Finance: HEDGE FUNDS
SOROS: ANATOMY OF A COMEBACK
George Soros has faced down many adversaries in his 65 years: Nazis in his native Hungary, Communist dictators suspicious of his philanthropy and advocacy of open societies, and, more recently, the central banks of Europe. Soros gained fame a couple of years ago as "the man who moves markets," by aggressive, highly leveraged trading in currencies and bonds. As a trader and investor, his long-term record is unsurpassed--an average annual return of 35% since 1969, among the best in the world. But in recent months, it seemed, Soros was facing a threat as daunting as any posed in the past. His flagship $6.1 billion Quantum fund was struggling. His reputation was in jeopardy.
The tension at Soros' headquarters, across the street from New York's Carnegie Hall, was almost palpable. In the first three weeks of 1995, Quantum was down 6%, and it fought to break even unsuccessfully through most of the first half. In the past, such declines were just temporary setbacks after good years, such as Quantum enjoyed from 1990 through 1993. Soros was troubled. "I was concerned," he noted the other day, "that it was not a soft landing--that we were actually sinking."
It was as if the markets were conspiring to destroy him. Soros and his chief lieutenant Stanley Druckenmiller bet on the dollar as 1995 began--and it fell. They bet on the Japanese market--and it fell. Their exposure to the U.S. stock market proved inadequate, and that was where the action was. Driven by financial stocks and a boom in technology, the S&P was up 20% at the end of the first half. Quantum was down 6.5%. July began hot and sticky in the East End of Long Island, where Soros spent most of the summer. But then came the shower of green.
PROSAIC PICKS. During the first two weeks of July alone, the Soros-Druckenmiller team moved their humongous portfolio skyward 9%--a half-billion-dollar gain worthy of the Soros of yore. Then, in August, Quantum began a steady climb, gaining 17% in that month alone (chart). During the same period, the S&P sputtered and profit-taking dogged the high-tech stocks. September began as spectacularly as in the glory days, with a $100 million stock gain on Sept. 5. On Sept. 13, Quantum reaped a heady $200 million windfall, largely through a leveraged bet on the dollar. Through Sept. 13, Quantum is up 24% after expenses and fees, vs. 26% for the S&P.
How did Soros and Druckenmiller pull it off? Soros has been mum--until now. In separate interviews with BUSINESS WEEK, a tanned and cheerful Soros, and his dour chief lieutenant Druckenmiller, disclosed for the first time how they managed to achieve this stunning reversal. Yes, currency trading played a role in Quantum's revival--but a far more limited role than has been rumored. Stock selection, he and Druckenmiller insist, was a major factor in Quantum's recovery.
Soros even disclosed the fund's largest stock holdings--a nearly unprecedented step for Quantum, except for its rarely publicized annual reports. But even while de-emphasizing the role of macro trading, he made it clear that he will increase his use of leverage as Quantum's fortunes improve. Clearly, he already has--as the Sept. 13 surge indicates. Druckenmiller acknowledges that he is using more leverage than he did as recently as June.
Soros' decision to go public is in contrast with other hedge fund managers, who have been largely silent. The big funds fell up to 30% in 1994--Quantum eked out a 3% gain--and none have rebounded in '95 quite so dramatically as Soros'. Such superinvestors as Michael Steinhardt, Leon G. Cooperman, and Julian Robertson Jr. are coming back, however, and they lead a resurgence among the previous laggard hedge funds (table, page 102).
CHALLENGES REMAIN. But for the hedge fund business in general, including Quantum, long-term problems remain. Unless their mediocre performance reverses as decisively as it has for Soros, investors could become reluctant to pay hefty incentive fees to hedge fund managers--which usually amount to 20% of profits. (Mutual funds, by contrast, reinvest their profits.) Size is a problem for the largest funds. Fed by the gains many achieved early in the 1990s, size works against Soros and the other megafunds. Soros has long acknowledged this, and it has been a particular problem for Steinhardt, who is widely rumored--for the second time in a year--to be planning to shut down and distribute fund assets to his investors. He won't comment, but the rumors are discounted by Steinhardt colleagues who say that the mercurial fund manager has ample reason to stay in business. (Quantum, though usually grouped with hedge funds--partnerships for the wealthy--is actually an offshore mutual fund, closed to U.S. citizens.)
For the moment, however, the ever-harsher realities of the hedge fund business seem far away for Soros. His successful confrontation with the markets is far more multifaceted than merely a leveraged bet on the dollar. It also has involved jettisoning projects that seem problematic, such as a fund investing in India and a real estate venture with Paul Reichmann. According to Soros, the deal with Reichmann fell apart because Soros refused to provide financial backing for Reichmann's effort to regain his Canary Wharf project--a deal rejected by Soros, he says, because of its huge size.
