The bizarre leaps and plunges in cotton prices had proved too wild for Houthakker. Either the data were bad-unlikely, as there were a lot of data, going back more than a century from records kept by the New York Cotton Exchange-or the models were faulty. Either way, he was on the verge of giving up.
"I"ve had enough," he told Mandelbrot. "I"ve done everything I could to make sense of these cotton prices. I try to measure the volatility. It changes all the time. Everything changes. Nothing is constant. It"s a mess of the worst kind."
Mandelbrot saw an opportunity. There might be a hidden relationship between his own a.n.a.lysis of income distributions-which also displayed wild, disparate leaps that didn"t fall within the normal bell curve-and these unruly cotton prices that had driven Houthakker to his wits" end. Houthakker happily handed over a cardboard box full of computer punch cards containing data on cotton prices.
"Good luck if you can make any sense of these."
Upon returning to IBM"s research center in Yorktown Heights, Mandelbrot began running the data through IBM"s supercomputers. He gathered prices from dust-ridden books at the National Bureau of Economic Research in Manhattan and from the U.S. Agriculture Department in Washington. He looked into wheat prices, railroad stocks, and interest rates. Everywhere he looked he saw the same thing: huge leaps where they didn"t belong-on the outer edges of the bell curve.
After combing through the data, Mandelbrot wrote a paper detailing his findings, "The Variation of Certain Speculative Prices." Published as an internal research report at IBM, it was a direct attack on the normal distributions used to model the market. While praising Louis Bachelier, a personal hero of Mandelbrot"s, the mathematician a.s.serted that "the empirical distributions of price changes are usually too "peaked" relative to samples" from standard distributions.
The reason: "Large price changes are much more frequent than predicted."
Mandelbrot proposed an alternative method to measure the erratic behavior of prices, one that borrows a mathematical technique devised by the French mathematician Paul Levy, whom he"d studied under in Paris. Levy investigated distributions in which a single sample radically changes the curve. The average of the heights of 1,000 people won"t change very much as a result of the height of the 1,001st person. But a so-called Levy distribution can be thrown off by a single wild shift in the sample. Mandelbrot uses the example of a blindfolded archer: 1,000 shots may fall close to the target, but the 1,001st shot, by happenstance, may fall very wide of the mark, radically changing the overall distribution. It was an entirely different way of looking at statistical patterns-all previous results could be overturned by one single dramatic shift in the trend, such as a 23 percent drop in the stock market in a single day. Levy"s formulas gave Mandelbrot the mathematical key to a.n.a.lyzing the wild moves in cotton prices that had befuddled Houthakker.
When plotted on a chart, these wild, unexpected moves looked nothing like the standard bell curve. Instead, the curve bubbled out on both ends, the "tails" of the distribution. The bubbles came to be known as "fat tails."
[image]
Word of Mandelbrot"s paper spread through the academic community. In late 1963, he got a call from Paul Cootner, an MIT finance professor. Cootner was putting together a book of published material on recent mathematical insights into the workings of the market, including a translation of Bachelier"s thesis on Brownian motion. He wanted to include Mandelbrot"s paper. He called the book The Random Character of Stock Market Prices The Random Character of Stock Market Prices. It was the same book Ed Thorp read a year later when he was trying to figure out a formula to price warrants.
In the book, Cootner attacked Mandelbrot"s submission in a vicious five-page critique. Mandelbrot "promises us not utopia but blood, sweat, toil, and tears." The wild gyrating mess of Levy"s formulas, the sudden leaps in prices, simply wouldn"t do. The result would be chaos. While several economists briefly glommed on to Mandelbrot"s a.n.a.lysis, it soon fell out of favor. Some said the approach was too simplistic. Others simply found the method too inconvenient, incapable of predicting prices, as if one were trying to forecast the direction of a Mexican jumping bean. Critics said that while it may work for brief time periods when price action can be erratic, over longer time periods, prices appear to move in a more orderly Brownian fashion. An eyeball test of long-term trends in the stock market shows that prices of an entire market do tend to move in more regular, less erratic patterns.
[image]
Mandelbrot agreed that over long periods, equilibrium tends to rule the day. But that misses the point. Prices can gyrate wildly over short short periods of time-wildly enough to cause ma.s.sive, potentially crippling losses to investors who"ve made large, leveraged wagers. periods of time-wildly enough to cause ma.s.sive, potentially crippling losses to investors who"ve made large, leveraged wagers.
