Book Review of The Alpha Masters: Unlocking the Genius of the World’s Top Hedge Funds by Maneet Ahuja

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Genre: Business & Money
Author: Maneet Ahuja
Title: The Alpha Masters: Unlocking the Genius of the World’s Top Hedge Funds (Buy the Book)

Summary

The mystique of hedge funds is undeniable. In the investment management world, hedge funds are often referred to as “smart money.” They command premium fees and are thought to attract the best and brightest talent. As complex as it may seem to many, the hedge fund industry essentially boils down to two deterministic factors: the type of investment vehicles and the investment managers that have self-selected to run them.

While they may vary in their sector focus and styles, hedge funds share four common and interrelated characteristics:

  • They target positive absolute returns rather than simply outperforming a certain market benchmark.
  • They have access to a very wide range of investment tools and instruments, including long and short bets.
  • They can lever their investment footing to a meaningful multiple of their assets under management.
  • They almost always follow a fee structure involving a base component and a performance component.
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The second element, the investment managers themselves, is the focus of Maneet Ahuja’s The Alpha Masters: Unlocking the Genius of the World’s Top Hedge Funds. The book discusses nine “alpha masters,” those able to consistently provide excess returns, and gives a unique look into the lives and stories of some of the industry’s most successful hedge fund managers.

Along the way, the reader is treated to many interesting, and in some cases surprising, asides as you get to know the managers, their philosophies, styles, quirks and working practices.

The managers covered in the book include Bridgewater’s Ray Dalio, Pierre Lagrange and Tim Wong of Man Group/AHL, John Paulson of Paulson and Co., Marc Lasry and Sonia Gardner of Avenue Capital Group, Appaloosa’s David Tepper, and several others.

Each section covers in great detail the investors’ backgrounds, both personal and professional, and the strategies or techniques their funds have used to become successful in a hyper-competitive industry. In doing so, the book shows just how broad the term “hedge fund” is, as these investors run the gamut from quantitative to activist to short-selling and everywhere in between.

Perhaps the most important thing to learn from The Alpha Masters is that while there is no single path to successful hedge fund investing, there are some commonalities shared by the investors covered in the book. As personalities, they stressed that their own road to success involved a tremendous amount of learning how to invest in their trading strategies.

To build an investment business, they all had to become experts in their discipline, which involved a combination of evolving theory and experience. Many disciplined themselves to approach investment as a business without emotion. Lessons shared among the investors included:

  • Trust your own intuition and be willing to make and learn from mistakes.
  • Take a longer-term perspective, realizing that the best strategies might take many years to come to fruition.
  • Handle risk aversion unemotionally, and make sure to diversify so it is easier to remain calm and analytical.
  • Take aggressive positions in combination with protecting the downside.
  • Invest with those who have their own money on the line.
  • Assign backup information gathering to the team, and test investment ideas by listening to others across a broad cross-section.
  • Work with the numbers to calculate value and test ideas.

Successful hedge fund managers are driven individuals with deep self-confidence about what they bring to the investment management table. They are innovative and intellectually curious. They know that they have to be different but intelligently and sustainably.

They are often able and willing to spend a lot of time not just on the “what” of investing, but also the “why” and “how.” Most important, they learn rather quickly from their mistakes and show an amazing ability to mid-course correct. In The Alpha Masters, Ahuja has done an excellent job exploring this unique set of capabilities and the individuals that have taken advantage of them.

Introduction

The mystique of hedge funds in undeniable. In the investment management world, hedge funds are often referred to as “smart money.” They command premium fees and are thought to attract the best and brightest talent. As complex as it may seem to many, the hedge fund industry essentially boils down to two deterministic factors: the type of investment vehicles and the investment managers that have self- selected to run them.

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Investment Vehicles

While they may vary in their sector focus and styles, hedge funds share four common and interrelated characteristics:

  • They target positive absolute returns rather than simply outperforming a certain market benchmark.
  • They have access to a very wide range of investment tools and instruments, including long and short bets.
  • They can lever their investment footing to a meaningful multiple of their assets under management.
  • They almost always follow a fee structure involving a base component and a performance component.

Investment Managers

The second element is less well known. This book discusses nine “alpha masters” and gives a unique look into the lives and stories of some of the industry’s most successful hedge fund managers. Along the way, the reader is treated to many interesting, and in some cases surprising, asides as you get to know the managers, their philosophies, styles, quirks and working practices.

The Global Macro Maven: Ray Dalio, Bridgewater Associates

Ray Dalio

Ray Dalio is the founder of Bridgewater Associates, the global macro fund that is the world’s largest hedge fund, with $120 billion under management. Bridgewater advises and runs portfolios for the most powerful pension funds, central banks, and countries around the world. Dalio is well known for how his big-picture view and innovative thinking has changed investing in important ways.

The Makings of a Maven

Growing up the son of a jazz musician and a homemaker, Dalio didn’t like following instructions or remembering what he was taught. Instead, he loved chasing after what he wanted and figuring out for himself how to get it. Because his parents afforded him the freedom to do this, he feels he received a better than normal education, learning more from negative experiences than the positive ones and developing the skills that serve him so well to this day.

