Clifford Asness
is probably going to be annoyed when he sees that this article begins with
a discussion about how much money he makes, but there's no way around it.
Asness is a very successful hedge-fund manager, and very successful hedge-fund
managers make stupendous amounts of money, even by Wall Street's extravagant
standards. And in the public mind, their staggering compensation tends to
overshadow pretty much everything else. ''Filthy Stinking Rich'' was New
York magazine's unambiguous take on the hedge-fund phenomenon some months
ago. Last month, in its survey of the best-paid hedge-fund managers, Institutional
Investor's Alpha magazine reported that the average pay for the top 25
hedge-fund managers was an astounding $251 million in 2004. Asness
himself has written, in one of his better lines, that hedge funds ''are
generally run for rich people in Geneva, Switzerland, by rich people in Greenwich,
Conn.''
Asness likes
to point out that he wrote that sentence before he moved his own hedge fund,
AQR Capital Management, to Greenwich, Conn. He started AQR, with three partners,
in the spring of 1998, when he was 31 and had just walked away from a high-paying
job at Goldman Sachs, where he was one of the firm's brightest young stars.
During AQR's first three years, Asness and his partners didn't make much money.
But by 2002, the firm was doing well, investors were clamoring to get in and
AQR was managing about $3 billion in assets. (It's up to around $13.5 billion
today.) And the partners were getting rich. Asness cracked the Alpha list
for 2002, taking down a reported $37 million. The next year, the magazine
reported, he made $50 million. Asness won't discuss the specifics of his pay,
but if you ask him what it's like to have that kind of money, he won't duck
the question the way most hedge-fund managers do. Instead, he'll lean back
on his couch, scratch his neatly trimmed beard for a minute and then offer
a sheepish smile and an endearing, exaggerated shrug. ''To quote Dudley Moore
in the movie 'Arthur,' '' he'll reply finally, ''it doesn't suck.''
Cliff Asness
says things like that. It is one of the qualities that make him different
from his brethren in the hedge-fund community, who tend to shroud themselves
in secrecy, as if they're trying to protect some special formula they've devised
for making investors -- and themselves -- money. They don't just shy away
from talking about their pay; they shy away from talking about just about
anything. Have you ever heard of Stephen Mandel Jr., or Daniel Och, or James
Simons? Among hedge fundies, they are three of the most respected names in
the business. Yet they studiously avoid having their names in the paper.
Cliff Asness,
on the other hand, is an outspoken, exuberant Ph.D. in financial economics
who has built a public reputation for his willingness to write and say what's
on his mind. In academia, he's known for the witty, biting papers he writes
for such publications as The Financial Analysts Journal. (One recent
title: ''Stock Options and the Lying Liars Who Don't Want to Expense Them.'')
Among financial journalists, he is known as a cogent and articulate bear --
someone who can make a compelling case that stock-market returns over the
next few decades will almost certainly be lower than the double-digit returns
investors have come to expect as their birthright. And among the hedge-fund
cognoscenti, Asness has become known as someone who has been thinking hard
thoughts about the future of hedge funds. A hedge fund is nothing more than
a private, largely unregulated pool of capital that can buy stocks, sell stocks
or do just about anything else. It is Asness's essential belief that hedge
funds -- or, rather, some hedge funds -- are doing things that are genuinely
useful for investors, especially sophisticated institutional investors like
pension funds and university endowments. You will not be surprised to learn
that Asness includes AQR among the useful hedge funds.
These are strange
times for hedge funds. They are, right now, at the absolute forefront of the
collective financial psyche. Every day, it seems, a half-dozen more young
Wall Street hotshots abandon the millions they're making at the big firms
like Goldman Sachs or Morgan Stanley and start hedge funds. There are now
8,000 of them, about 40 percent of which have been opened in
the last four years, and money is absolutely pouring into them -- they're
at $1 trillion and counting -- as institutions search for ways to generate
positive returns in this difficult market. Just as business-school graduates
once gravitated to venture capital or private equity or dot-coms, now they
all want to work for hedge funds.
Hedge funds
have also become a huge force in the market. When hedge funds are enthusiastic
about a stock, they have the collective buying power to drive up the price,
at least for a while. When they turn on a stock, they can drive the price
down. Some hedge-fund managers have become activists, buying up stakes in
companies and then demanding change from management. One hedge fund -- Eddie
Lampert's ESL Investments -- engineered a merger between Kmart and Sears.
