Speaker 1:
From the library of the New York Stock Exchange, at the corner of Wall and Broad Streets in New York City, you're Inside the ICE House, our podcast from Intercontinental Exchange on markets, leadership and vision in global business, the dream drivers that have made the NYSC an indispensable institution for global growth for more than 225 years. Each week, we feature stories of those who hatch plans, create jobs, and harness the engine of capitalism right here, right now at the NYSC and ICE's 12 exchanges and seven clearing houses around the world. Now here's your host, Josh King, head of communications at Intercontinental Exchange.
Josh King:
It was 19 years ago that one of the most perplexing football stories began to take shape. Hall of fame running back Barry Sanders, expected to lead the Detroit Lions for his 11th season, surprised the world by announcing that he was retiring via a fax to the Wichita Eagle newspaper. What does this have to do with today's podcast? Our guest, John Arnold, is known for reading the natural gas markets like Sanders read the football field. He was three steps faster than everyone else in knowing where to juke, when to hurdle, and most importantly, when it would be better to reverse momentum and pivot when everyone else was charging upfield. They also share something else. In 2012, just a decade after growing his own firm Centaurus Advisors from an initial $8 million investment to around $5 billion in assets under management, John announced that he was retiring to pursue other interests. He was a few years older than Sanders, but had years left to remain on the Fortune 40 under 40 list. Our conversation with John about that decision and how he now spends his time, right after this.
Speaker 1:
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Josh King:
Our guest today, John Arnold, co-founder of the Laura and John Arnold Foundation was dubbed the king of natural gas, for his early success trading in the nascent days of online energy trading at Enron. He founded Centaurus in 2002, which he ran until 2012. John is the second Inside The ICE House guest to sign the giving pledge, promising to give away most of the 3.5 billion that he earned over his career. He and his wife signed the pledge in 2008, the same year that they started the Laura and John Arnold Foundation to make, as they say, strategic investments in criminal justice, education, evidence-based theory and innovation, sustainable public finance, and research integrity. Since 2011, the foundation has awarded $967 million or more in grants to invest in a variety of strategic investments. Welcome to the ICE House, John.
John Arnold:
Thank you. It's a pleasure to be here. It's been a while since I've talked about a lot of these subjects. I hope we don't go too deep into football, but I do like the analogy.
Josh King:
Well, you also were pretty deep in hockey. I mean, you were arbitraging geography and hockey cards way back.
John Arnold:
I was interested in business from very early age. I remember when I was 12, 13 spending my summer walking around the block, trying to find yards to mow for $15 a hit. And when I was 14, 15, I figured that my nascent baseball card collection could turn into a bit of a business. And through a bit of starts and stops, I came across that there were these geographic arbitrage pricing specifically on hockey cards, but in sports cards generally.
Josh King:
Because Toronto Montreal were looking for the Bobby York cards, and you had plenty of them in Texas, but not many up in Canada.
John Arnold:
Exactly. So, I started this wholesale. In retrospect, I'd call it geographic pricing arbitrage, of buying cards in Texas, shipping them out up to dealers in New York, up in Canada, and then also doing the reverse arbitrage on things that were priced higher in Texas and buying them from across the country.
Josh King:
Was that the most profitable sub 15-year-old job you had, or what were the other ones?
John Arnold:
It allowed me to pay for a year of college. And also I think gave me a appreciation of money, and spurred me to decide to try to do college in three years rather than four, because I didn't want to spend what was left of my money on year four.
Josh King:
You did Vanderbilt in three years?
John Arnold:
I did.
Josh King:
So, in terms of geographic arbitrage, John, I'm wondering if the same things that apply to hockey cards apply to natural gas. As I said, in the introduction you were given the name, the king of natural gas for your smart decisions in the futures market to the late 1990s and 2000s. How did the market evolve over that time, and where has it gone since then?
John Arnold:
Well, I think when we just talk about the market of natural gas, have to even start before the '90s, and the '60s, '70s and '80s, which was a mishmash of poor regulation that led to fixed price gas, and had the direct effect of creating surpluses and shortages. And so, by the late '80s, the regulators decided that this market had to change. And they did this by regulating the pipelines, unbundling the merchant services associated with pipelines, and requiring title to transfer between the producer of natural gas and the end user of natural gas. And then with FERC Order 636 coming in 1992, which completely unbundled that merchant service from the pipelines, that really started this whole merchant energy independent business, which led to the creation of Enron's merchant business and then many others.