Dalio believes that “learning is through questions; it’s not through being told.” In 1967, Dalio was admitted to Long Island University’s C.W. Post Campus. It was in college that Dalio first began to study because he enjoyed it, not because he was forced to. He also learned to meditate during his freshman year. Dalio did so well that after graduating, he gained admission to Harvard Business School. In 1974, Dalio decided to strike out on his own. He was 26 years old.

Building Bridgewater

From the start, Dalio never built Bridgewater to draw investors. Instead, he wanted to focus on managing exposures, writing research, and continuing the pursuit of truth and excellence while he continued to study currency and commodities markets. Dalio soon built a reputation for quality macro research.

His Daily Observations became a critical touchstone not only for Bridgewater’s clients but from the early 1980’s onward, became so widely read that they rivaled other firms’ annual reports and are at least as popular, if not more influential.

They became required reading for corporate executives, policymakers, and central bankers around the world. Bridgewater evolved from corporate consultant to money manager in 1985, when the officials of the World Bank, after reading Daily Observations religiously for several years, approached Dalio with a $5 million test portfolio of domestic bonds to manage.

For the first few years, Bridgewater managed the accounts by creating a benchmark portfolio, as any manager would. That would be the neutral position. Then it would take deviations from the benchmark replication (beta). Dalio knew that to protect downside risk and promote alpha generation, he would need to transition to an active manager that could take a variety of alpha positions around the benchmark.

In 1991, Bridgewater set up its flagship Pure Alpha strategy. Pure Alpha traded global bond markets, currencies, equities, commodities, and emerging market debt. At any point in time, it would combine these 60 to 100 positions with any client-chosen benchmark. “After they put money into Pure Alpha, it’s overlaid on that benchmark. So pure alpha is just our best mix of alphas, calibrated at 12 or 18 percent volatility, depending on the leverage they’d like.”

Bringing Home the Alpha

The skill comes into play with structuring and engineering a portfolio of bets. “To create the proper balance, diversification is even more important than any particular bets, which is the opposite of how most investors operate,” Dalio says if you have 15 or more good, uncorrelated bets, you will improve your return to risk ratio by a factor of five.

He sets a simple example: say an investor has 15 bets and they all have an expected return of 3 percent with a standard deviation of 10 percent and they are uncorrelated. With one bet, you would have an expected return of 3 percent and a standard deviation of 10 percent. However, if you have a portfolio of 15 uncorrelated bets, you can still have an expected return of 3 percent but will only have a risk of 2 percent.

Perhaps, the most important application of this portfolio engineering has nothing to do with the firm’s Pure Alpha strategy. In 1994, Dalio created the “All Weather Portfolio” – a passive asset allocation that was designed to take full advantage of diversification. In 2001, following the equity market crash, Britt Harris, CIO of the Verizon pension fund, would become Bridgewater’s first institutional client to use All Weather.

Dalio believes that “as this approach is increasingly adopted, it will have a radical beneficial impact on asset allocation that will be of a similar magnitude to that of traditional portfolio theory.” The industry has quickly been adopting the All Weather strategy but has adopted the name “Risk Parity” for such approaches. Dalio’s greatest impact on the investment industry is likely his invention of All Weather.

Going After What You Want

Dalio does not think people should seek out what successful investors do and follow it. He stresses the importance of being true to yourself, especially when investing. Dalio thinks the path to greatness is challenging, and that it ought to be, but he also believes it is attainable.

In his Principles he writes “I met a number of great people and learned that none of them were born great, they all made lots of mistakes and had lots of weaknesses – and that great people become great by looking at their mistakes and weaknesses and figuring out how to get around them.”

Man versus Machine: Pierre Lagrange and Tim Wong, Man Group/AHL

The Merger

In 2010, Man Group acquired GLG Partners, creating one of the world’s largest hedge fund organizations, with $69 billion in assets. Each partner brought a unique set of characteristics. In the Man Group, a company started in 1783; shareholders get the hard-nosed quants that note every price fluctuation in every trend in order to patiently profit from the long-term trends. In GLG Partners, they get a star culture of investment gurus whose collective reputation for success attracted $30 billion in assets.

The flagship of Man’s operation, with $23.6 billion in assets, is AHL. Rigorous in its study of long-term trends, AHL has achieved an annualized return of 16.7 percent from its inception in March 1996 through September 2010. Two of the Man Group’s key executives, Tim Wong, the CEO of AHL, and Pierre Lagrange, one of the founding partners of GLG, each had very different paths they took to Man Group, but now work hand in hand to run one of Europe’s biggest, and most complex, hedge funds.

Tim Wong

Looking back, Tim Wong realizes that while his upbringing in Hong Kong was not steeped in the disciplines of finance, a great many of the people that he knew in his family and his neighborhood were involved in playing odds in one way or the other.

Concepts such as trends, odds, risk, winning and losing were introduced to him at an early age and must have taken hold. Wong left Hong Kong to study engineering at Oxford University. After graduating, Wong took a job at AHL, a company that he eventually became CEO of in 2001. Wong’s experiences during his first few years at AHL were hands-on writing programs that would deliver data and trading signals to markets more quickly.

Wong says he learned two lessons from these experiences. The first is teamwork. AHL was a very tight-knit group that shared ideas and tried to help each other. The second lesson is that AHL had no fear. They somehow believed that they could do whatever needed to be done.

