“I thought there must be something more virtuous, more ennobling to do with one’s life than make rich people richer” – Michael Steinhardt
In a recent interview with RealVision, the “dean of financial reporters” Jim Grant, publisher of “Grant’s Interest Rate Observer”, interviewed Michael Steinhardt, a member of the old guard of hedge-fund titans, about his views on markets and the hedge fund industry. And he’s certainly qualified to have an opinion: Steinhardt achieved, during his more than 30-year career, a phenomenal return, and those who invested $1 with Steinhardt in 1967 would have $481 in 1995, compared to $19 if one had stuck with the S&P.
While Grant admits that the title “world’s greatest investor” is bandied about without much thought nowadays, he believes Steinhardt truly does have a legitimate claim: One of Steinhardt’s first investors, a man from Chicago who put up $500,000 when Steinhardt Partners launched in 1967, noticed at one point that he was worth $100 million.
As an introduction to Steinhardt’s view on markets, Grant starts the interview with one of the most widely debated questions in finance: Is the efficient market hypothesis – the idea that asset prices reliably reflect all available information – correct? Are markets truly efficient?
The question made Steinhardt smile: markets are, after all, human institutions, he said. Meaning he has his doubts that this mythical “efficiency” has ever truly been achieved, even though the level of intellectual prowess lurking in markets has only increased since he left.
Efficiency is a funny word. Markets fluctuate. And the degree of volatility hasn’t changed in a secular sense, to my knowledge. So can markets be efficient and be as volatile as they have been historically? I’m not sure.
They are human institutions. And the idea of efficiency is one that has attracted intellectual thought from all sorts of investors, some of whom claim to do better in efficient markets, some, relatively few, who claim to look toward volatility, and, if you will, inefficiency as the route to opportunity.
I would be one of the latter. But I at the same time – and this is an important point. And I’m going to use my Brooklyn accent, if you will. I don’t know from efficiency. I don’t know that sort of stuff. I don’t know alphas, and betas, and all the efforts that the modern investor has made to create a new understanding of markets.
But while the efficiency question is widely discussed, having a well-developed view on this matter isn’t what’s important when it comes to investing, according to the legendary investor. Rather, Steinhardt argues, a good investor is one who has “the correct variant perception.”
There were trends in the market and areas of popularity and unpopularity that reflected themselves in exaggerated price movements…and those exaggerated price movements became the basis for that phrase that you used about what’s popular and what’s not popular.
In which you can in your own efforts create a degree of confidence that you may be right, there’s no easier way to make money in markets than having correct variant perceptions.
I must say from my early teen years until when i retired in 1994-1995, I was totally committed to one thing. Not building the biggest firm not having a well-oiled organization. I was committed to one thing and that was: Having the best performance as a money manager, period. I was prepared to do all sorts of things for which I wasn’t so well trained.
Steinhardt was an early entrant into the world of hedge funds, if not one of the first with his Steinhardt Partners, which was launched in 1967. But shortly after his exit from the industry in 1995, he has been what he calls “figuratively short” on hedge funds – and he still is (despite his subsequent return to head WisdomTree, which currently has over $43BN in AUM). He was an early skeptic in the hedge fund space, which has received endless criticism for its high fees and disappointing performance in recent yeas. Yet the industry has only grown as “30 somethings of no particular talent [asked fees of] 30 and up that seemed, if not unconscionable, at least aggressive.”
It was different in Steinhardt’s time: he achieved a 99% return in his first year of operation, and told his investors when he was first starting out that they should expect 15% annualized returns, over time. But if a hedge fund achieved those returns today, it would be cited as a grand achievement.
The call was early, because from 1995, when I left the business, until today, there has been an extraordinary blossoming in the number and the size of hedge funds. I hear there are 9,000 or 10,000 hedge funds. And although hedge fund performance in the last few years has not been so great, I don’t think it’s reduced the number of hedge funds very much.
I remember when we were trying to get people to invest with us, they would ask the question, what sort of returns do you think you will get? And I remember we had a fairly stock line. And the stock line was, we should be able to achieve 15% on average, year in, year out, with important variations per year. And if we do that, we will be happy.
