Book Excerpt: Hedge Hunters

In this chapter from Bloomberg News hedge fund reporter Katherine Burton's new book, she profiles Craig Effron, a hedge fund veteran who keys his investments to political and economic events. One strategy: read the advice in stock-picking columns, then do the opposite.

By Katherine Burton
Bloomberg Markets November 2007

The summer of 2007 won't be a happy memory for many hedge fund firms. At least a dozen of them closed funds or halted redemptions when the credit markets seized up. Boston-based Sowood Capital Management LP, run by Jeff Larson, a former Harvard University endowment manager, lost $1.6 billion, or about 60 percent of its value, and is returning its remaining cash to investors. New York- based Goldman Sachs Group Inc.'s Global Alpha fund, meanwhile, lost 33 percent of its value in 2007 through Aug. 31.

Many hedge fund managers were able to sidestep the kinds of blow- ups that have afflicted the industry this year. Some of those managers are featured in Bloomberg News reporter Katherine Burton's new book, Hedge Hunters , published on Nov. 1 by Bloomberg Press ($27.95). The book uncovers the secrets of some of the most successful traders in the industry, as they describe the biggest challenges they face, how they enter and exit a trade and how they became veterans in an industry in which mere survival is an achievement. They also name some of the most-talented managers in the game. In this excerpt, Burton talks to Craig Effron, founder of New York-based Scoggin Capital Management LP.

Effron, 48, runs a fund that invests in the stocks and bonds of companies that are going through events like mergers, spinoffs and emergence from bankruptcy. Though his company is almost 20 years old, he's kept a low profile, having closed his fund to new investors several years ago to limit growth and keep performance strong. Effron has produced an average return of about 18 percent a year. The fund escaped heavy damage in the July-August bloodbath partly because he doesn't use borrowed money to leverage his investments. And he's quick to sell out of a losing investment.

Adapted from Hedge Hunters: Hedge Fund Masters on the Rewards, the Risk, and the Reckoning. Copyright 2007 by Bloomberg LP. Published by arrangement with Bloomberg Press. Available wherever books are sold or at www.bloomberg.com/books

Craig Effron: Getting a Grip on Risk

By Katherine Burton

It's been two decades since Craig Effron traded gold, silver and crude oil at the New York Mercantile Exchange, but the lessons he learned in 10 years in the pits, where decisions are made at a manic pace, still dominate his approach to money management. His $3.25 billion hedge fund, Scoggin Capital Management LP, buys and sells the stocks and bonds primarily of companies that are merging, spinning off units or going through financially tough times. From November 1988, when he started the fund, to Aug. 1, he produced an average annual return of 18.2 percent after fees, using no borrowed money. He had only one losing year, 2002, when he was down 1.3 percent. His returns are not correlated to the stock market, and 90 percent of the time his funds make money in the months the Standard & Poor's 500 Index, the benchmark U.S. stock index, is down. "I'm a risk manager, which I believe is more important these days than being an analyst," Effron says.

That's because Effron's approach hinges on responding to change. The investment world gets smaller every day--and faster. Events that seem unconnected drive markets to move in sympathy. When Russia devalued its currency in August 1998, the S&P 500 tumbled 13 percent in the following two weeks. "Nowadays, cause and effect are much more instantaneous," Effron says. "It's much more like commodities trading."

Everything about Effron has its accent on now. The day we meet in his midtown Manhattan offices, he's wearing faded jeans ripped at the knees, argyle socks and brown suede loafers. His manner is definitely more akin to that ofa regular guy than an Ivy League big shot. When his son calls to talk about picks for the men's college basketball championships--the tournament is in full swing- -his mobile phone rings with rapper Eminem's "Lose Yourself." Although Effron, 48, got his undergraduate degree at the Wharton School of the University of Pennsylvania, he always counted on becoming an attorney. "It's all been happenstance," he says of his career path.

The first of the chance occurrences came in 1981 and was born of a hitch in Effron's plans for a legal career. He had been put on the waiting list at New York University's law school, and his parents suggested he find a job on Wall Street for a year before reapplying. Not many wanted to work on the Street then--the country was in the middle of a recession--and he readily got a job at brokerage firm E.F. Hutton & Co. Nine months into the gig, having decided that the law no longer interested him, he had dinner with a friend who had been a year ahead of him at Wharton. "Screw E.F. Hutton," his friend said. "You should see what I'm doing. It's really fun." His friend was trading commodities.

Effron took a day off and went down to the Nymex to see how it was done. There he saw young guys shoulder to shoulder in the pits, screaming their buy and sell orders. "It's a football game," Effron says. "You're standing with a bunch of very big guys, all pushing and shoving. It's very Darwinian. It's the purest form of capitalism I know."

