“It wasn’t my family’s fault,” he reasoned. Still, he couldn’t bear it when he saw his wife flipping through a catalogue. “Why are you buying all that stuff?” he snapped. She couldn’t understand. She was spending $50. “It was the worst period of my life,” he says.
Marcus felt fogged by his $60 million loss. He got up earlier and earlier. At home he’d usually plug into his computer from about 10 to midnight—trading is a kind of addiction. (At a yoga retreat in India, Loeb had a high-speed Internet connection installed.) When the market went in his face, Marcus decided he had to trade the opening—the opening in Europe. He was at his desk in the Citicorp building at 4 A.M.
Most of the market, needless to say, was elated by the run-up. CNBC seemed giddy, relentlessly so. Marcus watched the Cartoon Network. He thought of a hedge friend down 9 percent. In a week, he’d have to report to investors. “He swung for the fences,” says Marcus. It worked. This friend finished the year up 7 percent. Marcus couldn’t bring himself to risk his investors’ capital that way.
“I needed to stop,” he says. “You can’t think when you’re fucked up like that.” Marcus went to all-cash. Between losses and redemptions, his $400 million fund was soon worth $180 million. A few months later, the telecoms Marcus so disliked had fallen to almost zero. If only he’d been able to hold on or, he sometimes thought, go on vacation. A friend called: “How does it feel to be 100 percent right and 100 percent wrong?”
I want to kill you, Marcus thought.
Marcus couldn’t bear his results. He was a European ace. He vowed to come back. (And now, two years later, he’s lost 45 pounds, and has a new hedge fund, running $100 million. Hardly any shorts. He’s up 22 percent. Which is why the hedge-fund moment may be nowhere near its top.) But back then, he’d had to face it, come to grips with his own limitations. The risk was too scary. He closed the fund. “I tried hedge fund, and it didn’t work,” Marcus said soberly. “I’m a plain vanilla.”