There are plenty
of people, even in the hedge-fund world, who are convinced that we have entered
bubble territory. Their secrecy, their power, the incredible amount of money
flowing into them, the sense that everybody on Wall Street is trying to start
a hedge fund and of course the staggering riches: it all seems a little crazy
and out of control. Hedge funds right now feel a little like mutual funds
in the late 1960's, or junk bonds in the 1980's, or dot-coms in the late 1990's.
You just assume they are going to get their comeuppance eventually. Isn't
that what always happens?
But do you remember
what happened after the mutual-fund boom burst? Or after the junk-bond craze?
Or even after the dot-com insanity? It turned out, in every case, that underneath
the craziness, something enduring was being created. The modern mutual-fund
industry emerged in the wake of the early 1970's mutual-fund crash. Junk bonds
today are a critical part of the world's financial scene. Amazon and eBay
and lots of other real, profitable companies emerged from the dot-com mania,
after all the pretenders were swept away in the rubble of the collapse.
And so it is
with hedge funds. There are hedge funds today -- big ones, run by serious
people -- that are creating portfolios that are less risky than either the
typical mutual-fund portfolio or the market itself. Certain hedge funds are
becoming important tools for institutions that want to diversify their portfolios
and become less dependent on the ups and downs of the overall stock market.
Hedge-fund managers are convincing institutional investors that they are far
better served not seeking outsize returns, because those returns entail taking
too much risk.
Cliff Asness
uses a highly complex, computer-driven investing strategy. You and I will
never be able to invest the way he does. And yes, he's become immoderately
wealthy as a result. But if you can get past how much money he makes, you'll
find he has something worth listening to. Boiled down, what Asness really
does is try to understand the relationship between risk and reward. And in
that broad and important sense, there are lessons in what he does for anyone
in the market.
Asness is hardly
the first hedge-fund manager to employ techniques for managing investment
risk; in fact, that concept goes back to the very origins of hedge funds.
The man generally credited with coming up with the first such fund was a former
Fortune magazine writer named Alfred Winslow Jones, who hung out his
shingle in 1949 with $100,000 in capital and a new idea about making money
in the market. He wanted to invest aggressively while still trying to protect
investors' capital. These would seem to be contradictory goals, but here's
how he went about it: Instead of simply buying stocks and hoping the wind
was at his back, Jones also had a certain percentage of his portfolio on the
''short'' side -- that is, he was betting those stocks would go down. In doing
so, he was limiting his fund's exposure the market, or as they say today,
he was limiting his ''market risk.'' Since his shorts were likely to make
money in a down market, they acted as protection -- a hedge! -- when his ''longs''
weren't doing well. Yet because Jones also borrowed money to buy more shares
-- that was the aggressive part of his strategy -- when his stocks went up
(as they usually did, for he was a very good stock picker), his returns were
much higher than they might otherwise have been, despite having those shorts
hedging his portfolio.
Jones was enormously
successful; between May 1955 and May 1965, his fund returned 670 percent,
according to Fortune magazine, nearly twice as much as the best-performing
mutual fund. But Jones was also an innovator in other ways. Because he wanted
complete freedom to invest as he pleased -- and didn't want to deal with regulatory
restrictions -- he never let more than 100 wealthy investors into any of his
funds at any one time; under the rules, this allowed him to avoid registering
with the Securities and Exchange Commission, which regulated mutual funds.
And he used a fee structure that called for him to get a whopping 20 percent
of the profits if he made money. Mutual funds, by contrast, collected fees
based on the size of the fund: the more assets under management, the more
the fund company made, no matter how well (or poorly) the fund performed.
As hedge funds
evolved, Jones's essential structure stuck. Hedge-fund managers made sure
their investors were both wealthy and few in number; these days, the rules
allow them to have up to 500 ''qualified'' investors and still avoid
most S.E.C. regulation. (The theory is that wealthy investors should be able
to look out for themselves and don't need as much government protection as
the rest of us.) Of course they all adopted performance fees -- usually 20
percent, just like Jones. Hedge funds also became hooked on asset fees,
just like their mutual-fund brethren. Today, when a hedge-fund manager says
he charges ''2 and 20'' -- and many of them do -- he means he is taking a
2 percent asset fee as well as his 20 percent performance fee.
To the extent that hedge funds remain the most Darwinian of investment vehicles,
it is because most hedge funds simply can't afford to lose money for even
a single year: if they do, investors and employees head for the exits, and
the funds shut down. But that fee structure of ''2 and 20'' is what makes
the business so potentially lucrative. A $4 billion hedge fund that gains
10 percent in a year and charges 2 and 20 has generated $160 million for itself.