As Na.s.sim Nicholas Taleb, a critic of quant models, later argued in several books, investors who believe the market moves according to a random walk are "fooled by randomness" (the t.i.tle of one of his books). Taleb famously dubbed the wild unexpected swings in markets, and in life itself, "black swans," evoking the belief long held in the West that all swans are white, a notion exploded when sailors discovered black swans in Australia. Taleb argued that there are far more black swans in the world than many people believe, and that models based on historical trends and expectations of a random walk are bound to lead their users to destruction.
Mandelbrot"s theories were shelved by the financial engineers who didn"t want to deal with the messy, chaotic world they evoked. But they always loomed like a bad memory in the back of their minds, and were from time to time thrust to the forefront during wild periods of volatility such as Black Monday, only to be forgotten again when the markets eventually calmed down, as they always seemed to do.
Inevitably, though, the deadly volatility returns. About a decade after Black Monday, the math geniuses behind a ma.s.sive quant hedge fund known as Long-Term Capital Management came face-to-face with Mandelbrot"s wild markets. In a matter of weeks in the summer of 1998, LTCM lost billions, threatening to destabilize global markets and prompting a ma.s.sive bailout organized by Fed chairman Alan Greenspan. LTCM"s trades, based on sophisticated computer models and risk management strategies, employed unfathomable amounts of leverage. When the market behaved in ways those models never could have predicted, the layers of leverage caused the fund"s capital to evaporate.
The traders behind LTCM, whose partners included option-formula creators Myron Scholes and Robert Merton, have often said that if they"d been able to hold on to their positions long enough, they"d have made money. It"s a nice theory. The reality is far more simple. LTCM went all in and lost.
Black Monday left an indelible stamp on the very fabric of the market"s structure. Soon after the crash, options traders started to notice a strange pattern on charts of stock-option prices. Prices for deep out-of-the-money puts-long-shot bets on huge price declines-were unusually high, compared with prices for puts closer to the current price of the stock. Graphs of these prices displayed a curvy kink around such options that, according to the prevailing theory, shouldn"t exist. Traders soon came up with a name for this phenomenon: the "volatility smile." It was the grim memory of Black Monday grinning sinisterly from within the very prices that underpinned the market. left an indelible stamp on the very fabric of the market"s structure. Soon after the crash, options traders started to notice a strange pattern on charts of stock-option prices. Prices for deep out-of-the-money puts-long-shot bets on huge price declines-were unusually high, compared with prices for puts closer to the current price of the stock. Graphs of these prices displayed a curvy kink around such options that, according to the prevailing theory, shouldn"t exist. Traders soon came up with a name for this phenomenon: the "volatility smile." It was the grim memory of Black Monday grinning sinisterly from within the very prices that underpinned the market.
The volatility smile disobeyed the orderly world of "no arbitrage" laid out by Black-Scholes and modern portfolio theory, since it implied that traders could make a lot of money by selling these out-of-the-money puts. If the puts were too expensive for the risk they carried (according to the formula), the smart move would be to sell them hand over fist. Eventually that would drive the price down to where it should be. But, oddly, traders weren"t doing that. They were presumably frightened that another crash like Black Monday could wipe them out. They never got over the fear. The volatility smile persists to this day.
The volatility smile perplexed Wall Street"s quants. For one thing, it made a hash of their carefully calibrated hedging strategies. It also raised questions about the underlying theory itself.
"I realized that the existence of the smile was completely at odds with Black and Scholes"s 20-year-old foundation of options theory," wrote Emanuel Derman, a longtime financial engineer who worked alongside Fischer Black at Goldman Sachs, in his book My Life as a Quant My Life as a Quant. "And, if the Black-Scholes formula was wrong, then so was the predicted sensitivity of an option"s price to movements in its underlying index. ... The smile, therefore, poked a small hole deep into the dike of theory that sheltered options trading."
Black Monday did more than that. It poked a hole not only in the Black-Scholes formula but in the foundations underlying the quant.i.tative revolution itself. Stocks didn"t move in the tiny incremental ticks predicted by Brownian motion and the random walk theory. They leapt around like Mexican jumping beans. Investors weren"t rational, as quant theory a.s.sumed they were; they panicked like rats on a sinking ship.
Worse, the engine behind the crash, portfolio insurance, was the sp.a.w.n of the quants, a product designed to protect protect investors from big losses. Instead, it created the very losses it was meant to avoid. investors from big losses. Instead, it created the very losses it was meant to avoid.
Not everyone suffered catastrophic losses on Black Monday. Princeton/Newport Partners, due to Thorp"s fancy footwork, lost only a few million dollars that day. After the crash, Thorp"s models, scanning the marketplace like heat-seeking missiles, sought out numerous good deals. The fund closed the month flat. For the year, the fund earned a 27 percent return, compared with a 5 percent gain by the S&P 500.
