Maneet Ahuja on Hedge Funds and the 'Alpha Masters'Published: December 17, 2012 in Knowledge@Wharton
Maneet Ahuja began her career at age 17 as a credit risk analyst at Citigroup. Now, 10 years later, she has been named to the Forbes 2012 "30 under 30" list, works as a producer for CNBC's Squawk Box and has written a new book called, The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds. She earned a scholarship from the South Asian Journalists Association to attend Wharton's Seminar for Business Journalists, where Knowledge@Wharton recently had an opportunity to talk with her about the Alpha Masters she profiled in her book and where the hedge fund industry is headed.
An edited transcript of the conversation follows.
Knowledge@Wharton: Your book profiles 11 hedge fund managers at nine funds and the big trades they have made. Some win, some lose. It gives a good sense of how this industry operates and the kind of people who run it. You're quite young, and you got into the industry very young. Can you tell us about that?
Maneet Ahuja: I started on Wall Street at Citigroup as an intern when I was 17 years old. It was just supposed to be a semester-long internship. If you go to school in the city, they have year-round positions for folks like me. After 10 months, the lady I was working for decided not to come back after maternity leave. That opened up an opportunity because I was able to juggle the work with school, and I found it really interesting and fascinating.
Knowledge@Wharton: In addition to CNBC, you worked for the Wall Street Journal at one point. It is quite a varied background for somebody still in her 20s. Now you have a book under your belt. What was the reason for writing this book?
Ahuja: I was fascinated by one of the first individuals I met in the hedge fund industry, David Einhorn. In 2007 and early 2008, as the financial crisis was starting to pick up, I was fortunate enough to cover Einhorn during the Lehman Brothers analysis that he put out at the Ira Sohn Conference and the Value Investing Congress. As I spent more time with these hedge fund managers, analyzing them, I noticed that there were a small group of money managers who had profound impacts on the market. If you think about everyone who works on Wall Street, who runs a mutual fund, who runs a hedge fund, who runs a private equity shop, there are very few people who [are able to move the market] when they change a stock position. I wanted to dig deeper and see who these people really were and what their analysis was really all about....
Knowledge@Wharton: I want to run through a couple of the basics on what distinguishes a hedge fund. What are the key features of a hedge fund?
Ahuja: You should think about a hedge fund like a start-up enterprise or a start-up tech shop. They usually start out with just a handful of very successful money managers who spent a lot of time on Wall Street, made a lot of money for their prior employers and are ready to go out on their own. They are private investment companies, so you have to be a qualified investor according to the SEC [U.S. Securities and Exchange Commission] to be able to invest with them. They are very secretive, partially because they are minding their own business and running their own portfolio, but also because the SEC requires that they not market to the public because their strategies are typically riskier and you need a minimum of about $10 million, on average, to be able to invest with one.
Knowledge@Wharton: We have heard more in the news recently about private equity funds which are basically funds that buy companies and develop portfolios of companies and try to make them better. Hedge funds are more likely to be investing in securities -- stocks, bonds, derivatives, that sort of thing. Is that correct?
Ahuja: Correct. Right.
Knowledge@Wharton: In your title, you talk about "alpha." What is alpha?
Ahuja: Alpha, [in] the mathematical sense, just means excess return over the market benchmark. But I wanted to actually take it a step further and look at these alpha personalities, in addition to these Alpha Masters in the hedge fund industry who were moving the market. I looked for people who had a long history of out-performing the S&P and how they did that.
Knowledge@Wharton: In layman's terms, if you have the S&P 500 returning 10% in a decent year, alpha would be some return on top of this that they require to make this worthwhile.
Ahuja: Right. It's not every year; it's a general trend. There are some years where they do underperform. I have noticed that the majority of the managers in the book may have had one or two down years or were [slightly] under the S&P but then came back in a really big way, sometimes more than 63% over the S&P.
Knowledge@Wharton: There's also the term "beta," which you mention a number of times in the book. What is that about?
Ahuja: Beta is just the actual market return. You're always trying to deliver alpha versus beta. There is a big debate going on in the hedge fund industry now about what is actually alpha and what is beta. Some say that a lot of these hedge fund managers are just delivering beta yet charging exorbitant fees -- 2 and 20. It's not making sense for investors. So that's a part of the discussion right now.