Effron quit E.F Hutton and bought a seat on the Nymex. He was a natural. "It's all about feeling the energy in the pit," he says. "Is it going up or is it going down? You don't have a clear answer. It's all intuition. You can just tell." Success in the pits requires skills that can't be taught. Because the right choices depend entirely on sensing what's happening among the scrum of traders in the ring, Effron refused to read the newspapers until after the markets closed. "You didn't want to know what was going on," he says. "The more you knew, the worse you did. If you knew there was an oil strike in Nigeria, you'd be thinking all day, 'I'm bullish,' when in fact that might not be the driver at all. The real driver might be that Russia was selling 40 million barrels that day and you didn't know about it."

Effron started dabbling in stocks when commodities trading ended each day at 2 p.m. He liked to look for events that would send a stock higher or lower. He might read an article that said junk bond king Michael Milken was providing financing to investor Nelson Peltz to buy company XYZ. Peltz was offering $37, and the company was trading at $37.25. Effron would risk 25 cents on the likelihood that another bidder would come in with a higher offer. At first, buying and selling stocks was a lark for Effron, a hobby. He ran a few separate accounts free of charge for his parents and their friends. His neighbor in the silver ring, Paul Tudor Jones, who had gotten his start trading cotton, was the first to encourage Effron to think about stock picking as a business. Jones later went on to start Tudor Investment Corp., in Greenwich, Connecticut, one of the biggest hedge fund firms. Jones asked Effron to trade stocks for him but demanded he take a fee for managing the money. "You'll take it more seriously if you do," Jones told him.

In 1988, with $500,000 from Jones and another $2.5 million from other investors, Effron started Scoggin with his friend Curtis Schenker. Effron had first met Schenker at Camp Androscoggin in Wayne, Maine, and ran into him again at Wharton, where Schenker was a year ahead of him. The two were no more than acquaintances until after college, when a mutual friend who was supposed to go to Puerto Rico with Effron got sick and gave his ticket to Schenker. "We became best friends that weekend," Effron says. "We hit it off. We had everything in common. It was another happenstance."

Despite his respect for coincidence, Effron doesn't leave his portfolio to the vicissitudes of chance. The most important lesson he learned as a commodities trader was to cut his losses when a position moved against him, and he applies the same rule today. "I am the quickest guy to sell stuff and buy puts," says Effron, referring to a way of betting, through options, on the falling price of a security or index. "I do it more than I should."

That's because Effron has seen how unforgiving the markets can be. One day, he'd be in touch with a guy who everyone knew was a millionaire. Two days later, the fellow would be wiped out, having stuck with a trade when the market moved in the opposite direction. "I learned at a young age that markets are much bigger than the people working them," Effron says. "You can't outlast a market." He notes that many of the people driven out of business were market veterans. "These were experienced traders, moving a lot of money," he says. "I have nightmares about that. My whole focus for my business is this: I want to be around tomorrow."

Effron's bite-the-bullet handling of the WorldCom Inc. debacle in 2002 exemplifies his approach to managing risk. His fund was 90 percent invested in distressed debt, and Scoggin had been making money until June 25, the day WorldCom, the second-largest U.S. long-distance phone service provider, announced it would restate earnings after misreporting $3.9 billion in expenses. The next day, WorldCom bond prices fell as low as 14 cents from a high of 78 cents the day before. Many investors had been bullish on the bonds because their analysis suggested that they were trading below the value of the underlying assets of the company. "We had been long WorldCom, and everything else we were long went down," Effron says, including Qwest Communications International Inc. and cable operators Charter Communications Inc. and Comcast Corp.

"The minute the WorldCom news hit, we sold whatever had a bid that wasn't ridiculously stupid," Effron says. He continued to sell during the next month and a half, until the bonds got to prices that were so inexpensive he felt the downside was minimal. But he imposed a moratorium on buying. "If the world ends here, we don't want to be out of business," he said to his traders. Ultimately, Scoggin lost 8 percent peak to trough, its largest setback ever. The fund was flat for 2002, and Effron went from August to October without buying any bonds. He did buy puts on the S&P 500, a good call given that the index tumbled almost 8 percent in July. "We made a lot of money back on the shorts," Effron says. When Scoggin started buying debt again, it initially stuck to the safer play of senior debt. In 2003, the fund was up 40 percent.

Many managers like to talk about conviction, the gumption to stay put when other investors are jamming the exits, and although Effron isn't averse to staking as much as 10 percent of his portfolio on one trade, he'll sell a position, even one he likes, if the market isn't going his way. "I think having no conviction is how you want to be," Effron says. "When the market is ugly, I'm not buying stuff. I'm probably selling it. I can buy it back tomorrow." He tries to hold positions for at least a year because that lowers his investors' tax bill. That, however, is less of a concern for him than losing money. "I'll sell things out when I feel the market is ornery," he says. "I feel liberated. You get a clearer vision of what's going on when you don't have an ax to grind."