Thorp had managed to survive the most devastating drawdown in the history of the stock market. Everything was looking up. Then, out of the blue, disaster struck Princeton/Newport Partners. It was Ed Thorp"s black swan.
In mid-December 1987, an army of vans pulled up in front of a nondescript office complex in the heart of sleepy Princeton. A squad of fifty armed federal marshals clad in bulletproof vests burst from the vans and rushed into the office of Princeton/Newport Partners, which was perched in a small s.p.a.ce over a Haagen-Dazs shop. 1987, an army of vans pulled up in front of a nondescript office complex in the heart of sleepy Princeton. A squad of fifty armed federal marshals clad in bulletproof vests burst from the vans and rushed into the office of Princeton/Newport Partners, which was perched in a small s.p.a.ce over a Haagen-Dazs shop.
They were searching for doc.u.ments related to the fund"s dealings with Michael Milken"s junk bond empire at Drexel Burnham Lambert. The man in charge of the case was Rudolph Giuliani, the U.S. attorney for the Southern District of New York. He was trying to build more evidence for the government"s case against Drexel and was hoping employees of the hedge fund, threatened with stiff fines and possible prison terms, would turn against Milken.
It didn"t work. In August 1989, a Manhattan jury convicted five Princeton/Newport executives-including Regan-of sixty-three felony counts related to illegal stock trading plots. Thorp, more than two thousand miles away at the Newport Beach office and oblivious to the alleged dark dealings in the fund"s Princeton headquarters, was never charged. But Regan and the other convicted partners at Princeton/Newport refused to testify against Milken or acknowledge wrongdoing. Instead, they fought the government"s charges-and won. In June 1991, a federal appeals court tossed out the racketeering convictions in the government"s fraud case. Early the following year, prosecutors dropped the case. Not a single employee of Princeton/Newport spent a day in prison.
The biggest casualty of the government"s a.s.sault was Princeton/Newport. It became impossible for Thorp to keep the ship steady amid all the controversy, and his a.s.sociates in Princeton were obviously distracted dealing with the charges against them. Worried investors pulled out of the fund.
Thorp decided to simplify his life. He took a brief break from managing money for others, though he continued to invest his own sizable funds in the market. to simplify his life. He took a brief break from managing money for others, though he continued to invest his own sizable funds in the market.
He also worked as a consultant for pension funds and endowments. In 1991, a company asked Thorp to look over its investment portfolio. As he combed through the various holdings, he noticed one particular investment vehicle that had produced stunning returns throughout the 1980s. Every single year, it put up returns of 20 percent or more, far outpacing anything Thorp had ever seen-even Princeton/Newport. Intrigued, and a bit dubious, he delved further into the fund"s strategies, requesting doc.u.ments that listed its trading activities. The fund, based in New York"s famed Lipstick Building on Third Avenue, supposedly traded stock options on a rapid-fire basis, benefiting from a secret formula that allowed it to buy low and sell high. The trading record the fund sent Thorp listed the trades-how many options it bought, which companies, how much money it made or lost on the trades.
It took Thorp about a day to realize the fund was a fraud. The number of options it reported having bought and sold far outpaced the total number traded on public exchanges. For instance, on April 16, 1991, the firm reported that it had purchased 123 call options on Procter & Gamble stock. But only 20 P&G options in total in total had changed hands that day (this was well before the explosion in options trading that occurred over the following decade). Similar discrepancies appeared for trades on IBM, Disney, and Merck options, among others, Thorp"s research revealed. He told the firm that had made the investment to pull its money out of the fund, which was called Bernard L. Madoff Investment Securities. had changed hands that day (this was well before the explosion in options trading that occurred over the following decade). Similar discrepancies appeared for trades on IBM, Disney, and Merck options, among others, Thorp"s research revealed. He told the firm that had made the investment to pull its money out of the fund, which was called Bernard L. Madoff Investment Securities.
In late 2008, the fund, run by New York financier Bernard Madoff, was revealed as the greatest Ponzi scheme of all time, a ma.s.sive fraud that had bilked investors out of tens of billions. Regulators had been repeatedly warned about the fund, but they never could determine whether its trading strategies were legitimate.