Josh King:
And we're going to get into Enron's business in a minute. And now, I mean looking at the last 10 years or so, going from the beginning of the fracking boom, to where we are today, how do you see the market sort of where we sit today?
John Arnold:
It's been a just remarkable 10-year change in the natural gas market. And you look at it for the 40 years leading up to the 2006, 2007 production in this country was pretty flat. And so, we had spent 40 years of escalating prices. It was getting harder and harder to find the next molecule of gas. Meanwhile, demand for gas specifically within the power sector, was increasing. And so, prices were going up with the flat production, the beginning of the gas shale boom, which call it 2005 to 2007 when it really got started. And then 2008, when you started to see rural volumes, and you could extrapolate where this was going and it's just had dramatic effect. It was 10 years ago when we were still building L and G facilities to import gas. And now of course, those have all been turned around. And now United States has the cheapest natural gas of any developed country in the world and is a major exporter.
Josh King:
Do you remember where you were in 2005 and sort of the first either journals you read or rumors you heard about this new oil shale extraction process that was going to be revolutionary?
John Arnold:
I've always invested in energy assets along the way as well. And I remember a meeting we had looking at the Marcellus.
Josh King:
This is the area in the Allegheny Mountains and into New York?
John Arnold:
Exactly. Somebody came in and showed the area reserved, and we're planning on drilling, and needed some capital to drill. And they start looking at their projections, just this one tiny private company. And what their projections were for production. And you start looking at what was the tier one acreage, the tier two acreage. And if these projections held on this little piece of land, just start multiplying. And what does that mean? And the numbers were so staggering that it was almost hard to believe. You see this and you come to this math, but you can't believe it because the numbers were just so staggering. But then we started to see those real volumes show up, starting with the Barnett shale and then Fayetteville shale, and then the proliferation of the shales across the US.
Josh King:
So you were mentioning in the prior part of the conversation this move from the United States being a net importer to a net exporter. Do you see the conversion as potentially upsetting the balance of the world's market, and even having sociopolitical ramifications?
John Arnold:
There's been a lot of theories about this, about number one, what does energy independence mean for America? And what does that mean for our military interests in the Middle East and in other places? Unfortunately, I'm not sure that's really translated into our military policy to date. One would hope that one of the benefits of energy independence is that we could spend less money as a society on our military, but that hasn't proven to be the case. There's questions about what will US as an exporter mean for Europe and Europe's historic reliance on Russian gas imports, and whether Europe can start moving away from those Russian imports and use United States gas.
Josh King:
I saw you tweeting maybe just in the last couple days about the auto business, being a difficult business in even normal times. But in times like these, what role will the car industry play in the coming years in stabilizing or destabilizing the cost of energy in the United States?
John Arnold:
The intersection of autonomy of cheap electricity through renewables and ride sharing, are all complimentary technologies. And there is a very believable story that transportation becomes a service in the future rather than people owning their own car, do much like you do in New York where you just take a car right now, driven by somebody else. But potentially in the future, that's autonomous, which will cut the marginal a cost of that ride significantly.
John Arnold:
And so what does that mean? Autonomy and electrification at least today, have significant fixed costs upfront. If you can amortize those costs across many more miles, then these become very cost effective technologies. And so, that's why the complement that as ridesharing picks up, that means an individual car can be used for many more miles, which then allows you to amortize the fixed costs over those miles. And it could be revolutionary in terms of oil demand.
Josh King:
I had a mind blowing experience just on Sunday. You and I were talking before we went on air about picking our kids up at camp. I was up in the Berkshires heading back to New York. And we just got a new car, an Acura, and I've been sort of loathed to press a lot of buttons on it. And I set cruise control for 75. And I pressed the autonomous spacing mechanism, which I'm sure has been around for many years, but the first time I ever played with it and I just found myself completely zoning out in traffic of going from 75 miles an hour to a complete stop in highway traffic.
John Arnold:
I had a very similar experience a couple days ago when I had rented a car, and it had the lane centering.
Josh King:
Lane centering. I had lane centering going too.
John Arnold:
And whenever I start drifting off, it's pushing me back into the center. And then eventually after an hour doing this, I get comfortable. I take my hand off the steering wheel, and the car starts going crazy. Get the hands back on.
Josh King:
Unbelievable where our world has come. But let's go back 20 years to the Enron days, John. You joined right out of Vanderbilt where you studied math, the topic that you excelled in from an early age. How did you develop that interest in math? And did that background provide a foundation for the career to come?