Wong says that the one thing most people do not understand about systematic trading is the tradeoff between profit potential in the long term and the potential for short-term fluctuation and losses. Wong says that “most traders want to be very good gamblers and beat the roulette table, I would rather be the house and own the roulette table.

Every day somebody is going to bet against us and win, and from time to time, lots of people may bet against us and win. We will have losing nights and losing weeks. But if we play the game over and over again, eventually we’ll win because of the statistical advantage that we have.” Pushing this advantage is the most important job of a hedge fund.

Pierre Lagrange

At the age of 50, Pierre Lagrange, a native Belgian who is one of the richest men in England, is a successful leader of hedge fund operators. He says “I love finding investments that people have missed. I love the whole discussion and arguing cases with bright people or reviewing an obscure company. And I just hate to take no for an answer.”

Coincidentally, like Wong, Lagrange began his professional career studying engineering. He didn’t know what he wanted to do with his degree, and when J.P. Morgan invited him to join a six-month training program in New York, he jumped at the opportunity. His next move came in 1995 when he and two colleagues opened their own hedge fund.

“Our whole philosophy of how to invest was based on getting people with different backgrounds and different views to work together so we can see something that someone else is not seeing.” By the time of the merger, GLG had recruited a roster of elite traders from big investment banks and built a roster of multi-strategy funds with more than $30 billion under management.

GLG built its reputation by fostering a “star culture,” one that attracted the very best proprietary traders from leading investment banks by offering them the freedom to follow their own strategies. GLG has a lot of really smart people. They do not want to normalize their processes but want to normalize their output. It does not really matter how a trader reaches that output.

The Risk Arbitrageur: John Paulson, Paulson and Co.

The Making of a Risk Arbitrageur

Paulson was very independent, and at the age of 14, he began to dabble in stocks with some money his father had given him. When Paulson entered college in 1973, he had no interest in business. After his freshman year, he took a break from school and went on what would be an extended journey through Panama and Colombia that ended in Ecuador where he would stay for two years.

He eventually went back to NYU and graduated summa cum laude from the business school. He then went to Harvard Business School where he thrived on being challenged in the classroom and felt excited about the future. The case study approach made attending class fun for him, and the lively, interactive environment taught him how to analyze situations quickly and how to articulate himself to other people.

Upon graduating from Harvard Business School, Paulson accepted a job at Boston Consulting Group.

Paulson soon realized that it was not where his heart was and pursued working at a hedge fund. Odyssey Partners hired him and working for their 10-person office helped Paulson build a solid foundation; in fact, most of what he learned there he still does at his own firm today. However, Paulson soon realized that his lack of experience in investment banking was holding him back.

He needed to learn the business from an agency perspective, and in 1984, he landed a job as an associate at Bear Sterns. While at Bear, Paulson worked hard and advanced fairly rapidly. He held the position of associate vice president, limited partner, then managing director all within the span of four years. Paulson left Bear Sterns in 1988 to become a general partner at Gruss Partners. Paulson focused most of his time at Gruss on distressed and bankruptcy investing. As much as he liked working at Gruss, he realized that he ultimately wanted to be in business for himself.

In 1994, he launched Paulson & Co. Paulson & Co. specializes in three types of event arbitrage: mergers, bankruptcies, and any type of corporate restructuring, spin-off, or recap litigation that affects the value of a security. In merger arbitrage, a major focus of the firm’s proprietary research is to anticipate which deals may receive another bid and then to weight the portfolio towards those specific deals.

The goal of the Paulson funds is to produce above-average returns with less volatility and low correlation to the broader equity markets. Their correlation with the S&P 500 since 1994 has been .07 percent. A risk arbitrageur, Paulsen explains, typically gets involved when others want to get out.

“Say you get a $50 offer from a company that was trading at $35, and it immediately jumps to $49. Now, most investors don’t want to stick around for the last dollar and risk losing $14 if the deal breaks. They made a good profit and want to take the property and go home. On the other hand, the arbitrageur steps in, and for that extra dollar, take the $14 risk of deal completion.”

The Greatest Trade Ever

One of the unique skills that Paulson had developed through his career was in shorting bonds. The attraction of shorting bonds is the asymmetrical nature of the returns. If you could short a bond at par or close to par at a tight spread to Treasuries, then the downside would be limited if you were wrong, but the upside could be substantial if the company defaulted.

By the spring of 2005, Paulson became increasingly alarmed by weak credit underwriting standards and excessive leverage being used by financial institutions. The bubble nature of the real estate market, the frothiness of the credit market and Paulson’s focus on shorting bonds led Paulson to investigate short opportunities in the mortgage market.

Slowly, Paulson and his team were able to piece together how housing prices, and the trillion-dollar market built around them, were doomed to collapse like a house of cards. This gave Paulson the green light to begin purchasing protection through credit default swaps on debt securities they felt would decline due to weak credit underwriting.

In the end, Paulson bought protection across his fund on about $25 billion of subprime securities. As spreads widened, and the value of those securities fell, Paulson and his team cashed in at an increasingly accelerated pace. Paulson & Co. had amassed $15 billion in profits off these trades by the end of 2007 with the Paulson Credit Fund up 600 percent that year. The firm’s assets under management grew from a respectable $6.5 billion in 2006 to a monstrous $28 billion by the end of 2007.