A $4 billion hedge fund that charges 2 and 20 and makes no money for investors
still pockets $80 million thanks to its asset fees.
What got lost
over time was the idea that hedge funds were supposed to hedge. That was primarily
because of the powerful bull market that began in August 1982 and ended in
March 2000. Investors took outsize risks and invariably wound up being rewarded,
because the market was going straight up. The bull market forgave a lot of
investing mistakes. Hedging seemed unnecessary -- even a little silly.
In fact, during
the bull market, hedge funds became synonymous not with hedging but with the
most extreme forms of investment risk-taking. Think for a moment about the
hedge-fund giants who captured the public imagination in the 1980's and early
1990's -- George Soros, Julian Robertson, Michael Steinhardt and a handful
of others. Those men were all swashbucklers who didn't want to control risk
-- they wanted to embrace it. They ran billions of dollars, and their fame
and fortune was based on their willingness to make stunning bets on markets,
currencies, stocks, even on entire economies. When they bet right, they made
hundreds of millions of dollars; Soros netted more than $1 billion when he
made his legendary bet in 1992 against the British pound. And when they bet
wrong? On Valentine's Day in 1994, Soros got caught on the wrong side of the
yen and lost $600 million in one day. ''Making money took courage,'' says
Steinhardt, who is now retired, with no small satisfaction.
Today most people
still think of the Soros-Steinhardt-Robertson model when they think of hedge
funds. And indeed, there are still hedge funds that make the kind of big ''macro''
bets the grand old men were so justly famous for. But there are all kinds
of other hedge funds as well. There are hedge funds that deal in distressed
securities. Others are dedicated to short-selling. Still others deal in the
various derivative markets. The main thing hedge funds have in common today
is not the way they invest, but their structure -- including, of course, those
lucrative fees.
Since the end
of the bull market, though, the idea of using hedge funds to actually hedge
has been making a comeback. Some of the best hedge funds, like Maverick Capital
and Lone Pine Capital (the latter is run by the aforementioned Stephen Mandel)
use the classic A.W. Jones technique of having a certain percentage of their
portfolios on the short side -- betting stocks will go down -- to limit their
market risk. Others search for small inefficiencies in discrete segments of
the financial world to eke out small but steady returns. All of them are offering
institutional investors ways to generate returns that are less connected to
the rise and fall of the market itself than, say, a mutual fund is. And then
there's Cliff Asness, who runs something called a ''market neutral'' fund.
Which means that although he's buying and selling stocks, the returns he generates
aren't connected to the overall market at all.
One crisp day
this past April, Cliff Asness was sitting on a sofa at one end of his large
corner office in a nondescript low-rise building in Greenwich. ''Sitting,''
however, doesn't quite do justice to what he was doing. One second he was
scrunching into the sofa, the next he was leaning forward intensely, and the
second after that, he was gesturing excitedly, as some new, interesting thought
entered his head that he had to convey right that instant. He was like an
exuberant, well-dressed, overgrown kid, so overflowing with enthusiasms that
he couldn't contain himself. Except that the enthusiasm in question at that
particular moment was the research that had led to one of his earliest published
papers, ''OAS Models, Expected Returns and a Steep Yield Curve'' --
which, frankly, made it a little bewildering to be on the receiving end of
his monologue. Realizing that I was pretty much lost, Asness finally stopped
talking and let out a loud, self-aware cackle. ''This is so geeky!''
he said finally. Well, yes, it was.
Asness did not
emerge from the womb a fully formed geek. Growing up in Roslyn Heights, N.Y.,
he was an underachiever who played soccer and didn't spend a lot of time engrossed
in his studies. Much to everyone's surprise -- including his own -- he did
well on his SAT's, which got him into the University of Pennsylvania, from
which he graduated with degrees in engineering and economics. It was the mid-1980's
by then, and the bull market had begun, but Asness wasn't exactly walking
around campus with The Wall Street Journal tucked under his arm. ''I
tacitly assumed I would be applying to law school,'' he said, following in
the footsteps of his father, a trial lawyer. When his father heard of his
plans, however, he told his son: ''Why do you want to go to law school? You're
good at this math stuff. You should do that.'' It was good advice.