While Thorp was taking a break from the investing game, the stage for the amazing rise of the quants had been set. Peter Muller, working at a quant factory in California, was itching to branch out and start trading serious money. Cliff Asness was entering an elite finance program at the University of Chicago. Boaz Weinstein was still in high school but already had his eyes trained on Wall Street"s action-packed trading floors. was taking a break from the investing game, the stage for the amazing rise of the quants had been set. Peter Muller, working at a quant factory in California, was itching to branch out and start trading serious money. Cliff Asness was entering an elite finance program at the University of Chicago. Boaz Weinstein was still in high school but already had his eyes trained on Wall Street"s action-packed trading floors.
As Thorp wound down Princeton/Newport Partners, he handed off his hedge fund baton to a twenty-two-year-old prodigy who would go on to become one of the most powerful hedge fund managers in the world-and who would play a central role in the market meltdown that began in August 2007.
FOUR OF A KIND
[image]GRIFFIN[image]
In 1990, Ed Thorp took a call from one of his longtime investors, a reclusive financier named Frank Meyer with a gimlet eye for talent. Meyer had a special request. "I"ve got a great prospect," Meyer told Thorp, his gruff, no-nonsense voice booming over the line. He sounded as excited as a college football coach who"d just spotted the next Heisman Trophy winner. "One of the savviest guys I"ve ever met. Traded convertible bonds out of his dorm room on his grandmother"s bank account."
"Who is he?"
"A whip-smart Harvard grad named Ken Griffin. Reminds me of you, Ed."
"Harvard?" the MITeducated Thorp snorted. "How old?"
"Twenty-one."
"Wow, that is young. What do you want from me?"
"Docs."
Hoping to save money, Meyer wanted to use Princeton/Newport"s offering doc.u.ments as a template for a hedge fund he was setting up for Griffin, a lanky, six-foot math whiz with a singular focus on making money. Thorp agreed and shipped a copy of PNP"s legal papers (Thorp had renamed the fund Sierra Partners after the Giuliani debacle) to Meyer"s office. At the time, it typically cost roughly $100,000 to draft the papers needed to set up a hedge fund. Using the shortcut-Meyer"s lawyers essentially changed names on the partnership papers-it cost less than $10,000. The joke around Meyer"s office was that they used the law firm of Cookie & Cutter to launch Griffin"s fund. It would eventually be called Citadel Investment Group, a name designed to evoke the image of high ramparts that could withstand the most awesome financial onslaughts imaginable.
Meyer ran a "fund of hedge funds" in Chicago called Glenwood Capital Management. A fund of funds invests in batches of other hedge funds, pa.s.sing the gains on to clients while taking a cut for themselves, typically around 10 on the dollar. The fund of funds industry is ma.s.sive today, with hundreds of billions of dollars under management (though it shrank like a punctured balloon after the credit crisis). When Meyer launched Glenwood in 1987, the industry was practically nonexistent. a "fund of hedge funds" in Chicago called Glenwood Capital Management. A fund of funds invests in batches of other hedge funds, pa.s.sing the gains on to clients while taking a cut for themselves, typically around 10 on the dollar. The fund of funds industry is ma.s.sive today, with hundreds of billions of dollars under management (though it shrank like a punctured balloon after the credit crisis). When Meyer launched Glenwood in 1987, the industry was practically nonexistent.
Indeed, when Princeton/Newport Partners had closed its doors in the late 1980s, hedge funds were still an obscure backwater in the rapidly expanding global financial ecosystem, a Wild West full of quick-draw gunslingers such as Paul Tudor Jones and George Soros willing to heave millions in a single bet based on gut instincts. Other upstarts included an obscure group of market wizards in Princeton, New Jersey, called Commodity Corp., a cutting-edge fund that largely dabbled in commodity futures. Commodity Corp. sp.a.w.ned legendary traders such as Louis Moore Bacon (who went on to manage the $10 billion fund Moore Capital Management) and Bruce Kovner (manager of Caxton a.s.sociates, with $6 billion). In New York, an aggressive and cerebral trader named Julian Robertson was in the process of turning a start-up stash of $8 million into more than $20 billion at Tiger Management. In West Palm Beach, a group of traders at a fund called Illinois Income Investors, better known as III or Triple I, was launching innovative strategies in mortgage-backed securities, currencies, and derivatives.
But trading was becoming increasingly quant.i.tative, and more and more mathematicians were migrating to Wall Street, inspired by Thorp and fresh waves of research sprouting from academia. Jim Simons"s firm Renaissance Technologies was launching its soon-to-be-legendary Medallion Fund. David Shaw was setting up shop over a communist bookstore in Greenwich Village with his stat arb white lightning. Investors in Thorp"s fund, after losing their golden goose, were on the hunt for new talent. For many, Ken Griffin fit the bill.