Distressed Debt’s Value Seekers: Marc Lasry and Sonia Gardner, Avenue Capital Group

Brother-and-Sister Partnership

Lasry and Gardner were born in Marrakech, Morocco, the family home for generations. Their parents left Morocco in 1966 and moved to Hartford, Connecticut. With the help of scholarships and loans, Marc and Sonia both attended Clark University in Worcester, Massachusetts.

That is where Lasry met his future wife, Cathy, a friend of Sonia’s who lived across the hall in their freshman dorm. Lasry graduated in 1981 with a BA in history. With the help of his wife, he decided to go to law school and received his JD in 1984.

He spent the following year practicing law at Angel & Frankel, which focused on bankruptcies. Going through all the filings and financials, Lasry became an expert on distressed companies and how to profit from them. He realized he was looking at a large and relatively untapped market with very little competition.

In 1987, he landed a big position at Cowen & Company, managing $50 million in partners’ capital. It was right around the time that his sister Sonia had graduated from law school and Lasry’s new department at Cowen needed a lawyer. Lasry needed someone he could trust, and Gardner agreed to take the job, thinking of it as a temporary gig. They have worked together ever since.

Catching the Eye of Robert Bass

It was while working at Cowen that Lasry caught the eye of legendary Texas billionaire investor Robert Bass. When Cowen decided to raise money for a fund, the Robert M. Bass Group, then a client of the firm, offered to provide Cowen with virtually all the capital.

After Cowen refused to take all of the Bass capital, the siblings decided to leave the firm and go work for Bass.

When Marc and Sonia joined the Bass Group, they were given a portfolio of $75 million to invest in trade claims, bank debt, and senior bonds. The siblings wanted to call the entity “Maroc” after their birthplace, Morocco, but switched the first two letters so they would be at the top of all the distribution lists.

Aside from Amroc’s flagship $75 million fund, they also had the ability to draw down an additional $75 million, giving them one access to $150 million in capital, which made them one of the largest distressed funds in the United States at that time. Even though they were doing very well under the Bass umbrella, after about two years, the siblings were ready to really strike out on their own.

Lasry and Gardner opened their own boutique distressed brokerage firm in 1990 with $1 million of their own capital, keeping the name, Amroc Investments.

Killer Combination

By 1995, the Amroc distressed brokerage firm was facing new competition as big players like Goldman Sachs, Merrill Lynch, and Citibank entered the market. As a hedge against their brokerage business, Lasry and Gardner formed their first Avenue fund using capital from friends and family. They started Avenue with less than $10 million in 1995, building it into a $1 billion hedge fund firm over the next five years. By 2001, Avenue’s assets under management had grown substantially, and they were also still running Amroc Securities, their distress brokerage firm.

Lasry and Gardner were at a crossroads, as they realized they could no longer operate both businesses if they wanted to continue to meet the standards they had set for themselves. So, in August of that year, they decided to close Amroc to focus all their energies on Avenue.

Lasry and Gardner complement each other by having different strengths. In fact, their killer combination has worked so well that Lasry was named one of the 50 most influential people in hedge funds by industry trade publication HFMWeek in 2010.

Detecting Diamonds in the Rough

While Wall Street concentrates largely on investing in strong, healthy companies, Lasry feels perfectly comfortable looking at companies in distress. Unlike most investors, he is not afraid of being in the middle of an investment where credit conditions could get progressively worse before they get better.

For Lasry, with his long history of distressed investing, sifting through distressed companies is second nature. When he sees a troubled company he asks himself, “What’s the value of the company? What assets does this company have? And where do we want to be in the capital structure?” Distressed investing is often perceived to be riskier than equity investing, but Lasry believes it actually presents less risk.

He only pursues investment ideas where he is comfortable that his downside is protected, so when his investment professionals do their homework, he wants to know the worst-case scenario.

Lasry believes Avenue’s real edge over its peers is the firm’s experienced investment team and its deep, fundamental understanding of all the ramifications and risk of bankruptcy proceedings and restructurings.

Avenue’s team is adept at recognizing the potential value of companies struggling with financial distress, at gauging the risks inherent in the bankruptcy process itself, and at evaluating the opportunities that will emerge after restructuring. As a result, the firm has captured outsized risk-adjusted returns in the distressed investing space.

The Fearless First Mover: David Tepper, Appaloosa Management

The Early Days

David Alan Tepper was born in 1957, the second of three children. He had a lower-middle-class upbringing in the Stanton Heights neighborhood in the East End of Pittsburgh, Pennsylvania. Tepper attended Peabody High School, an inner-city school in the East Liberty neighborhood near his family’s home.

Even though he was in the scholar’s program in high school, Tepper was not motivated to work hard and never earned an “A” in four years. When he was a junior, he bought his first stock.

Things changed very quickly for Tepper when he entered college at the University of Pittsburgh.

He sums it up in seven words: “I had to pay for it myself.” In 1978, Tepper graduated summa cum laude with an honors degree in economics and started as a credit and securities analyst in the Trust department of Equibank in Pittsburg. Two years later, unsatisfied with his position, he enrolled in Carnegie Mellon University’s business school.