John Arnold:
I remember, I think I was in sixth grade. I was raised Jewish. My brother had done a bar mitzvah. And in sixth grade, I was doing eighth grade math. And then I would go to Hebrew school on Wednesday after school, and I'd be doing fifth grade Hebrew. And that was a very strong indication to me that my future lay in the quantitative fields. And so, I followed that. I was again, very interested in business and remember reading Liar's Poker in high school.
Josh King:
Michael Lewis' best seller, Salomon Brothers.
John Arnold:
Yes. And so, I didn't know anything about banking. I didn't know the difference between investment banking and trading. But I had read enough about the culture of it and about how young people could succeed, that I knew that's where I wanted to be. That's where the action was. So, I grew up in Dallas. My mom was an accountant. My dad was a corporate lawyer. I went to Vanderbilt. Again, very far from Wall Street, and didn't have that flavor taste of it. But when I came out of school, I wanted that job. And I applied for a number of jobs in New York. Not many of the banks were interviewing at Vanderbilt, and got turned down from all of them.
John Arnold:
And the best job I got coincidentally, was back in Texas. And this was Enron even growing up in Dallas at the time in '95, I had never heard of Enron until that interview process. It was nickname was the investment bank of the energy industry, and had been ranked number one by Derivatives Magazine for natural gas derivatives. And I thought, this is close enough. I'll go try that for a couple years, go to business school, and then try again for Wall Street.
Josh King:
So, come to you for quantitative analysis, not necessarily bar mitzvah for tutoring.
John Arnold:
Exactly.
Josh King:
When I think of you, I think about your career, I think about Malcolm Gladwell's outliers. Take me through the first couple of years at Enron, and how you went from being a trading assistant to you're leading the natural gas desk in just a matter of months.
John Arnold:
So to back up just one step at a college, I double majored in economics and math with a concentration in statistics, which in retrospect was the perfect degree to get into trading.
Josh King:
Kids, make notes.
John Arnold:
Economics is how do you price and allocate scarce resources, and statistics you learn that the concepts of expected value and probably distribution function, and causality and regressions. I remember doing my interview at Enron, the super Saturday, where you go down to Houston, get the five interviews. And I happened to have an interview with the head of quantitative research. And I didn't know it when I stepped in, and I'm talking about how I like statistics. And in his mind, I think he's thinking, "Game on." Get the job offer. I accept it. Analysts coming in from undergraduate generally go to the trading floor. And they had seen something in me.
John Arnold:
I got very lucky with timing that happened throughout my career in that, a couple people had left the oil trading group a few months before I was supposed to start. And I get a call from Enron. They say, "If you can start immediately, you can start on the trading floor." And I said, "Well, I still have two or three weeks at school, but I'll come the Monday after that." And sure enough, I did. I showed up, and I was the only undergraduate that was on the trading floor that had the first rotation on the trading floor. And I got the huge benefit of getting that first job, was the perfect one for my skill set.
John Arnold:
And so, I never left the trading floor. I was supposed to rotate through all the different divisions of Enron for the first each six months, and just never did. I stayed in trading. So, I was in oil trading for the first year. And something very-
Josh King:
Was that you keeping yourself on the trading floor, or did upper management say, "Keep this Arnold kid where he is. He's doing great,"?
John Arnold:
I think both. I certainly felt very much at home. I realized that I had a knack for this, as well as my boss and my boss's boss liked me. But that first year when I got there... So, I started at Enron in 1995 and 1995, '96 was a very significant year for natural gas. Again, the market had recently been deregulated, so still very nascent. But there was a severe cold front in the Eastern part of the United States. And it was the first time where you had significant geographic basis differentials blow out. So, gas that was in Louisiana and east was worth one price, and gas that was Texas and the west was worth another price. The ramifications of that was, nobody knew what gas was worth anymore.
John Arnold:
So, all this experience that people had who had been in the industry for a decade or two decades, was all worthless because this was a completely new environment. One of the basis desks at Enron, hadn't had a good run of it that winter. Removed those traders and they decided, we'll take this older gentleman who knows the natural gas business really well, but doesn't know trading. And we'll pair him with a young guy that knows the numbers and the quantitative aspect, doesn't know anything about gas. We'll put them together and see if they can figure it out. And so, that was my start in the gas trading area.
Josh King:
The founder and CEO of Intercontinental Exchange, Jeff Brecker spoke on this podcast about the discussions that he had with Enron as both were working to electrify the markets. And in 1999, Enron introduced Enron Online. Let's listen to this clip.
Jeff Brecker:
Enron Online will change the markets for many, many commodities. It is creating an open transparent marketplace that replaces the dark blind system that existed. It is real simple. You turn on your computer, and it's right there. And if you want to do business, you push the button.