Thorp also handed over a gold mine to Meyer and Griffin: cartons of prospectuses for convertible securities and warrants, many of which could no longer be obtained due to the pa.s.sage of time. It was an incomparable archive of information about the industry, a skeleton key to unlock millions in riches from the market. By scanning the kinds of deals Thorp had invested in, Griffin learned how to hunt down similar deals on his own.
The information helped Griffin better discern what kind of trades were possible in the convertible bond market. While Thorp"s records didn"t provide every nugget of every trade, they did provide something of a treasure map. With the records in hand, Griffin had a much better notion for which parts of the market he should focus on, and he quickly developed strategies that were in many ways similar to those Thorp had pioneered decades before.
To learn more, Griffin flew out to Newport Beach for a meeting with Thorp, hoping to study at the feet of the master. Thorp walked Griffin through a series of bond-arbitrage trades and pa.s.sed on priceless know-how gathered in more than two decades of trading experience. Griffin, an eager apprentice, gobbled it all up.
Thorp also described for Griffin Princeton/Newport"s business model, which involved "profit centers" that would evolve over time depending on how successful they were, a concept Citadel copied in the following years. Griffin adopted Thorp"s management fee structure, in which investors would pay for the fund"s expenses rather than pay the flat management fee most hedge fund managers charged, usually around 2 percent of a.s.sets.
Meyer promised to back Griffin under one condition: he had to set up Citadel in Chicago. Griffin, a Florida native, agreed. In November 1990, he started trading with $4.6 million using a single, esoteric strategy: convertible bond arbitrage, the very same strategy Ed Thorp had used.
The son of a project manager for General Electric, Griffin had a high-tech mechanical bent and was always interested in figuring out how things worked. Known for his unblinking, blue-eyed stare, Griffin always seemed to be able to peer deeply into complex issues and take away more than anyone else, a skill that would serve him well in the chaotic world of finance. of a project manager for General Electric, Griffin had a high-tech mechanical bent and was always interested in figuring out how things worked. Known for his unblinking, blue-eyed stare, Griffin always seemed to be able to peer deeply into complex issues and take away more than anyone else, a skill that would serve him well in the chaotic world of finance.
As a student at the Boca Raton Community High School, he"d dabbled in computer programming and got a job designing computer codes for IBM. His mother would ferry him to the local Computerland, where he would spend hours chatting up the salespeople about new gizmos and software. In 1986, when Griffin was not yet eighteen, he came up with the idea of selling educational software to schools, teaming up with some of his pals from Computerland to launch a company called Diskovery Educational Systems. Griffin sold out a few years later, but the company is still in business in West Palm Beach.
During his first year at Harvard, after reading a Forbes Forbes magazine article arguing that shares of Home Shopping Network were overpriced, he purchased put options on the stock, hoping to profit from a decline. The bet was a good one, earning a few thousand dollars, but it didn"t pay off as much as Griffin had hoped: commissions and transaction costs from the market maker, a Philadelphia securities firm called Susquehanna International Group, cut into his winnings. He realized the investing game was more complex than he"d thought, and started reading as many books about financial markets as he could get his hands on. Eventually, he came upon a textbook about convertible bonds-the favored investment vehicles of Ed Thorp. By then, Thorp"s ideas, laid out in magazine article arguing that shares of Home Shopping Network were overpriced, he purchased put options on the stock, hoping to profit from a decline. The bet was a good one, earning a few thousand dollars, but it didn"t pay off as much as Griffin had hoped: commissions and transaction costs from the market maker, a Philadelphia securities firm called Susquehanna International Group, cut into his winnings. He realized the investing game was more complex than he"d thought, and started reading as many books about financial markets as he could get his hands on. Eventually, he came upon a textbook about convertible bonds-the favored investment vehicles of Ed Thorp. By then, Thorp"s ideas, laid out in Beat the Market Beat the Market, had filtered into academia and were being taught in finance cla.s.srooms across the country. Of course, Griffin eventually went to the source, devouring Beat the Market Beat the Market as well. as well.
Like Thorp, Griffin quickly discovered that a number of convertible bonds were mispriced. His computer skills came into play as he wrote a software program to flag mispriced bonds. Hungry for up-to-the-minute information from the market, he wired up his third-floor dorm room in Harvard"s ivy-draped Cabot House with a satellite dish-planting the dish on top of the dorm and running a cable through the building"s fourth-floor window and down another floor through the elevator shaft-so he could download real-time stock quotes. The only problem with the scheme: the fourth-floor window could never be completely shut, even in the frigid Cambridge winters.