By 1982 he had earned his MBA and began his real education: two years in the treasury department at Ohio’s Republic Steel. There he was introduced to the junk bond market by working on the financing of non-investment grade debt. In 1984, he was recruited to Keystone Mutual Funds in Boston, where he worked as an analyst for their junk bond group.

Tepper had worked like a dog while he was a credit analyst at Keystone, but when given the opportunity, made the move to Goldman Sachs. Tepper’s instincts were impeccable, and he pulled in millions for the firm year after year. He was up for partner in 1988 and then again in 1990. By 1990, at the age of 33, being passed over for partner the second time was very upsetting.

“A” for Appaloosa

By early 1993, after eight years at Goldman Sacks, he decided to strike out on his own. With the assistance of mutual fund legend Michael Price, who had been a Goldman client, Tepper started trading aggressively for his own account off a borrowed desk at Price’s office, hoping to raise enough money to start a fund.

He and his partner, Jack Walton, collected $57 million in assets from fund of funds, insurers, and investors they met at Goldman. They knew they needed a name that started with “A” to be first to receive faxes on trades. They settled on “Appaloosa,” and the fund was born.

Fierce and Fearless

Appaloosa has the air of a very high-end frat house. But no matter how it appears to outsiders, Tepper is very focused on running a fierce and fearless operation. Tepper states, “the main thing that makes Appaloosa stand apart from the pack is the depth of our analysis and the fact that we’re not afraid to be the first one to act on our convictions.

If you look at our history over the years, we are usually the first mover in a country or situation, time and time again.” As of January 2012, Tepper’s firm had about $12 billion under management divided into two separate funds: Appaloosa and Thoroughbred. After starting with $57 million in 1993, the funds grew quickly, and by 1996, it had already hit $700 million.

Besides having one of the best track records of any hedge fund manager in the business, returning an average of 28.5 percent net to the firm’s investors since 1993, his fund is consistently ahead of the industry on deals as well. Three times in the life of Appaloosa it has lost more than 20 percent: 1998 (down 29 percent), 2002 (down 25 percent), and 2008 (down 27 percent).

All three times, the firm made its high water mark back in six months en route to a stellar year after that. Indeed, Tepper’s investors have been trained to look forward to down years at Appaloosa. The year after Tepper lost money in each of the three years he was down; he had record performance: up 61 percent net in 1999, up 149 percent net in 2003, and up 132 percent net in 2009. Tepper feels that what separates his firm from the pack and enables it to bang out such stellar returns is that they are not afraid to lose money.

The ABC’s: AIG, BAC, and C

By February 2008, the financial crisis was accelerating, with bank stocks bearing the brunt of market pressures. Instead of panicking like much of the investing world by bolting into gold and cash, Appaloosa was preparing to dive into the debt and equity of financial institutions.

The underlying thesis regarding financials was twofold: extraordinary measures would have to be taken so the institutions could survive in some form, and in order to see the greatest upside, most of Appaloosa’s investments would initially be debt securities under the premise that as “credits” the banks would most likely be all right.

There was a skewed upside versus downside. Then in 2009, the U.S. Treasury put out a white paper and term sheet online for the government’s Capital Assistance Program. Connecting the dots, Tepper figured the government was not positioning to nationalize the banks if it was putting out this paper, which signaled the time was right to buy.

So, Appaloosa quickly began buying all the common, preferred, and junior subordinated debt it could get its hands on, paying as little as 5 cents on the dollar for securities of AIG, Bank of America, and Citigroup. As the stocks soared through the end of the year, the fund raked in more than $3 billion in those three names. Tepper says, “Sometimes it’s time to make money, sometimes it’s time not to lose money. Last year was a time not to lose money; we’ll see what this year brings.”

The Activist Answer: William A. Ackman, Pershing Square Capital Management

Bright Beginnings

William Albert Ackman was born in 1966, the younger of two children. Raised in the affluent suburban town of Chappaqua, New York, Ackman was an ambitious, blunt, competitive, and confident student at Horace Greeley High School. Ackman captained the tennis team and made it to the New York State quarterfinals.

Ackman still managed to balance work with play and graduated fourth in his class. He even had a $2000 bet with his father that he would earn a perfect score on the SAT’s, although his dad withdrew the bet the night before the exam for fear that he would lose. Though he did not get a perfect score, Ackman’s confidence and ability got him quite close. Ackman was accepted to Harvard in 1983. Already entrepreneurially minded, Ackman came up with an idea for a book while he was a freshman in college.

Seeing firsthand how competitive the application process for Harvard College had been, Ackman wrote a book on how to write a college admission essay and included 50 or so successful application essays as well as interviews with admissions officers from Ivy League colleges. He presented the idea to seven different publishers but received six rejections and one job offer.

Two of the most influential, and what Ackman perceives as formative, experiences that he had at Harvard Business School were hearing Warren Buffet, and Richard Rainwater speak to students. Buffet said one could immediately obtain the qualities that make for a good reputation by just making good everyday life decisions.

He also reminded the students that your reputation could be lost overnight and so, therefore, protect it with your life. Richard Rainwater, however, gave Ackman the courage to start his own fund. Ackman asked Rainwater if he thought it was a stupid idea for him to start his own fund right after graduating.