Knowledge@Wharton: That fee structure is 2% of assets under management and 20% of profits?
Knowledge@Wharton: The idea is to beat the market and do it with a minimum amount of risk or volatility while you're doing it? That's the basic idea, which sounds very simple but is quite hard to do.
Ahuja: In actuality, it's a little bit tougher.
Knowledge@Wharton: One of your chapters talks about Paulson & Co. John Paulson is one of the most well-known hedge fund managers, especially because he managed to make $15 billion in 2007 when everyone else was losing their shirts. I wonder if you could take us through that chapter and describe what it was he did as an example of how a hedge fund operates?
Ahuja: There is no one example of how a hedge fund is supposed to operate. It was interesting to go through the 11 different personalities in the book. They all had some similarities but were all incredibly different. What I found to be inspiring about Paulson's story, at least in the beginning, is that he didn't start his hedge fund until he was looking at 40. He got passed up for promotions. He was a good merger arbitrage analyst and was doing fairly well. But he was running a pretty small fund until around 2006, 2007, where he was able to identify this trade with a handful of employees who worked for him at Paulson & Co.
Knowledge@Wharton: And the big winning bet was on the subprime mortgage market -- how did that work?
Ahuja: Paulson was able to identify and predict the housing bubble bursting. He purchased something called "credit default swaps," which is like shorting the housing market. Prior to these instruments being available, there was no way to do that. It was a highly contrarian bet to make because everyone prior to that time believed that real estate was a fairly safe asset. There were a lot of subprime mortgages being sold, and banks were getting in on many of the trades, so there was a lot of collusion on Wall Street. No one really understood who was a counterparty and what the risk could entail if the entire system fell apart.
Paulson was able to identify that through his funds research and made very heavy bets in credit default swaps. He ended up netting $15 billion on the subprime trade. He was also one of the first, interestingly enough, to start to go long on housing in about 2009, way earlier than the rest of the Street. Up until about 2011, Paulson was doing extremely well. Things have obviously changed.
Knowledge@Wharton: Subprime mortgages like other mortgages are bundled into securities that are like bonds, and the credit default swaps are like an insurance policy that pays off if the security falls in value. That's what he was betting on. I guess he also used a lot of leverage, borrowing a lot of money so that his wins were amplified.
Knowledge@Wharton: His genius seems to have been that he spotted something that other people didn't spot -- there was a bubble that was going to burst. On the other hand, it wasn't a total secret. Everybody knew that housing prices had been going up faster than wages, which clearly can't happen forever. What do you think it was about his approach that allowed him to take that gamble when other people were all getting a little bit nervous about what was going on with the housing market?
Ahuja: There are always economists who predict market activity in the economy. And there are a lot of analysts on Wall Street who would agree with what you said. The main difference was that he was seeing a high in-flow of assets, and he was able to convince a couple of other friends on Wall Street and counterparties to help him get the assets to make the trade in a very big way. He was willing to bet the farm, as they say, on this one trade. Very few people had the assets and the liquidity to be able to do that at that time or were willing to take that risk.
Knowledge@Wharton: One of the things I noticed in reading the book is that Paulson really started hustling very young. He was selling candy at school at one point, and trading in stocks when he was still a teenager. You get a lot of little stories like that throughout the book of people who just really worked very hard, seemed to be very smart, usually ahead of the game in school. Not always, though. Were there individuals you interviewed who really surprised you? Who just didn't seem like the Master of the Universe stereotype that we think of?
Ahuja: There were a couple of very key examples of situations across the board that surprised me.... I was fascinated to find out that the majority of these billionaire money managers all started out from very humble beginnings. If you're looking for a corollary, I myself started out with very humble beginnings. I know that that's a motivator to succeed. It was interesting to see the stories of them hustling from a very young age.
The other interesting thing I noticed is that they continued hustling. At the point where they were all multimillionaires, they didn't stop. I spoke to one hedge fund manager, Bill Ackman, and I said, "What motivates you to continue to outperform year and year again?" He said, "Well, every year I start again from zero." Investors look at every year on a singular level. It was interesting to know that you can have 10, 15 years of good performance, but investors don't care even though they may be committed for two to three years at a time. The hedge fund industry is looked at month to month and then on a year-to-year basis. A lot of these managers constantly feel the pressure in their small community to out-do each other and to continue to out-do themselves.
