White-knuckle ride on the Soros express: The Wall Street wizard is having to take more and more risks to maintain the huge returns for investors

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The Independent Online
GEORGE SOROS is as close as anyone in the financial markets to becoming a legend in his own lifetime.

He has already become a guru - where he leads, other investors follow. His status has been confirmed twice this year. When it was revealed that he was buying shares in Newmont, a gold mining company, the market responded by pushing up the price of gold shares and gold itself. When Soros announced a deal last week to invest in property through a joint venture with British Land, property shares rose.

Soros has been raised to his exalted status by a number of recent and well-publicised coups. The best-known, and probably the biggest, was the pounds 1bn profit he made out of the Bank of England during the ERM debacle last year. But the groundwork to his fame has been laid over the past two decades by the astonishing and consistent performance of his investment funds.

In 1990, for example, his main fund, Quantum - one of the world's most formidable investment machines - grew by 68.1 per cent or a net dollars 1.1bn ( pounds 714m). This is not exceptional. Since its inception in 1969, the fund has had eight years of more than 50 per cent growth, including two when it went up more than 100 per cent. It has lost money in only one year, 1981, when it fell by 23 per cent. To put this performance another way, if you had invested dollars 100,000 in Quantum in 1969 and had reinvested the annual dividends, you would now be worth well over dollars 80m.

These are not just unusual returns; they are in a different universe to those of most investment funds. To many experts in New York and London, Soros is a genius.

But some people wonder about the basis for this astronomic performance. There is no suggestion that Soros bears any similarity to Ivan Boesky, the insider trader, but for a long time Boesky's arbitrage funds produced returns that were too good to be true, while no one questioned how he did it. With George Soros, however, there is considerable interest in how a fund manager can make so much money so consistently.

The structure of the Soros investment machine is quite simple. There are now five funds. Quantum invests in almost anything from currencies to commodities, as does the Quasar fund. Quantum Emerging Growth invests in smaller markets mainly in the Far East and Latin America; the Quota fund is farmed out to a range of managers around the world, and the new Realty fund invests in property.

The funds are now worth a total of about dollars 9bn, with Soros himself owning between 15 and 30 per cent of them. His main shareholders are European since US law prohibits American investors from buying shares in offshore funds such as Quantum.

Although he is a shareholder, he runs the funds from his company, Soros Fund Management, as a consultant and earns a fee of 1 per cent. He also gets a 15 per cent performance fee (lower than the 20 per cent charged by many US fund managers), which earned him dollars 150m last year and dollars 50m for his right- hand man, Stanley Druckenmiller.

According to Edgar Astaire, the leading dealer in the shares in London, you can buy into Quantum at around dollars 25,500 a share. Stakes in the other funds range from dollars 140 to dollars 250. Demand for the shares is so high that they trade at up to a 40 per cent premium above net asset value.

The funds, however, had humble beginnings. Soros set up Quantum in 1969 with a starting capital of dollars 4m, based in Curacao in the Netherlands Antilles. It was a so-called 'hedge fund' which, in those days, involved 'shorting' techniques (for example, selling currencies or equities the fund does not own) to hedge risks. Soros was among the first in this field, although other aggressive fund managers, including Julian Robertson, Michael Steinhardt, Bruce Kovner and Paul Tudor- Jones, have since jumped on the bandwagon.

Soros's funds grew, and in the early 1980s he was again among the first to use financial derivatives - such as futures, options and swaps - in increasingly complex patterns to maximise investment returns. Soros gave a memorable demonstration of his technique and the risks it involved when he predicted the stock market crash of 1987. Unfortunately, he predicted it would hit hardest in Japan, so he heavily shorted Tokyo equities and hedged this by buying shares in New York. When it came, the crash hit New York much harder than Tokyo. Soros is said to have lost dollars 1bn in less than three weeks. Only a big outperformance earlier in the year enabled Quantum to limp in at the year end with a 14 per cent net asset increase.

Soros, who regards himself as an intellectual of the financial markets, has evolved a sophisticated theory about the way markets work, which he describes in his 1987 book, The Alchemy of Finance. There is a constant interaction between economic fundamentals and the way people perceive them. The trick to the investment game, he believes, is to understand how the markets perceive the fundamentals. It is what the markets think that matters most.

Certainly, Soros seems to have few peers in understanding market psychology. He is careful to be well informed and has, for example, built up formidable contacts in central banks around the world. A detailed knowledge of Bundesbank policy almost certainly played an important part in his play against sterling last September.