Rainwater said, “you don’t have to be old to be right.” That gave Ackman the reassurance he needed, and from that point forward, he decided that he would start his own fund.

Getting Gotham Going

“Everyone told me it was a really stupid idea to start my own hedge fund right out of business school,” says Ackman. “That’s how I knew that it was a good idea.” As graduation approached, Ackman and Berkowitz started seeking investors. From day one, Ackman was always unafraid of asking someone to invest because, he thought that while capital was a commodity, good investment ideas were rare assets.

They eventually scrounged up $3 million and set up shop in a windowless office in the Helmsley Building. So, Ackman started Gotham Partners in 1992, at age 26, straight out of Harvard Business School. By 1998, five years after opening up shop, Gotham Partners had grown from $3 million under management to over $500 million. According to public sources, Gotham attracted prominent, well-respected investors as its limited partners.

Buying the Farm

In mid-2002, Ackman made his first publicly disclosed short position in a company called Farmer Mac. Ackman used credit default swaps to express the short position. As he took a closer look at the company, which was chartered by the U.S. government to create a secondary market for farm loans, Ackman got more and more interested.

The company relied extensively on short term financing to fund its business, making its viability highly vulnerable to its ability to access the capital markets. Ackman had concerns about the quality of the company’s loan portfolio and its leverage ratios.

The only problem with this short idea, Ackman believed, was that unless somebody was willing to say that the emperor had no clothes, the game could go on for years. On the advice of his lawyers, Ackman decided to write and publish a white paper about the company’s weak financial condition and failed business model.

The market reacted quickly to the publication. Pleased with the profits from his Farmer Mac investment and interested in the potential returns from purchasing CDS on companies with undeservedly high credit ratings, Ackman began researching other potential short candidates. Ackman zeroed in on MBIA. It was the largest of the bond insurers, the largest guarantor of municipal bonds in the United States.

Ackman concluded that the business, despite its triple-A rating, was likely insolvent. Ackman shorted the stock and built a large position in credit default swaps on the company. Ackman published another “white paper” on MBIA. After MBIA complained to New York Attorney General Eliot Spitzer that Gotham was spreading false and misleading information about their company, in January 2003, Spitzer subpoenaed Gotham, and the SEC began an inquiry shortly thereafter.

Rising from the Ashes

With the overhang of MBIA still on his shoulders and his reputation dragged through the mud, Ackman felt an obligation to the investors. He worked unpaid in 2003, dealing with the issues and winding down the Gotham fund.

However, in the fall of 2003, he ended up negotiating a deal with Leucadia to invest $50 million and launch his new firm, Pershing Square. Pershing Square was born in January 2004, with Ackman vowing not to make the same mistakes twice: this time around, he would only invest in publicly traded securities.

Making Cents at McDonald’s

In the second half of 2005, Ackman invested in McDonald’s with a very active plan. He viewed McDonald’s as three separate entities: a franchising operation (representing 75 percent of McDonald’s restaurants); a restaurant operation (company restaurant ownership of remaining 25 percent); and a real estate business (land ownership of nearly 37 percent of all restaurants and 59 percent of all buildings).

His principal goal was to convince McDonald’s to sell or spin off its company-operated stores to the more entrepreneurial franchisees, which would materially improve the operating performance of the restaurants. This would have the additional benefit of improving the quality of McDonald’s earnings and cash flow as the assets that remained at McDonald’s would generate cash from rent and a franchise royalty stream from the franchisees.

Now, McDonald’s did not like being told what to do by a hedge fund in New York, and they rejected Ackman’s proposal, but ultimately the company quietly capitulated by beginning a process of selling restaurants to franchisees. That’s a big move for a large-cap company, and McDonald’s has continued to improve its operating and financial performance to this day.

What Makes an Activist

Ackman says of his investing style: “I don’t care what other people think. I invest based on what I believe the opportunity for profit is compared with my estimate of the potential for loss.” Despite the high stakes and high-profile nature of his investments, Ackman says he rarely feels stress on the job. Ackman is more concerned with the health and well-being of his family and the world. He is emotional about life, but not about investing.

But Ackman is emotional when it comes to his charitable work.

To date, his foundation has committed over $130 million to various causes in the greater New York area and around the world. Ackman’s personal goal is to have one of the best investment records of all time, but he understands that the industry often judges investment managers a year at a time. After a spectacular year, Ackman is reminded that “every year I start over from zero!”

The Poison Pen: Daniel Loeb, Third Point

The Young Whippersnapper Finds His Way

Loeb grew up in Santa Monica, California, one of three children. He attended the University of California at Berkeley before transferring to Columbia University, in part because he wanted to be in New York to better pursue a career on Wall Street.

After graduating, he worked in private equity at Warburg Pincus for several years in the mid-1980’s, where he acquired the foundational building blocks of value investing, business analysis, and valuation. Loeb also spent three critical years at Jefferies & Co. as an analyst and bond salesman focusing on distressed debt and forming relationships with the buyers of this paper.

In 1995, he made his biggest leap and launched Third Point with $3.3 million of capital. When Loeb started Third Point, he had a strong background in high-yield credit, and risk arbitrage, but necessity pushed him to expand his areas of expertise.