''I think it's
a little weird for a 20-year-old to be interested in finance,'' Asness said,
but the academic, ''portfolio theory'' side of finance -- the geeky side --
had captured his imagination. By the late 1980's, the field of portfolio theory
was undergoing enormous ferment. The long-accepted academic dogma, the so-called
efficient-market hypothesis -- which states that the stock market is entirely
efficient, with all available information already built into stock prices,
and thus can't be beaten on any consistent basis -- was coming under at least
mild assault. Accepted into the Ph.D. program at the University of Chicago's
business school, Asness found himself right in the middle of the ferment.
The dominant
figure in the University of Chicago's finance department -- indeed, one of
the dominant figures in all of academic finance -- is Eugene Fama. Fama is
often described as the father of the efficient-market hypothesis, because
in the 1960's and 1970's he wrote a series of elegant papers that laid out
the theory with more clarity than anyone else had before, gave it its name
and said, in effect, that it seemed to make a lot of sense. He also said,
however, that it needed to be tested. To test it properly -- by going back
and looking at the historic performance of stock prices -- you had to grapple
with a series of issues that had yet to be worked out: how should a stock's
riskiness be measured? What kind of risk-adjusted returns should a stock have
if it were, in fact, acting ''efficiently''? And so on. Still, a series of
early, crude tests seemed to bear out the theory, and in time, the central
idea behind the efficient-market hypothesis even filtered down to the rest
of us. Although Wall Street still makes most of its money convincing people
that they can beat the market, it also peddles index funds, which have become
popular precisely because people want to be in the market but don't believe
they can beat it.
By the time
Asness got to Chicago in 1988, academics had begun to come to a better understanding
of risk. Most of us think of risk as being related to the volatility of an
individual stock -- that is, how much it bounces around from Point A to Point
B. But new research was measuring how the risk characteristics of an individual
stock changes the overall riskiness of an entire portfolio. Fama, along with
a younger colleague named Kenneth French, was among those conducting a newer
and deeper series of tests. In particular, they were working on a paper comparing
the risk-adjusted historic returns of two different types of stocks -- value
stocks versus growth stocks. (Growth stocks are typically those of companies
whose investors are optimistic about their futures. Their stock prices are
high relative to their actual corporate earnings and other measures. Value
stocks are the opposite -- their stock prices are low compared with their
earnings because the market is either pessimistic or nervous about their prospects.)
A draft of that paper began circulating soon after Asness arrived on campus,
and when it was finally published in 1992, under the unassuming title of ''The
Cross Section of Expected Stock Returns,'' it created something of a sensation.
It essentially showed that if you took a large, diverse portfolio of value
stocks, which are cheap, and put it next to an equally large, equally diverse
portfolio of growth stocks, which are expensive, the value stocks would outperform
the growth stocks more than the efficient-market hypothesis suggested they
should. Asness describes the results of that paper: ''Cheap beats expensive
more than it should.''
Using a large
universe of stocks, going back to 1927, Fama and French showed that if you
divided the stocks into thirds, put the cheapest third in the ''value basket''
and the most expensive third into the ''growth basket,'' the value stocks
outperformed the growth stocks in more than two-thirds of the years. This,
of course, did not mean you couldn't lose money betting on value over growth
-- no investment strategy is risk-free. It did mean that if you took this
approach, history strongly suggested that the odds would be on your side.
What's more, it seemed to make no difference whether the market had a good
year or a bad year. The pattern stood up. There were years when the market
was down, and cheap beat expensive -- and other years when the market was
up, and cheap still beat expensive. In other words, this method didn't just
reduce market risk, the way A.W. Jones did when he was devising the first
hedge fund. It eliminated it entirely. To use hedge-fund lingo, the pattern
was uncorrelated to the market.
By his second
year in the Ph.D. program, Asness had become Fama's teaching assistant and
had enlisted both Fama and French as his thesis advisers. For his dissertation,
Asness had his own idea about testing the efficient market: he would take
a look at a popular short-term strategy called momentum investing,
in which an investor buys a stock for the simple reason that it is going up.
In an early draft, he called it the ''fool's strategy.'' (Most day traders
during the Internet bubble were momentum investors, for instance.) ''I was
nervous telling Fama that I wanted to investigate momentum investing,'' Asness
says now. ''But his reply was the best thing he ever said to me: 'Sure
you can write it. If the data shows something interesting, then write it.'
What Gene really believes in is empirical testing. Go where the data takes
you.''