WINNING COACH. In his interview with BUSINESS WEEK, the normally dour and philosophical Soros was cheerful, even elated. His new, sometimes chatty, sometimes opaque book--Soros on Soros--is selling well. But there was a tangible reason for his cheeriness. He had just reaped his one-day $100 million gain, not from the kind of high-octane "macro" investing that made Soros famous, but through that most prosaic of Wall Street pastimes--stock-picking. It epitomizes the chastened, more cautious George Soros of 1995. That $100 million gain sprang from Soros' portfolio of stock holdings, led by Burlington Northern, Chrysler, Newmont Mining, Intel, and Scott Paper.
In mid-July, as Soros on Soros began to cascade off the printing presses, Soros told his funds' investors that he was retreating from the big-picture, highly leveraged macro investing in currencies and bonds that had been his forte. Yet in the few weeks since the book began arriving at the stores, Soros has seen his macro strategies pay off dramatically, and has "coached" his flagship Quantum fund, by far the biggest and most successful hedge fund in the world, to dramatic gains.
Although Soros spent June tending to his philanthropic operations in Eastern Europe, particularly Ukraine, and then July and August in Southampton, he kept in daily contact with Druckenmiller and with other key subordinates--including Nicholas Roditi, the London-based trader who runs macro trading for Soros' Quota fund.
Roditi, who declined to be interviewed, has emerged as a star of the Soros organization. He steered the $1.5 billion Quota fund to the kind of performance that distinguished Quantum in the old days--a gain of 105% in the year to date. He was in daily contact with Druckenmiller as well as Soros throughout the year, but they did not see eye to eye very much. According to Druckenmiller, at times Roditi took macro positions that were the exact opposite of the money-losing positions held by Quantum. "He was on the right side of the markets from day one this year," notes Druckenmiller.
Quota was able to build on its gains, to risk old profits to make new profits. But Quantum didn't have that option. Even though Soros felt that his bullishness toward the dollar was basically right, he was restrained from using leverage by his own losses. For macro investors like Quantum, losing money is like a progressive disease. The more money you lose, the harder it is to take the leveraged risks that are required to help you recover--because those very risks can destroy you.
LOST MOMENTUM. But if you're making money, you are not risking the firm's very existence, only its recent profits. It is a simple but dead-serious dilemma. "When you're losing money, it's harder to make money," says Soros. "It was very difficult to regain momentum." Every time a trade proved successful in the first half, it was not successful enough--the leverage was minimal--and the currency markets turned sour again. Momentum was lost. "If I were to look at a chart of our asset value I'd say that we touched the break-even point at least five times, and then we fell back.... But once we put our head above zero, we could move ahead."
For Quantum, the psychological turning point came in early July. What got the fund really moving was the gain in the Japanese market, early in July, that coincided with the concerted intervention in the dollar-yen market. Fortunately for the wounded Quantum, Druckenmiller called the bottom of the Japanese market right on the nose.
"That might have been the psychological bottom," says Druckenmiller. "I think it was a confidence booster, yes. That was certainly one of the things that made us feel we weren't totally incompetent around here.... We had been short [the Japanese market] and we successfully avoided getting killed when it went back up. It gave us a sense of confidence to do other things"--such as take a long position in the dollar vs. the yen, and in European and Japanese bonds. Failing to call the bottom, he notes, "might have prevented us from being aggressive in some of the areas we were right in."
Druckenmiller is peeved at rumors that have dogged the fund, dismissing its gains as a simple-minded leveraged bet on the dollar. "Complete baloney," says Druckenmiller. "Our worldwide fixed-income gains this year are larger than our currency gains."
Soros and Druckenmiller insist that stock-picking has been as significant for Quantum lately as macro investing--an assertion certainly buttressed by the $100 million Sept. 5 gain. Soros favors companies "where there's a change in the way the companies are managed." He cited Scott Paper as an example of a company where "management has made a tremendous difference. We are very interested in the quality of management."
FIRST LOVE. But macro investing is clearly his first love. The Sept. 13 gain shows that Quantum is again taking leveraged macro bets, despite Soros' decision on July 14 to cut back on macro investing. Macro investing was eliminated entirely--except as "market conditions permit"--for Soros' Quasar and Quantum Emerging funds. But with macro investing coming back, Soros now apparently feels that the conditions are right for Quasar and Quantum Emerging to resume macro trading. Now he says that "some other younger people do some macro trading" in those funds.
For Soros, macro investing is an intellectual challenge and one that he makes sound downright easy. He likens the recent situation to the period discussed in his book the Alchemy of Finance--the time of the Plaza accords of 1985, which allowed governments to intervene in the freely floating exchange-rate system.
At that time, Soros had a firmly held view on currencies, and it took a nudge from the central banks to help him make money. Likewise, Quantum's recent dollar bonanza stems from a passionate view that the dollar had to move up--and that a push from the authorities would send it there. What the bankers did was "to make it move in the direction where it ought to have gone by its mwn. How shall I say--the situation demanded it."
Clearly, macro investing will be one area where George Soros will continue to lead. "We're finally getting it right," says Soros. And how. But the early months of this year prove that even the smartest practitioners of macro investing can come very close to being knocked out for good. Soros pulled it off this time. But if the markets send him reeling once again, he may not be so lucky.By Gary Weiss in New York