Third Point’s philosophy is to be opportunistic across the capital structure from debt to equity, across industries and different geographies. They invest wherever they see some kind of special situation element, an event that will either help create the investment opportunity or help to realize the opportunity. In finding these opportunities, Loeb begins with an investment framework, a financial point of view that helps define patterns of events that have consistently produced outsized returns.

Third Point also develops top-down thesis’s about sectors, industries, and economic trends. Loeb gives an example: “In the 1990s, we recognized that the growth of the internet would have a huge impact, but instead of focusing just on new internet companies, we bought a bunch of old-line companies that had internet companies embedded within them, and we did quite well without taking the risk attendant in purchasing shares of high-flying overpriced internet companies.

Evolution and Revolution

Loeb became known for his unique investment style and perhaps is best known for his letters to executives. Loeb’s frank, insightful missives to the officers of the companies in which he is invested have made him feared in underperforming boardrooms and companies. He essentially created a new literary art form. Call it the Blast.

Since he started Third Point in 1995, Loeb has periodically shared with the delighted public, candid, direct letters he has written to the top brass at companies suffering poor results brought about by management’s missteps. His assertions attract attention, and his criticisms run the gamut from accusations of incompetence to laziness.

Many observers noted that Loeb’s “poison pen” quieted during the past four years and in its absence, the investment world’s focus shifted to how Third Point has spent 95 percent of its time since its founding investing in classic special situations globally in long/short equities, corporate credit, mortgage bonds, and tail risk trades.

Loeb’s rigorous investment process, honed over almost 18 years and taught intensively to his analysts, produced investment ideas that have generated 21.5 percent net annualized returns for his investors since inception.

The Third Point Tao and Team Approach

A lifetime surfer, Loeb also competes in triathlons, lifts weights, runs, swims, bikes, and skis, in addition to practicing yoga. Right now, Loeb is concentrated on continuing the path of excellence he has established. “I love what I do,” he says.

“I love the investing process – the problems and the puzzle- solving and testing my wits. But I have also really enjoyed building an organization. That realization came to me later in life, but as fine as building a great portfolio is, building a great organization with great people is even better.”

For anyone contemplating a career as a hedge fund manager, Loeb offers three points of advice.

“First, make sure you’re passionate about investing,” Loeb says. “I have seen too many people go into this because they’ve done the math on the business model and have concluded that it’s a very lucrative business to be in. But I have never seen anyone with that approach really make a great investor. The great hedge fund managers, guys like Bill Ackman, David Einhorn, and David Tepper are super- passionate.

If you aren’t going to match them, don’t bother.” Second, while you are being passionate about investing, do not forget about running your business. He advises that managers spend at least 20 percent of their time thinking about how they want their company to run.

Finally, make sure that you have confidence. The essential Loeb, a direct line traced from young surfer to aggressive salesman to forthright activist investor – is confident, contrarian, aggressive, willing to take big risks and to be a rabble-rouser for what he thinks is right.

The Cynical Sleuth: James Chanos, Kynikos Associates LP

Cause for Cynicism

Chanos founded Kynikos, who were the cynics in ancient Greece, in 1985, just five years after he graduated from Yale University with a degree in economics. Chanos had grown up wanting to be a doctor, but destiny would have other plans. He stumbled into short selling by accident when, while working at Gilford Securities as an analyst in Chicago, he issued his first stock report in the summer of 1982.

The company was the Baldwin-United Corporation. Chanos found that the company had a hefty debt load and what he called “liberal accounting practices,” a red flag that would come up throughout his search for investment opportunities time and time again. Chanos’s view of the world has always been against the grain, and he runs his firm the same way.

First and foremost, he identifies himself as a securities analyst, second a portfolio manager, meaning with Chanos, everything is bottom up. Despite what people might think when they see Kynikos making macro calls, all of it derives from work it does in companies.

The Secret Sauce of Short-Selling

First, some basics about short-selling. It is a tough business. In bull markets, where a rising tide lifts even the weakest performers to high valuation levels, shorts must be right more often than they are wrong. The stocks may be hard to borrow. Governments have been imposing restraints and bans on certain short-selling activity, using short-sellers as scapegoats for the implosion of investment banks and sovereign debt woes.

While a percentage of short-selling is directional, meaning the investor has an adverse view of a company’s valuation based on analysis of its financial statements or a sector outlook and hopes to profit when the stock falls, hedging is another reason. Investors may be long in a sector but believe one or two companies will underperform, taking a short position may boost overall performance. Market and options makers may take short positions to balance order flow or hedge their long exposures.

There are four areas where Chanos generates most of his short ideas. The first is structurally flawed accounting. A company’s profitability is not a concrete number, but one that involves estimates, guesses, and accruals. Therefore, Chanos and his team are looking for is a discrepancy between economic reality and the reported numbers.

The second place he looks for short opportunities is booms that go bust. Throughout history, investors have rushed into overvalued investments based on a “new” idea that “old” methods of valuation and analysis failed to understand. The third area is consumer and corporate fads. He gives an example of how leveraged buyouts in the 1980s were used frantically to acquire or expand.

Investors extrapolated growth farther into the future than they should have. The fourth is technological obsolescence. For example, the digitization of music and video overnight changed business models. People often believe the old technology will last longer than it typically does.