And wouldn't
you know it? Asness (along with other academics doing similar work) discovered
that a large, diverse portfolio of momentum stocks also ''worked'' more than
it should under the efficient-market hypothesis. Nobody can say with any assurance
why these things worked. Asness guesses that in both cases, investors, as
he puts it, ''overextrapolate.'' There is usually some bad news associated
with value stocks -- and investors assume there will always be bad news, so
they avoid these stocks more than they should. As for momentum, people often
get too optimistic about growth stocks and pay too much for them. In the short
term, that enthusiasm will often drive the prices higher. But eventually the
enthusiasm will wane, and the stocks will come crashing down.
Academics still
argue about what these discoveries mean. Fama remains a committed efficient-market
man. He says he thinks these findings don't overturn the hypothesis but suggest
instead that academic finance needs a better model for measuring risk. Asness,
however, came to the view that the market was not perfectly efficient: that
human beings thought and acted in ways that created market anomalies.
There is now an entire branch of economics that tries to explain the market
in terms of the way humans behave -- both rationally and not. Asness does
not classify himself as a strict behavioralist; ''I think the market is reasonably
close to efficient,'' he says, ''but there are a lot of little inefficiencies.''
And in exploiting these inefficiencies a business could be built.
After grad school,
Asness landed at Goldman Sachs, where he spent a year and a half trading mortgage-backed
securities on the fixed-income desk while finishing his dissertation. Then
Goldman asked him to set up a ''quantitative research desk.'' The firm wanted
Asness to somehow use the wealth of new research coming out of university
finance departments to help it make money. Asness quickly hired two friends,
Robert Krail and John Liew, both of whom he knew at the University of Chicago,
and they began building a model that would combine both Fama and French's
value insight with Asness's momentum insight.
The computer
model they developed -- and which, after many refinements, they still use
today -- grabs a wealth of up-to-the-minute data to identify the cheapest
value stocks (Fama and French), but only value stocks that seemed to have
started on an upward swing (Asness). They buy a large block -- about 200
to 300 -- of those stocks. Then the model identifies stocks with the opposite
characteristics: growth stocks whose rise is stalling. They sell an equally
weighted amount of those stocks short. Unlike A.W. Jones, who had only a percentage
of his portfolio on the short side, the Asness portfolio is perfectly balanced
between longs and shorts. That is what makes his fund ''market neutral.''
It doesn't matter to him whether the market goes up or down. AQR makes money
if its basket of value stocks beats its equally weighted basket of growth
stocks -- the way the history suggests it should two-thirds of the time.
Asness and his
colleagues soon discovered that the strategy they had come up with worked
not only with stocks but with currencies, commodities and even entire economies.
(Yes, economies. Asness and his team use economic data to sort out ''overvalued''
versus ''undervalued'' countries, and then buy -- or short -- those countries'
market indexes, their S.&P. 500 equivalents.) In time, they developed
models that sorted out cheap versus expensive in all kinds of different investments.
In 1995, Asness's
group started an internal hedge fund for Goldman partners and a few clients,
using the new model. The fund did so well that the firm rolled it out and
began to market it. Within two years, Asness and his crew had $7 billion under
management. Their run was amazing -- barely a down month, and some spectacularly
good years. Like A.W. Jones, they borrowed money, using leverage as their
way to take on more risk and boost returns; one year they returned more than
100 percent before fees. ''Intellectually,'' Asness says, ''I knew we couldn't
sustain that kind of performance. It was a lucky period. But I was young and
I was arrogant.''
And in his youth
and his arrogance, he looked around him and saw that other Goldman hands were
leaving to start hedge funds and that they were putting themselves in a position
to make geometrically more money than he was making. For much of his time
at Chicago, his working assumption was that he'd be an academic and make maybe
$100,000 a year. At Goldman, by 1997, he was making millions, and he was unhappy.
The firm wouldn't leave him alone to do his research and run money; it was
always asking him to fly to Tokyo, or to make a presentation to clients, or
to help some in-house portfolio manager whose performance was down. One member
of his original group quit to open a hedge fund. ''That bugged me,'' Asness
said. ''He was doing what we had all invented together.'' His colleagues kept
pushing him to quit and kept meeting secretly to map out plans. Finally, in
November 1997, he decided to break from Goldman. He gave notice two days after
receiving a big bonus.
The four founders
of AQR -- Asness, Liew, Krail and an ex-Goldman hand named David Kabiller
-- set up shop in New York City in March 1998. They immediately set out to
rebuild their computer model and to raise money. By August 1998, they had
$1 billion committed, which at the time was thought to be the largest sum
ever raised for a hedge-fund startup. (Last year, a young former Goldman partner,
Eric Mindich, started a hedge fund and raised the current record: more than
$3 billion.) That first month, AQR made money. Then came a market event that
all of Asness's historical stock research, and all his complex models, hadn't
prepared him for -- a market that was not just a little bit inefficient, but
that was insanely inefficient. The Internet bubble had begun.