Knowledge@Wharton: That's really the same process you see with great athletes like Roger Federer. You could ask, why do you do it? You're rich, you've won all these titles, why bother? They are still just very competitive, and they love the game.
Ahuja: I don't think that it's about the money. It's a rewarding experience for them. [They have] very strong personalities, as you would expect. That wasn't so much of a surprise. But they are willing to take big risks and bet large portions of the fund's capital to single trades. I would mention Bill Ackman. Just getting a 1% stake in Procter & Gamble is a $1 billion position. His fund is only about $10 billion, so relative to the size of his fund, that's a huge position to take on one bet. These managers all have a very strong conviction in their analyses. I noticed that they were able to take the emotion out of the investing process, which they all cited as highly, highly important and key. That actually helped them to pare back on positions, because they have all, at one point, made big mistakes. Many of the managers had several scenarios where they almost risked losing the fund on a single bet. They learned from those mistakes early in their careers. Some had to close their fund and start again. They called on that in the recent financial crisis. Because of that, most of them were very profitable during that time.
Knowledge@Wharton: They are very intellectually curious as well. One of the things that comes through in a lot of the quotes is that they really just love detecting some new truth or what they believe may be some new insight that they don't think anyone else has. And that seemed to drive them forward. Now, when you look at the kind of educations they have, were there any common denominators in the kind of education that seemed to be key to success in this industry?
Ahuja: There were some people who had the education of just investing from a very young age, taking bets on themselves. People like David Tepper who went to Carnegie Mellon and before that to the University of Pittsburgh. He never really had good grades in school. He was a C or D student, and he would skip class to go hang out with the nuns across the street, even though he was Jewish, because they had free pancakes. I would say that about half of them really excelled at school. Folks like Ray Dalio never really adjusted to the school environment and didn't really excel until a bit later in life. Once ... you're motivated by something you enjoy, you tend to devote a lot of energy and become really good at that skill.
David Einhorn [went] to Cornell but he doesn't have an MBA or a CFA. I asked him if that's something he thinks that people who want to emulate him should try to do achieve. He said, no, the best education is just being a very diligent investor and studying your investments and the companies' balance sheets and financial statements and learning that way. I wouldn't necessarily say that getting an MBA from Harvard or Wharton guarantees you to be a great investor.
Knowledge@Wharton: But being intellectually curious and working hard and studying constantly, always learning -- that was another thing that comes through. These guys are always learning and looking for the next insight.
Ahuja: They are in their 50s and 60s, and they are constantly looking for ways to do their jobs better, even if it means risking having investors pull out of the fund. People like Ray Dalio, he was at one point over $160 billion and today he's at $120 [billion]. He's still the world's largest hedge fund manager. But when he was at a $160 billion, he figured out a way to manage risk better. Many investors didn't want to conform to that way. It was just pure alpha strategy. They didn't want change, and he basically said, "That's too bad. If you want to stay in the fund, we're changing how we do things." He went all the way down to $90 billion, lost about $70 billion of investors' money, but now has a model for the industry and out-performed over the last couple years and has people dying to get back into the fund.
Knowledge@Wharton: I also noticed that almost all of your subjects, except for one, were men. The public has this view that this is a men's club, a male-dominated industry. Is that true, and is that changing?
Ahuja: I would say that there need to be more women in senior roles across the work force. On Wall Street, we are seeing a lot more successful female investors, but I was looking for the top performers right now who had been managing large sums of money for over 10 years. On that scale, Sonia Gardner was definitely in that realm. Are there other great female investors? Will there in the next five years be women who are Alpha Masters? I would hope so. I would say definitely. I do see more women entering into the hedge fund industry and Wall Street in general, but I think overall it's still an uphill battle for women across the workforce to get into senior positions.
Knowledge@Wharton: In terms of strategy and investing styles, I know they vary radically. From your research, do you see any trends, and if so, is that just due to the opportunities that are available or is it due to an advance in their thinking?
Ahuja: There are two different things that I'm noticing right now. Number one, I'm seeing a lot of pension funds and endowments and [an interest] in the activist investing space -- also sovereign wealth funds, but there's less information publicly available about them because they choose to stay behind the curtain, so to speak....