During his summer vacation in 1987, between his freshman and soph.o.m.ore years, he frequently visited a friend who worked at the First National Bank of Palm Beach. One day, he was describing his ideas about convertible bonds and hedging. A retiree named Saul Golkin happened to step into the office. After listening to Griffin"s spiel for twenty minutes, Golkin said, "I"ve got to run to lunch, I"m in for fifty."
At first, Griffin didn"t understand, until his friend explained that Golkin had just forked over fifty grand to the young whiz kid from Harvard.
Eager to raise more funds from friends and relatives, including his mother and grandmother, he eventually stockpiled $265,000 for a limited partnership, which he called Convertible Hedge Fund #1 (strikingly close to Thorp"s original fund, Convertible Hedge a.s.sociates). After returning to Harvard in the fall, he started to invest the cash, mostly buying underpriced warrants and hedging the position by shorting the stock (Thorp"s delta hedging strategy).
His timing proved auspicious. On October 19, the stock market crashed, and Griffin"s short positions. .h.i.t the jackpot, tumbling much further than the warrants.
Having weathered the storm, he quickly raised $750,000 for another fund, which he called Convertible Hedge Fund #2.
Griffin"s ability to ride through Black Monday unscathed-and even with a tidy profit-was something of a revelation. The pros on Wall Street had been clobbered, while the whiz kid trading out of his Harvard dorm using satellites, computers, and a complex investing strategy had come out on top. It was his first inkling of the incredible possibilities that lay ahead.
But there was much more work to do. He needed access to more securities. And that meant an inst.i.tutional trading account-the kind of account used by professional traders such as mutual funds and hedge funds. In 1989, Griffin, just nineteen years old, approached a Merrill Lynch convertible bond expert in Boston named Terrence O"Connor and presented what must have seemed like an insane plan: Give me, Ken Griffin, a nineteen-year-old college kid, access to your most sophisticated trading platform, which will allow me to dabble in nearly every instrument known to G.o.d Give me, Ken Griffin, a nineteen-year-old college kid, access to your most sophisticated trading platform, which will allow me to dabble in nearly every instrument known to G.o.d.
Somehow he pulled it off, wowing the bond expert with his technical know-how. O"Connor agreed to bring Griffin on, despite the fact that the average inst.i.tutional account ran around $100 million million at the time. at the time.
Griffin started trading, and calling everyone on Wall Street who would speak with him. A typical reaction: "You"re running two hundred grand out of your dorm room? Don"t ever call me again." Slam Slam.
But some were intrigued by the young Harvard phenom and would explain certain trades they were engaged in-arbitrage trades, why hedge funds were doing them, why the bank itself was involved. Griffin started making trips to New York and sitting at the feet of seasoned traders, sucking up knowledge. He was particularly interested in stock-loan desks, which gave him a peek at which funds the bank was lending shares to-and why.
Shortly before Griffin graduated from Harvard with a degree in economics, he met Justin Adams, a manager for Triple I. The two met over breakfast in a restaurant in West Palm Beach and discussed the market. Over a steaming omelet, Griffin explained how he"d developed contacts with traders at brokerage firms across Wall Street and had learned many of the inner secrets of the trading world.
A former member of the Army"s Special Forces who"d served in Vietnam before venturing into the world of high finance, Adams was agog. Griffin was smart and focused, and he asked penetrating and coherent questions about the market-questions that were so pointed they made Adams stop and search for a coherent answer.
Adams arranged a meeting in New York between Griffin and Frank Meyer, an investor in Triple I as well as Princeton/Newport. Meyer too was floored by Griffin"s broad understanding of technical aspects of investing, as well as his computer expertise, an important skill as trading became more mechanized and electronic. But it was his market savvy that impressed Meyer most. "If you"re a kid managing a few hundred thousand, it"s very hard to borrow stock for short selling," Meyer recalled. "He went around to every major stock loan company and ingratiated himself, and because he was so unusual they gave him good rates."
Griffin set up shop in Chicago in late 1989 with his $1 million in play dough, and was quickly making money hand over fist trading convertibles with his handcrafted software program. In his first year of trading, Griffin posted a whopping 70 percent return. Impressed, Meyer decided to help Griffin launch his own fund. He thought about other funds with similar strategies, and that"s when Ed Thorp came to mind.
Griffin had his office. He had his seed money. He hired a small group of traders, some of whom must have been shocked to be working for a kid who still smelled like a dorm room. The only thing he needed was a name. Griffin and several of his new employees wrote down their nominations on a list, then voted on their favorites.
The winner was Citadel. By 1990, the start of a decade that would see phenomenal growth in the hedge fund industry, Griffin"s fortress of money was ready for battle and on its way to becoming one of the most feared money machines in all of finance.