Most of the time, however, Soros's activities are shrouded in secrecy even from his own shareholders, because his funds are exempt from any reporting requirements. One reason for basing his funds offshore is that his European investors do not want to pay US tax on their gains. But the offshore status also means that these aggressive funds, with their ability to influence whole markets with staggering effects, are completely unregulated either by the Securities and Exchange Commission in New York or any other national regulatory authority. Nor is Quantum required to make the exhaustive filings to the SEC on its activities that are required from onshore US companies.

So far, the SEC seems unworried by this. It produced an exhaustive 500-page report on offshore funds last year when it emerged that the hedge funds - including Quantum - had been big buyers of US Treasury bonds at auctions in which Salomon Brothers is now accused of having tried to execute a market squeeze. Salomon is now subject to legal action, but the funds have always denied they were involved in any conspiracy to fix the market. The SEC report concluded that for the time being, the funds did not need to be more closely regulated.

The lack of stringent reporting, however, means Soros's shareholders have little idea of the real risk in their investment. When people buy shares in Soros funds, they are putting all their faith in the judgement of one man. 'Soros enjoys risk but he calculates everything carefully,' said Mr Astaire. 'He isn't a gambler.'

Yet even compared to other hedge fund managers, Soros appears to be a risk-taker on a huge scale. 'I try to pick undervalued stocks and short overvalued stocks,' said David Nicholson, manager of a Florida-based hedge fund. He is typical of a large number of conservatively run hedge funds. Soros, however, prefers large speculative bets on the direction of the whole market. His vast returns seem, perhaps not surprisingly, to be the reward for taking massive risks.

What may be more worrying for some shareholders is that the risks seem to be getting bigger with each passing year.

'A key area in the 1990s is going to be the risk assessment,' said one hedge fund manager in New York last week. 'I hope it won't happen as a result of one of these big players being caught with their pants down.'

The danger, he believes, is that the big players like Soros are being forced into taking greater risks to keep up their high returns. This is partly because Soros started out in areas such as derivatives very early on - five or 10 years ago - when there were fewer players and it was relatively easy for them to take advantage of discrepancies in the market. But the markets have changed. Now there are many more big and sophisticated derivatives players, such as the banks and Wall Street brokerages, so the opportunities are fewer. Pure sophistication is no longer enough to stay ahead - taking bigger risks is.

As they grow larger, the funds also need to invest ever greater amounts of money - so they are drawn to the most liquid markets, such as global currency markets. Increasingly, very large returns can only be generated by placing huge leveraged bets in very risky areas such as currencies.

The most startling illustration of this was Soros's play against sterling last year. By leveraging his funds to the hilt, he bet dollars 6bn on the currency markets. That time, it paid off with a handsome profit.

It is this kind of spectacular coup that has made Soros a guru. Markets - particularly US markets - love to follow a leader. In the early 1980s, Henry Kaufman of Salomon Brothers could move markets by a few words. In the mid-1980s investors followed Ivan Boesky in the corporate share market. Now Soros must be well aware that he has a similar power.

Not everyone is happy about this. 'Soros uses his guru status to move markets,' said a London gold fund manager. 'He is far too sophisticated not to know this. He bought his stake in Newmont Mining in a manner to create his own publicity so that his view of a rising gold market became a self-fulfilling prophecy.'

With impeccable timing, this fund manager believes, Soros noticed that the equity markets around the world were drifting and that investors wanted to be shown a new direction. He chose gold and property. 'The danger is, people follow him into something, but they don't know what he's going to do next; they don't know his strategy.'

In neither property nor gold, however, has Soros hit the market at the bottom. Property shares had been rising for weeks in London before he announced his deal with John Ritblat's British Land. And he bought into Newmont after its shares had risen sharply to a disturbingly high multiple of more than 30 times earnings.

Because these moves do not look spectacularly clever, rumours have already begun to circulate in the markets that Soros is up to a more devious game. One suggestion is that he has shorted US Treasury bonds and by moving into gold and property - traditional hedges against inflation - he is trying to create an inflation scare that will depress the value of the bonds. There is no evidence this is true, yet the fact that such a rumour exists shows there is both fear and suspicion of Soros in the markets.

What worries some experts - particularly among other hedge fund managers - is that Soros's run cannot last for ever. Genius or not, he may one day trip up. If he does, for one reason or another, it will be on such a scale that the effects could be cataclysmic for his investors.

(Photograph omitted)

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