Investing more than 10 percent of capital in any one company is something Effron won't do, and he generally prefers to limit positions to 5-7 percent. Historically, his portfolio is 20-70 percent net long, with an average of about 40 percent net long. "That's a bit deceiving, because when the market gets ugly, we can get to zero very quickly by selling longs and buying puts," Effron says. "We're big players of options. I love options, because I understand what I'm risking."

Effron will also buy puts on positions if he's uncomfortable. The day I was in his office, he had bought 40 April puts on Qualcomm Inc., the world's second-largest maker of mobile telephone chips, for 30 cents, which means he locked in a price of $40 for Qualcomm shares between his purchase date--March 14--and their expiration date in April. The shares had climbed to $43.21, but he was happy to have the insurance, given that the S&P 500 had plunged 4 percent in the previous two weeks. "If the world ends next month, we get out at $40," Effron says. "I throw away 30 cents all the time. It's all about staying in business."

As protection against a big market tumble, Effron likes owning puts on the S&P 500. When that index moves around with greater volatility, making options more expensive, he uses futures or the SPDR Trust, an exchange-traded fund keyed to the S&P 500, to protect his downside. Although Effron does sometimes wager on stocks he expects to fall, he doesn't short individual stocks as a hedge against his long positions. There's nothing worse, he says, than being short 15 stocks on a day when the S&P 500 tumbles 2 percent and not having any of your 15 shorts lose ground. The day before our interview, the S&P 500 had dropped 2 percent, and Scoggin lost only 15 basis points because Effron owned puts on the index. (A basis point is 0.01 percentage point.)

Effron has other ways to position the portfolio conservatively. Ninety percent of the debt owned by Scoggin in 2007, for example, was in senior paper because Effron felt that debt with a bigger default risk wasn't paying enough. The so-called junior paper of distressed companies traded at about 60-70 cents on the dollar two years ago, whereas the senior debt traded between 90 cents and $1. In mid-2007, senior paper traded at $1.02 and junior paper at 92 cents. "It's too expensive to short, but we're waiting for stuff to happen," he says. "You'll see the spread go out 20 or 30 points."

Like a lot of successful managers, Effron says his main flaw is leaving profits on the table. "I sell too soon," he says. "We have targets and we abide by them. A lot of guys, they get to a target and then they raise it 10 percent. I like to say, 'Stocks don't know you own them. You can sell them and they don't care.'"

Effron's game plan has always depended on moving to new strategies or geographic regions once a space gets crowded or the investments no longer work. When Scoggin first started, Effron and Schenker traded in companies that were the targets of leveraged buyouts and mergers. Milken, head of the Beverly Hills, California, office of Drexel Burnham Lambert Inc., helped create the junk bond market that sent investors and companies on a nearly decade-long buying spree. It was a very easy way to make money, at least until Oct. 13, 1989, when the airline pilots union and the management of UAL Corp., parent of United Airlines, called off their $300-a-share bid for the airline because they couldn't get financing. UAL shares plummeted more than $56 once trading resumed, and the Dow Jones Industrial Average fell almost 7 percent. The Scoggin fund had been up about 50 percent for that year, but market turmoil during the next few days wiped out 20 percentage points of its profit. Effron knew the days of merger arbitrage were over for the time being.

Still, there was a silver lining. Many hedge funds had made leveraged bets on UAL and, as a result, some had gone out of business or were forced to scale back, putting good analysts out on the streets--people Scoggin couldn't have afforded to hire a year earlier. The firm picked up a distressed-bond analyst who led Scoggin into a new investment game. The junk bond market had also crashed, and there were scads of cheap corporate bonds to pick through. "We learned quickly," Effron says. "A lot of names we traded in the mid-1980s as leveraged buyouts were coming back as bankruptcies." Scoggin traded distressed debt until about 1995, when that game got too crowded. By then the firm had discovered the next course in the feast Effron calls idiot-proof investing: spinoffs.

Lots of companies, including AT&T Corp., H&R Block Inc. and Minnesota Mining & Manufacturing Co. (now 3M Co.), were spinning off units. Many of their stockholders were mom-and-pop investors who dumped the shares in the new companies. They wanted to own shares of AT&T, a well-known telephone service provider, not some company called Lucent Technologies Inc. about which they knew nothing. "For a year or two, no one knew this phenomenon existed," Effron says. "We were buying all these companies at half multiples." Later, he bought shares of Freescale Semiconductor Inc., which Motorola spun off at $13 a share in July 2004. In December 2006, Freescale was bought by a group of investors led by Blackstone Group LP for $40 a share.