Remember earlier
in this article, when I quoted Asness's funny line about hedge funds being
''run for rich people from Geneva, Switzerland, by rich people from Greenwich,
Conn.''? There was a time when that was true -- when the vast majority of
hedge-fund investors were, indeed, rich people trying to get richer. By the
time Asness set up AQR, however, that was all changing. Although AQR had a
few individuals among its investors -- some friends and relatives, mainly
-- the fund was primarily marketed to large institutions, especially university
endowments. The best of the institutional investors were sophisticated, they
were demanding and they insisted on understanding the underlying strategy
and having regular conversations with the fund managers.
If an investor
had asked George Soros or Michael Steinhardt for that kind of access, he would
been given the back of the hedge-fund manager's hand. But the new breed of
hedge-fund manager had a different mind-set. From Cliff Asness's point of
view, sophisticated investors who understood his complex, quantitative approach
were exactly the people he wanted as clients. They would understand how his
approach fit into their overall portfolios. If he hit a bad patch, he had
a far better chance of holding on to a big institution's money than that of
a panicky rich person. Most of all, Asness and the other partners at AQR understood
that the most forward-thinking of the endowments had themselves become influenced
by what was going on inside academic finance and were trying to incorporate
some of those ideas into the way they managed their own money. Indeed, in
setting up his ''market neutral'' hedge fund, Asness was reacting to the changing
demands of the marketplace.
Even in the
middle of a roaring bull market, these institutions had come to believe, first
of all, that they shouldn't be completely reliant on a rising stock market
for their returns. After all, someday the market was going to go down. Thus,
having a diversified portfolio didn't just mean having a broad mix of stocks
and bonds. It also meant going beyond the market and adding ''alternative''
asset classes. Timber, energy, real estate -- these were all assets that could
help institutions diversify. And so could hedge funds, so long as they were
the right kind of hedge funds. These hedge funds weren't set up to make the
kind of huge gains Michael Steinhardt and George Soros made, but that was
O.K. They had a different goal. They were trying to manage risk and produce
a return that was commensurate with the risks they were taking. Just as important,
by adding hedge funds that were uncorrelated to the market -- even ones that
were moderately risky -- they were lowering the risk characteristics of their
overall investments.
The institutional
money manager who led the way into hedge funds was David Swensen, who took
over the Yale endowment in 1985. A former investment banker himself, Swensen
had a deep understanding of both portfolio theory and the hedge-fund industry.
He and his endowment colleagues got to know which were the best of the lot
and sank money into a diverse range of hedge funds. Simultaneously, he cut
way down on stocks, despite the bull market. The results are undeniable: over
the past decade, Yale has generated annualized returns of 16.8 percent. (The
S.&P. 500, by comparison, generated annualized returns of 10.8 percent
during that period.) Seeing these results, other institutions -- Notre Dame,
Stanford, Princeton among them -- began emulating Swensen's hedge-fund strategy.
Which, it turns
out, was a good thing for Cliff Asness and AQR. Had he been operating in the
old days, when the clients were all wealthy individuals, his firm would never
have survived the Internet bubble. His investors would have all cut and run
and put their money in some fund that was investing in dot-coms. But the institutions
understood what Asness was doing, and even though his fund shrank from that
original $1 billion to $400 million over the next 20 months, a surprising
number of them stuck by him. What he was doing made intellectual sense, and
it would work again so long as the bubble eventually ended. Which had to happen,
didn't it?
Not that Asness
was sanguine during the bubble. AQR's first year and a half in business was
a time when investors completely lost their heads, when dot-coms with neither
profits nor revenues had triple-digit stock prices and when millions of investors
actually believed that the rules of investing had changed. It was a period
of such utter insanity that it seemed to repudiate the essential mathematics
that had always guided the market. That drove Asness completely crazy. He
had never lost money for investors over any significant period; indeed, he'd
never in his adult life been anything but a superstar. Now his new hedge fund
was like a dripping faucet he couldn't turn off: every month, it seemed, it
was down another 2 percent. The fundamental insight that drove his model --
cheap beats expensive more than it should -- simply didn't work during the
Internet bubble. Expensive wasn't just beating cheap. It was crushing cheap.