[image]MULLER[image]
When he was ten years old, Peter Muller went on a tour of Europe with his family. After visiting several countries, he noticed something strange: exchange rates for the dollar varied in different countries. He asked his father, a chemical engineer, whether he could buy deutschmarks in London and make a profit by exchanging them for dollars in Germany.
The young Muller had intuitively grasped the concept of arbitrage.
Born in 1963 in Philadelphia, Muller grew up in Wayne, New Jersey, a half hour"s drive west of Manhattan. He showed an early apt.i.tude for math and loved to play all kinds of games, from Scrabble to chess to backgammon. As a senior at Wayne Valley High School, Muller mixed his obsession with games with another growing interest, computer programming, and designed a program that could play backgammon. It was so effective his math teacher claimed the program cheated.
At Princeton, he studied theoretical mathematics, fascinated by the crystalline beauty of complex structures and by the universal patterns that abound in the more esoteric realms of number theory. Muller also grew interested in music, taking cla.s.ses and playing piano for a jazz band that performed at student functions and college clubs.
After graduating in 1985, he drove across the country to California. A job in New York at a German software company called Nixdorf was waiting for him, but he kept putting off his starting date for various reasons. He wasn"t sure he wanted to go back to the East Coast anyway. Muller had fallen in love with California.
He soon found himself in a gymnasium playing an electric piano as several tightly muscled women danced balletically in leotards while twirling plastic hoops and tossing around brightly colored rubber b.a.l.l.s. He was trying, somewhat desperately, to pursue his music career and had landed a job playing background tunes for a rhythmic gymnastics team.
Apparently the job as a rhythmic gymnastics maestro didn"t pull down enough for food and shelter, including the $200-a-month rent Muller was paying to stay at a friend of a friend"s house. There was also the annoying habit of a roommate who liked to blast off random shotgun rounds in the backyard when he got the blues.
One day, Muller saw an ad from a small financial engineering outfit in Berkeley called BARRA Inc. for a programmer who knew Fortran, a computer language commonly used for statistical problems. Muller didn"t know Fortran (though he had little doubt that he could learn it quickly) and had never heard of BARRA. But he applied for the job anyway, interviewing for it at BARRA"s Berkeley office.
Muller strolled into BARRA"s office confident, his mind crackling with the theoretical mathematics he"d learned at Princeton. But he was completely unfamiliar with the quant.i.tative financial world he was stepping into, having never taken a finance course. He even considered himself something of a socialist and had needled his girlfriend, a parttimer at the Wall Street Journal"s Wall Street Journal"s San Francis...o...b..reau, about being a capitalist shill. But he was theoretically intrigued by how money worked. More than anything, he wanted to start making some of it, too. San Francis...o...b..reau, about being a capitalist shill. But he was theoretically intrigued by how money worked. More than anything, he wanted to start making some of it, too.
Before the interview, Muller made a pit stop in the men"s bathroom and was horrified by what he saw: a cigarette b.u.t.t. A compulsive neat freak and health nut, Muller despised cigarettes. The b.u.t.t was nearly a deal killer. He thought about canceling the interview. There was simply no way he would work in an office where people smoked. Reluctantly he went ahead with the interview and learned that BARRA didn"t allow smoking in the office. The b.u.t.t must have been left by a visitor.
After a string of interviews, he was offered the job, and accepted. Muller didn"t know it at the time, but he had just stepped into the world of the quants.
By 1985, BARRA was the West Coast axis mundi axis mundi of the quant universe. The company was founded in 1974 by an iconoclastic Berkeley economics professor, Barr Rosenberg, one of the pioneers of the movement to apply the ivory tower lessons of modern portfolio theory to the real-world construction of portfolios. A tall, lanky man with a wavy mop of hair, he was also a longtime Buddhist. Rosenberg had always defied rigid categorization. In the 1960s, he"d studied how groups of patients reacted in different ways to the same medication. At the same time, he"d been collecting data on stocks, an interest that developed into an obsession. He noticed that just as patients" reactions to drugs differed, stocks exhibited strange, seemingly inexplicable behavior over time. There must be a logical way to find order beneath the chaos, he thought. of the quant universe. The company was founded in 1974 by an iconoclastic Berkeley economics professor, Barr Rosenberg, one of the pioneers of the movement to apply the ivory tower lessons of modern portfolio theory to the real-world construction of portfolios. A tall, lanky man with a wavy mop of hair, he was also a longtime Buddhist. Rosenberg had always defied rigid categorization. In the 1960s, he"d studied how groups of patients reacted in different ways to the same medication. At the same time, he"d been collecting data on stocks, an interest that developed into an obsession. He noticed that just as patients" reactions to drugs differed, stocks exhibited strange, seemingly inexplicable behavior over time. There must be a logical way to find order beneath the chaos, he thought.