Over the years, Scoggin has made money betting on the outcome of litigation, be it related to asbestos, cigarettes or lead paint. Effron never shies away from playing outside his usual sandbox, and his search for gains has led him to buy Chinese equities, Russian vouchers, commercial real estate and the government debt of Zaire. "A lot of people who have an analytical mind-set don't go there, where the risk is," Effron says. "It's outside their thinking. I want to go where the risk is, but I want to understand it. I'll watch a dog piss for a dime if it will go to 20 cents. There's no reason to put yourself in a box."

Effron watches for opportunities outside the usual boundaries, regionally and otherwise. About 20 percent of Scoggin's portfolio is outside the United States, primarily in Europe. Most of those investments are in the stocks of merging companies and in spinoffs, particularly in Sweden. "What we've been able to do is to find the place where people aren't willing to go, and go there and learn it quickly," Effron says. "I can't tell you there are a lot of great undiscovered opportunities out there."

There have been some. To get a piece of the action in Russian vouchers in 1995, Effron sent someone to Russia to buy them. In 1992, President Boris Yeltsin had given every Russian citizen a voucher worth 10,000 rubles that could be used to buy shares of state-owned companies when they were sold to the public in the next several years. Many people sold the vouchers because they needed the money immediately or didn't understand the concept of shareholding. Early on, the vouchers changed hands for as little as 3,000 rubles. "That was a good gig," Effron says, laughing. Equally unusual was Effron's purchase in 2003 of the debt of Zaire, by then called the Democratic Republic of Congo, from the Bank of Brazil, which had loaned money to the African nation to build a power plant. It was a 20-year loan, and the bank had seen no money from Congo for 19 years and 11 months, so the Brazilians decided to sell the $150 million of debt for 5 cents on the dollar, or $7.5 million, just to get it off the books. Four years and $11 million in legal bills later, Effron collected $70 million from the Congolese government.

To get its money, Scoggin had to sue Congo in courts from Luxembourg to Dallas, and once the firm had won (it was victorious in 98 percent of the cases), it had to uncover pockets of money so it could get paid. When the government of Congo realized that Scoggin was not only serious but also making inroads in going after some cash held in France, the Congolese Finance Ministry sent a seven-person delegation to Scoggin's offices, where the parties made offers and counteroffers until they settled on the $70 million figure. "The rate of return was 20 percent a year--not that high--but it was kind of fun," Effron says. Scoggin is now getting calls from other lenders who want to sell their debt because Congo was considered the hardest country to collect from, given its minimal assets and widespread corruption. "Even the Congo is calling us to settle its other debts, offering us 10 percent of the take," he says. That deal is on.

Effron's Chinese investments resulted from a vacation he and his wife took with another couple in 2005. "When I got to China, I realized immediately that we were in America 1910," Effron says. "Today in America, everyone hates everyone. There is so much negativity. In China, it is all positive. I don't know how it will play out, but this place is for real."

Effron posted a notice at Harvard Business School, seeking someone to travel to China to work for Scoggin there. The firm got 65 responses, narrowed the list down to three people and finally chose Emily Dong, who was born in western China. She worked for Scoggin in New York for nine months and then headed for Hong Kong. Whereas most foreigners concentrate on Shanghai and Beijing, Effron is focusing on the western provinces, closer to Tibet. "Dong grew up there," Effron says. "She meets companies that have been around 20 or 30 years trading at two times cash flow, but they are small--$500 million to $1 billion." In 2007, Effron made money in China. "Dong's done better than the indexes," he says. "The wind is at our backs."

Effron or Schenker approve every position in Scoggin's portfolio. They figure out how to construct the trade (whether to use options, for example) and how big to make the bet. Effron and Schenker are the largest investors in the fund, together accounting for 10 percent of assets. Scoggin has been closed to new investors since 2004, in part because Effron figures that if he establishes long-term relationships with his clients, they will be less likely to jump ship in the event of a loss.

Scoggin's investment ideas come from the news. The 10 investment professionals who work at the firm read newspapers from around the world and synthesize any interesting tidbits into e-mails they send to Effron. Analysts don't wait for a formal meeting to pitch ideas. "Everyone knows my attention span is three minutes, so if it doesn't hit me right away, it means I'm not going to put it on the sheet," a list of the company's investments, Effron says. He will sometimes use news articles to help him decide when to go the other way on a trade. It's a tool he calls the Wall Street Journal test: If journalists are writing about an investment idea or trend, it's usually the time to do the exact opposite. "They tend to be late, because the guys they're talking to are late," he says.

Late may be better than never in some jobs--not in Effron's.

KATHERINE BURTON covers hedge funds and investment management at Bloomberg News in New York. kburton@bloomberg.net

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