Outrageously expensive tech stocks just kept getting more expensive. During
the height of the dot-com era, the fund fell about 20 percent.
''I snapped
during the bubble,'' Asness concedes today. His partner John Liew looked
at the bubble the way a statistician might -- it was a hundred-year flood,
and there was nothing you could do but wait for it to recede. Intellectually,
Asness agreed, but emotionally he could not distance himself from the awful
downward slide. He had much of his own money in the fund; many of his investors
were people he had known for years; even his father had put a good portion
of his retirement money in the fund. The pressure was nearly unbearable. He
railed about the stupidity of investors who were driving up the stock prices
of tech stocks. One night in the middle of one such diatribe, his wife, Laurel,
said, ''But Cliff, you always told me you made money when people acted
stupidly.'' Asness stopped talking and looked up at her. He knew she was
right. ''Now you're whining about it,'' she continued. ''I guess
you just want them to be a little stupid.''
What Asness
didn't do, however, was capitulate to the bubble. ''Our belief in the process
never wavered,'' Liew said. ''The evidence was that the models we had
devised had worked going back to the 1920's.'' In fact, the bubble gave Asness
a cause. ''We try to make money by making a lot of little venal trades,''
Asness said. But fighting the bubble seemed to imbue him with some larger
purpose. He began to see himself as on the side of good fighting evil. Bubbles,
after all, put investment capital into the hands of company founders who know
nothing about how to build companies. They finance lots of terrible ideas.
And they hurt investors, who wind up losing money once the giddy ride ends.
Mostly, though,
it offended Asness that so many investors were willing to blindly toss aside
decades of accumulated market history and data. By early 2000, he began to
write a lengthy article exposing what he saw as the fallacies being used to
justify crazy stock prices. It was unlike anything Asness had ever written.
It was biting, sarcastic, tough-minded and occasionally even funny. He laid
out the math for why even the stock prices of strong companies like Cisco
Systems were not sustainable. He called the paper ''Bubble Logic.''
The draft of
''Bubble Logic'' that Asness showed me is dated June 1, 2000. As we
all now know, the bubble had ended by then; the air began leaking out of it
three months earlier. That March was the low point for Asness and his partners
at AQR. Feeling that his father had too much money in the fund, Asness --
against his father's wishes -- tossed him out. (''If I was going to go
down,'' he says now, ''I didn't want to take him with me.'') But
in April, the fund made money, and it gained again in May, and when the year
ended, AQR had made back a substantial chunk of its losses. It would be another
year before the partners started making hedge-fund-like compensation themselves
-- that's because it is standard practice for hedge funds to make back all
their investors' money before they start tacking on that 20 percent performance
fee again -- but the ship had righted itself. For months, an early draft of
''Bubble Logic'' had been circulating among Asness's friends in academia;
it was discussed in online forums; it was even quoted here and there in business
publications. But it was never published. There was no need to publish it.
Asness says that if the bubble had lasted six more months, he would have been
out of business. But it didn't. He had outlasted it.
Once the bubble
ended, the AQR model went back to working just the way the data say it is
supposed to. Over the last five years, the firm's primary hedge fund is up
an average of 13.2 percent a year after fees. Those are not George
Soros-like numbers, of course, but AQR generates those returns with a little
less risk than the overall market. More to the point, when it is added to
an institutional portfolio of stocks and bonds, it reduces the overall riskiness
of that portfolio. And though it does not seek out new investors, big institutions
are banging down the door trying to get in. Why? Because once the Internet
bubble ended, the market did go down, a lot. And the institutions that had
loaded up on stocks for the past 18 years were suddenly losing money. So they
all decided, en masse, to load up on hedge funds, to replicate what Yale was
doing.
Hedge funds,
it turns out, had a fabulous run during the downturn; while the mutual-fund
industry was losing more than $1 trillion, the hedge-fund community was essentially
breaking even. The best of the hedge funds made money during the bust.
Even CalPERS, the giant California state pension fund, began dabbling in hedge
funds a few years ago. The real reason so many new hedge funds are being started
these days is that the demand is insatiable. And that demand is coming from
institutions. Every big institutional investor in the country -- if not the
world -- wants what Yale has: a truly diversified portfolio that generates
decent, positive returns with less risk than the market itself offers. And
really, who wouldn't want that?
''David Swensen
was so successful, and so eloquent in explaining what he did that he convinced
folks that he had it figured out,'' says James Chanos, who runs Kynikos
Associates, a short-selling hedge fund with more than $2 billion under management.