The Derivatives Pioneer: Boaz Weinstein, Saba Capital Management

The Rise of a Trailblazer

Growing up, Weinstein amazed those around him with a precocious aptitude in two interrelated pursuits: numbers and games of strategy. He earned the title of Nation Master in chess at the age of 16. His first exposure to investing was at Stuyvesant High School when he entered a citywide stock-picking competition sponsored by New York Newsday.

Weinstein recalls, “I wasn’t looking to come in 937th out of 7,500. I was looking to come in first, and so I shouldn’t do what most of the kids in the contest were likely to do, which was pick popular companies like Nike or Walmart.” He ended up winning the contest, and his prize was a visit to the New York Stock Exchange.

At the age of 15, he interned after school at Merrill Lynch; at 18 he had a summer job at Goldman Sachs; at 24 he joined Deutsche Bank and was named vice president at 25, director at 26, and managing director at 27. Weinstein joined Deutsche Bank in January 1998, when the market for credit derivatives was in its infancy.

This was an ideal situation for young Weinstein. For years, while his peers had all followed equities, Weinstein had been fascinated by the complexity of credit. This promising young man found himself at a moment of tremendous opportunity in an area that he loved, where there were essentially no veterans let alone experts.

“Lehman Weekend” at the Fed

Over the years at Deutsche, as Weinstein’s team increased its scope, it more closely resembled a hedge fund. It was only natural that Weinstein began to think about launching his own hedge fund. Highly reluctant to lose Weinstein, Deutsche gave him wider authority and responsibility within the bank. By 2006, Weinstein was running junk bonds, corporate bonds, convertible bonds, and credit derivatives globally.

As part of Deutsche’s senior management, Weinstein spent that dramatic “Lehman Weekend” at the Federal Reserve Bank in New York, in the company of senior government officials and the top executives of the other large banks, attempting to work out contingency plans. Weinstein worked in the credit group. Their assignment was to try to figure out what sort of transactions the banks would need to do with each other to reduce their exposures to Lehman if it failed.

The Technicalities of the Trade

As an example of the way his firm works, Weinstein discussed the case of American Axle, an auto parts maker based in Detroit that ran into trouble in 2009. The market thought that American Axle was on the brink of bankruptcy. One of Saba’s analysts disagreed, pointing out that if the company received an infusion of just $100 to $200 million, it could survive.

The best incentive for Saba to trade on American Axle was that the bonds were selling for 33 cents on the dollar. Weinstein says that “our fund is looking for asymmetric investments, ones where we can make a lot more than we can lose. Buying bonds at 33 might sound like it meets that test, but the bonds could go back to 80, and obviously, a drop to 12 cents would inflict a significant loss.”

The usual approach if an analyst likes a trade, but the market is dicey, is to take a small position. Or you can try and find a different way to structure the trade, so that you can have upside while limiting the downside. Weinstein began to consider a less familiar product used in the credit derivatives market, called recovery swaps.

Recovery swaps allow you to hedge away not the chance that something defaults, like a credit default swap does, but to hedge the loss amount given a default. Basically, it locks in the recovery rate that the two parties to the trade agreed to at inception. With the recovery swap, Saba could lock in American Axle at 30. Meaning, if it were to default, Saba would be obligated to deliver the bonds, and in return, Saba would receive 30.

Having bought the bonds at 33, Saba’s risk was reduced to just three points. They no longer had to worry about losing 22 or 33. The most they can lose is 9 percent, and if it goes from 33 to 66, they can make a 100 percent return. The aspect Weinstein most likes about the swap is that it costs nothing. Weinstein’s ability to think outside the box when structuring risk has allowed Saba to achieve higher than average return on risk for investors.

Conclusion

What did I learn about these investors?

As personalities, they stressed that their own road to success involved a tremendous amount of learning how to invest in their trading strategies. To build an investment business, they all had to become experts in their discipline, which involved a combination of evolving theory and experience.

Many disciplined themselves to approach investment as a business without emotion. Lessons shared among the investors included:

  • Trust your own intuition and be willing to make and learn from mistakes.
  • Take a longer-term perspective, realizing that the best strategies might take many years to come to fruition.
  • Handle risk aversion unemotionally, and make sure to diversify so it is easier to remain calm and analytical.
  • Take aggressive positions in combination with protecting the downside.
  • Invest with those who have their own money on the line.
  • Assign backup information gathering to the team, and test investment ideas by listening to others across a broad cross-section.
  • Work with the numbers to calculate value and test ideas.

Successful hedge fund managers are driven individuals with deep self-confidence about what they bring to the investment management table. They are innovative and intellectually curious. They know that they have to be different but in an intelligent and sustainable manner.

They are often able and willing to spend a lot of time not just on the “what” of investing, but also the “why” and “how.” Most important, they learn rather quickly from their mistakes and show an amazing ability to mid-course correct.

HookedtoBooks.com would like to thank the Titans of Investing for allowing us to publish this content. Titans is a student organization founded by Britt Harris. Learn more about the organization and the man behind it by clicking either of these links.

Britt always taught us Titans that Wisdom is Cheap, and principal can find treasure troves of the good stuff in books. We hope only will also express their thanks to the Titans if the book review brought wisdom into their lives.

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