Number two, I'm seeing that a lot of managers -- at least the top 10% -- are using credit default swaps, not just as a way to get higher returns, but to manage risk. I would predict that it should become a more standard practice across the industry.
Knowledge@Wharton: The industry certainly has its critics. All the alternate investment fields do, including the private equity funds and other forms of funds. One of the criticisms is that a lot of this is not creating anything or making anything. They're not starting a new car company and hiring thousands of people to do it. They have their own employees. But a lot of these bets are sort of zero-sum games. With a credit default swap, you make money but somebody else loses it. For society as a whole, there's not really any change. I'm wondering whether you have a sense of whether their role in society is a positive role or a negative one, as some critics claim. What is the social benefit of having it? What if the hedge fund industry were to disappear over night? Is there any reason why those of us who are not investors or employees would care?
Ahuja: Hedge funds really do a great [deal] to make the markets way more efficient, for the basic reason that they are willing to take risks that many other investors aren't. They are very often the counterparties to banks on transactions that have become the norm on Wall Street. One could argue that Wall Street itself is a zero-sum game. Part of the problem with the financial crisis was that the banks were behaving like hedge funds when they had a fiduciary responsibility to their depositors and investors and clients to behave like a bank. When people and institutions and organizations do what the government wants them to do and has said is legal for them to do, then they are doing their part to provide efficiency to the markets.
On a second note, retail investors actually do benefit from hedge funds, even if they are not directly invested. Many of the managers profiled in my book had a big part in unveiling frauds. These short sellers like Jim Chanos, who was the one behind uncovering Enron, WorldCom and Tyco. Now they choose to speak to journalists when the time is appropriate, and we follow the normal protocols to be able to bring this fraud or these accounting frauds to the market. I know for a fact that they are trying to have a more active discussion to work with the SEC so that instead of being more reactive we can be more proactive.
There is an upside when an activist makes a big change in a company like JC Penney as Bill Ackman has committed to doing; all the improvements that are expected to come through in the next year or two make the shopping experience a better experience. The same can be said of Burger King and also companies like Target. There are some examples of successes and some examples of failures, of course. But, again, to go back to Bill Ackman, with General Growth Partners, he saw a more than 200% return on that investment, and I know for a fact and I had heard at investment conferences, that other retail investors got in on that trade right after it got back into the market, and they became millionaires just riding out what these hedge fund managers were doing on the long side.
Knowledge@Wharton: I think the public has a hard time understanding processes like short selling and the sort of things that sound like betting on disaster. But, in fact, they're providing insight that is just as useful as the insight for those who are betting on the upside.
Ahuja: Right. Eventually some frauds come to light and some don't, but many investors and stockholders lost their entire worth by being invested in companies like Enron. It's better to bring that to the market rather than risk the general public losing their life savings. Everyone has a motive for everything that they do, and short sellers are no different. They are investing in the market on the down side. When CEOs come on a business news channel to talk about their company, they are trying to push the stock up and have a vested interest in doing so on the long side. Every time anyone speaks publicly about a company, there's an interest in why they're doing so, unless you're a journalist like us.
Knowledge@Wharton: Now before we finish I want you to take out your crystal ball and say what you think will happen with this industry in the next five or 10 years. Is it going to grow? Has it reached a sort of saturation point, or will it shrink? What do you think?
Ahuja: It's a tipping point for the hedge fund industry right now. They're seeing a lot of legends in the hedge fund industry retire, like Louis Bacon, Stanley Druckenmiller, Carl Icahn, turning into family offices and basically shuttering their doors for investors and citing difficult market environments. Investing today is definitely much harder than it was 20 years ago. You can't really be the value investor, the sole value investor that you were back then following the Warren Buffett model because you basically need to have a minor or a degree in economics and understand how different economies in the world are affecting our markets here in the United States. Things are more interconnected than ever before, and that's making a lot of the older, legendary hedge fund managers retire. It's also making a lot of the start-up funds close their doors as well. People who thought that they can be like a David Tepper or a Dan Loeb deciding to go out on their own, raising money, after a year or two are very preemptively just shutting their doors.
The industry is getting more and more competitive. I would say it definitely is, and it breeds more competition as we're seeing across Wall Street. I wouldn't say that I see the hedge fund industry expanding, but I would say I probably see it evolving into a better oiled machine.