One way to understand how stocks tick is to break down the factors that push and pull them up and down. General Motors is a medley of several distinct factors in the economy and the market: the automobile industry, large-capitalization stocks, U.S. stocks, oil prices, consumer confidence, interest rates, and so forth. Microsoft is a mix of large-cap, technology, and consumer factors, among others.
In the early 1970s, working long hours in his Berkeley bas.e.m.e.nt, Rosenberg had cooked up quant.i.tative models to track factors on thousands of stocks, then programmed them into a computer. Eventually Rosenberg started to sell his models to money management firms that were increasingly dabbling in quant.i.tative strategies (though few were as yet remotely as sophisticated as the high-powered hedge fund Ed Thorp was running out of Newport Beach). In 1974, he started up a firm called Barr Rosenberg a.s.sociates, which eventually turned into BARRA.
In just a few years, BARRA developed a cultlike following. Rosenberg scored a hit with the company"s Fundamental Risk Management Service, a computerized program that could forecast a stock"s behavior based on categories such as earnings, industry, market capitalization, and trading activity.
By the time Muller arrived at BARRA, thousands of managers were running money using the newfangled quant.i.tative strategies. Rosenberg himself left BARRA in 1985, soon after Muller was hired, with a small group of colleagues, to start his own money management firm, Rosenberg Inst.i.tutional Equity Management, in Orinda, California. Within a few years it was managing several billion dollars in markets around the world. (More recently, Rosenberg has drifted away from the worldly pursuit of riches and has been teaching courses on Buddhism for the Nyingma Inst.i.tute in Berkeley.) One of the first projects Muller worked on at BARRA concerned an a.n.a.lysis of the various components of stock returns, the bread and b.u.t.ter of BARRA"s factor models. Just before he left, Rosenberg took a look at Muller"s work and demonstrated his ability to see the push and pull of economic forces at work in the market. the first projects Muller worked on at BARRA concerned an a.n.a.lysis of the various components of stock returns, the bread and b.u.t.ter of BARRA"s factor models. Just before he left, Rosenberg took a look at Muller"s work and demonstrated his ability to see the push and pull of economic forces at work in the market.
"This factor must be oil prices," he said. "Look at the spike during the energy crisis. ... And this one must be related to interest rates."
One problem: Muller had screwed up the math and the data were bunk. He reworked the a.n.a.lysis and sheepishly showed the results to Rosenberg.
"This makes much more sense," Rosenberg said. "This factor must be the oil factor. ... And here"s where the Fed came in and tightened."
While this showed that Rosenberg could quickly convert math and models into real-world events, it also demonstrated that the models could fool the best in the business. Even with all the high-powered math, there always seemed to be a bit of the witch doctor in Rosenberg and the quant methods he sp.a.w.ned. The constant search for hidden factors in market prices could turn into a voodoolike hunt for prophecies in chicken entrails, dark portents in cloud shapes.
The relaxing, sun-splashed atmosphere of BARRA was something of a revelation to Muller after the do-nothing burbs of Jersey and the cloistered corridors of Princeton. It was the mid-1980s. Nostalgia for the sixties was on the rise. And there were few better places to catch that wave than Berkeley, a short hop to the surfer hangouts at Half Moon Bay and the hippie haven of Haight-Ashbury. Of course, working for a financial research outfit didn"t exactly fit the cla.s.sic hippie mold, but Muller was fine with that. He"d had enough of scrounging for money, playing music for peanuts. The $33,000-a-year salary he was making at BARRA was a boon, and there was certainly more to come. Most of all, he was determined that however much money he made, he wouldn"t turn into Ebenezer Scrooge. Rosenberg had already set an example that one could make buckets of money and still retain a sense of spirituality.
And life was good at BARRA. The casual atmosphere. The go-easy dress code. The only guy seen in a suit was the company"s marketing chief. Employees would take long lunches to talk about academic theory, politics, world events. Muller had a girlfriend and was playing part-time in a jazz band. Once a month, a group of employees would take late-night runs under a full moon, followed by a trip to a bar or, even better, an ice cream parlor.
Muller quickly learned Fortran and worked on fixing code for the company, but he was itching to learn more about the real work going on at BARRA: financial modeling. He put aside his music and buried himself in the literature of modern portfolio theory: Eugene Fama, Fischer Black, Robert Merton, the cla.s.sics.