To give readers an idea of how Steinhardt thinks about markets, Grant asked the hedge fund icon about some of his trading “triumphs”, the greatest of which Grant envisioned as Steinhardt’s “bond bet”: on which modern managers like Bill Gross have frequently tried to replicate, if with far less success . Steinhardt, traditionally an equity manager, realized in the early 1980s, not longer after Paul Volcker became Fed Chairman, that interest rates could not rise forever.
It was an interesting time. And Volcker had an important impact. And interest rates kept going up. And it was clear to me, because it so fit this variant perception, that interest rates could not go up forever. They had to, at some point, impact the economy. And in doing so, they would, by their own weight, decline.
So the question was, how to do it? When to do it? How much leverage to use? And what instruments to use?
So, Steinhardt went long two-year notes. The trade was an immediate money loser, and several prominent clients ended up pulling their money before it was over.
…What we used to do at what was then Steinhardt Partners was give our investors a monthly letter listing our major positions, longs and shorts, and describing our performance for the month. And I thought that was an obligatory thing for a hedge fund to do, because if people were investing with you, they didn’t have to invest so blindly. It was reasonable for them to know what was going on.
At one point the bond position became so large that I listed as one of our longs – US treasury notes. Because I think we had twos and fours, or something like that. And they were notes. They were not bonds. Toward the end of our then fiscal year, I started to get calls from investors.
And they were nasty calls. What are you doing in the bond market? You don’t know anything about bonds. You don’t know anything about fixed income. What gives you the right to take our money and fling it around, on leverage, in bonds?
Not a bad question. And I didn’t have such great answers. And we lost – I remember. I’ll use a name that I shouldn’t use. We were the first, and for a while the only, hedge fund investment of McKinsey. McKinsey. I mean, they’re fancy people. They withdrew, because of the bond bet.
Other people withdrew their investment from us because of the bond bet, because we were not deemed able to overcome the vast amount of common information that came to one in the world of bonds.
But when the federal government’s new fiscal year began in 1981, the bond market took a dramatic turn. Steinhardt was vindicated, and his position made a fortune.
And the punchline: when the bond market turned, it turned so furiously, that the bulk of the profits were concentrated in just the first 10 minutes of the reversal trade.
And I’m not sure if we made all that much more through the rest of the bond bet than we had made in the first, figuratively, 10 minutes of the bond bet. It was extraordinarily fulfilling, because it was a very difficult bet.
I remember– and I may have mentioned this in my book– that I used to go down at the end of the day to get a cab. And then I said, I need measures. I need measures that are distinctive and individual, and not commonplace as to what’s really happening in the economy. So I would stand on the corner. My office at that time was 39th and Park. On 39th and Park. And I would count the cabs. And there are two types of cabs, one with a light on, meaning empty, and one with a light off being filled.
And I came to the conclusion that over time for the economy to fade there had to be more empty cabs and less full cabs, cause taking a cab ride at that time was a consequential thing for most people.
And I did that. And I asked every question I could. I had a good friend named Peter Foreman who was a stockbroker in Chicago. And he knew the industrial world. And I had him go to these various companies and try to get nuanced judgments as to what was going on in rail car manufacturers, and all sorts of companies that I wasn’t so familiar with. And I did everything I could to try to persuade myself that this bet wasn’t going to last to be of such duration that it would end my duration as a money manager, which was always possible. Because you really could lose or gain a lot in a short period of time.
Gain he did and with a lot of leverage, as well as margin calls in the process:
Between 95% and 98% [of the trade was] borrowed. That’s leverage. Which was common. I think we borrowed it through Goldman Sachs. And I think we got a few margin calls, but not many.
But it was scary. And it was fulfilling. And it captured, perhaps, as well as anything the idea of variant perception, because it was variantly perceived that interest rates could come down and could come down a lot when you were in the midst of Volcker, who was tough, and kept raising the short rate, and felt that he was doing the right thing. So that was a moment in my life that turned out to be a happy one. But it certainly could have been otherwise.
All because he had the courage to stand by his view against the consensus – something which by definition is impossible for the trend-following algorithms, and many of the new generation of traders, that dominate the market today.
Courtesy of RealVision, an excerpt of the full 1 hour interview is below. The full interview is available at the following link.
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