''It looked like he had found the Holy Grail.''
But here's the
problem: there is no Holy Grail, not when it comes to investing. Or, more
precisely, investing Holy Grails are, at best, temporary phenomena. As hedge
funds proliferate, for instance, the quality of fund managers is bound go
down, and that will hurt the performance of hedge funds. That's what happened
when mutual funds became wildly popular, and it is already happening in hedge-fund
land as well. (Hedge-fund returns are down slightly this year, for instance.)
Let's face it: even though there are 8,000 hedge funds, are there really 8,000
great hedge-fund managers? Of course not.
There is a second
issue as well. You know those little inefficiencies that so many hedge-fund
managers are trying to capture? Those strategies work well when there are
only a handful of people employing them. But once there are hundreds of fund
managers all trying to exploit the same inefficiencies, the anomalies tend
to go away. The very fact that all these people are trying to do the same
thing makes the market more efficient. As Chanos puts it, ''Success breeds
imitation, and imitation breeds mediocrity.'' He adds: ''I think a
lot of the institutions that are just getting into hedge funds now are going
to be extremely disappointed. And there is going to be a gradual recognition
that the fees aren't worth it.''
Most people
I talked to in the hedge-fund world don't believe that the hedge-fund bubble
will end in some giant cataclysm that threatens the foundations of the financial
system. It is far more likely that the air will gradually come out of the
bubble in ways that most of us will barely notice. Hedge funds with mediocre
returns will go out of business. A lot of the power hedge funds now have in
moving the markets will dissipate. Some scam artists -- who always emerge
during bubbles of any sort -- will be exposed. Some hedge funds that have
taken too much risk will crash and burn. New regulations will be put in place
(indeed, next year the S.E.C. will require hedge funds to register with the
agency.) Business-school grads will find the next hot thing to gravitate toward.
And what will
be left? There are those, like Chanos, who say they believe that hedge funds
will contract over time and that what will be left is a cottage industry of
successful funds that don't outlast their founders. But there are others who
believe that the hedge funds that are left standing -- the funds run by grown-ups
who understand how to manage risk, and who position their funds as an alternative
asset class for institutions -- have a shot at becoming permanent institutions
and a normal part of the investing landscape. There is, after all, something
powerful in these ideas of managing market risk and generating returns that
are uncorrelated to the market.
This is not,
however, a case in which a big idea eventually filters down to the rest of
us. Theoretically, mutual funds could develop market-neutral funds like the
one Asness runs; the regulations that limited how much short-selling a
mutual fund could engage in were repealed years ago. But the fund industry
has historically shied away from shorting stocks. For one thing, there's a
strong psychological aversion to short-selling in the investing world. Rather
than pumping money into companies to help them grow and prosper, the short-seller
is rooting for a company's defeat. It seems somehow un-American, or at least
not very nice. But other things once viewed as unseemly or un-American, like
buying on credit, were quickly adopted by the masses once some smart guy figured
out how to sell the idea in an appealing way. The real obstacle to the massification
of hedging is that it is hard. What Cliff Asness does requires an immense
amount of skill. There just aren't that many people who can do it well. And
that's not going to change any time soon.
Of course, if
the mutual-fund industry did start rolling out such funds, it would further
degrade the ability to make decent returns, because it would mean there would
be yet more people trying to execute the same strategies. Around and around
it goes.
Asness, of course,
is in the camp of those who would like to see hedge funds become a more permanent
part of institutional portfolios. But he can see the impediments as well.
Last year, he published a lengthy paper on the subject of hedge funds in The
Journal of Portfolio Management. Titled ''An Alternative Future,''
it was written as a two-part series. In the first part, he laid out all the
reasons that hedge funds could wind up achieving the same kind of permanence
as mutual funds: the power of the ideas behind them, the attractiveness of
using them to diversify institutional portfolios and so on. In the second
part, he laid out all the reasons that it might not happen -- at least any
time soon -- including the real possibility of lower returns in the near term,
as well as ''those pesky fees,'' as he put it.
In our various
discussions, I pushed him often on the subject, but I could never get him
to commit one way or the other. ''I'm very schizophrenic on the subject,''
he said toward the end of one of our talks. ''To me, the real question
is whether these institutions are rationally going to accept lower returns.
Or are they secretly hoping that even if everybody else is getting lower returns,
their hedge funds will still be getting the big returns? If it's the latter,
we'll have problems.'' Some things even Cliff Asness doesn't have the
data to predict.
.
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