Josh King:
I keep thinking of that Enron audio cue. I hadn't heard of for 20 years.
John Arnold:
We used to make so much fun of that last bit.
Josh King:
How were you able to adapt the new environment of online trading, and what was the hardest market behavior to translate from traditional ways of trading to the screen of Enron Online?
John Arnold:
There's story of Enron Online was fascinating as a business case study, which the idea for it was originated, I think in 1997, by a gas trader in London. And previous to the standard convention of how you traded then, is if you had physical gas that you needed to buy yourself for the next day, you'd call the various gas merchants. You might make four calls, find out who had the best price, go call that person back up. What happened if the price changed? It was a mess. It was just terribly inefficient. And her idea was what if we just put all of our prices online? Now, this was a bit scary for Enron, because this disrupted their business. This was really during an era of disruption. If you remember the late '90s, the whole internet boom. But it was all when Clayton Christensen came out with his book, Innovator's Dilemma, I think in 1997, which was, if you don't disrupt your business, somebody else is going to do it for you, so you might as well do it. And so, that concept was very much fresh in management's mind.
John Arnold:
And so, Enron had benefited from opaque pricing. It was the place that would generally give you decent two ways. When you called up, stand on the markets, we could deal in any product for any size. We were disrupting our own business by providing the price transparency, one price to all. And that was very scary. The flip side, I think, what the benefit was was threefold. One was, if we could more volume, even though our margins came down, if we could capture more market share, that might maintain a profitability. Second was, we were the biggest trader in the market, both in physical and financial. So, we had a lot of physical gas we needed to place or that we had obligations to take. So, if we had so much of it going through us, that it would make our job easier, both from placing physical gas, as well as taking speculative financial positions. The third way was, because we were in the center of all this flow, we could figure out what everybody else was doing. We saw very high percentage of the transactions that happen in the industry. So, we would be able to see things develop before others.
Josh King:
Was that you seeing them and making these conclusions, other analysts, sort of the group think of the data being sort of in front of everybody's eyeballs?
John Arnold:
This was before the time of really big data. So, we weren't mining this, trying to figure things out. It was more just the intuition of, you see these trades go through your system, and you see the counterparties, and you can start piece seen together the story of the market. I had never used technical analysis in trading. Because I think that was really trying to piece together what's the story of the market, trying to quantify the psychology of the market because we were in the center of all that volume, I didn't have to use technical analysis. I could see that volume coming through and tell the story of the market, just by seeing what others were doing.
Josh King:
Just sort of like geographic arbitrage and hockey coins.
John Arnold:
It all comes back.
Josh King:
Enron Online was one of the most profitable divisions of Enron leading up to that company's collapse. While you weren't involved in that, your emails became public as part of the investigation. Looking back, what are your takeaways from the experience that helped you immediately after that, to move on and still resonate with you two decades later?
John Arnold:
So Enron Online was a trading tool. But it wasn't its own PNL center. It was just a mechanism to trade. But we still, each trader had the responsibility of managing the position that came from that, of setting the prices to deciding whether he or she wanted to get long, short, et cetera. But it was a crazy two years. And I think about it, I would come in at 7:00 central, I'd have to turn on the system. I'd have two ways, live two ways in a multitude of products that I would keep live accurate tradeable from 7:00 AM to 3:00 PM every day, Sunday nights as well. And although it was only open for two years, I think it probably took four years off my life. But it was just an incredible, crazy experience that very few people, I think have ever had an opportunity to be a part of.
Josh King:
One of the bits of history that's not all that well known is that UBS bought Enron Online, or at least what remained of it, I think. And you were offered a position at UBS. Were you tempted to join your colleagues there?
John Arnold:
So late 2000 Enron stock's around $80. By October of 2001, the stock crosses $20 on the way down. And the rhetoric on the company is terrible. And that was when the people started wondering about the credit quality of Enron. And of course, trading at that point a significant component of it was over the counter. And so, you had to take the credit worthiness of many counterparties and other counterparties took the credit quality of Enron. And once the market started to lose that, it became clear that Enron as a standalone trading company, wasn't going to last. So, management started the process about trying to bring in a joint venture to bring the credit into the business.
John Arnold:
The three finalists were JP Morgan, City Bank, UBS. All had either negligible or tier three trading shops, but had money, had credit. And so, combined what Enron had with what the banks could provide, and it seemed like a good way to preserve value of the trading floor, both for Enron and then later for the estate of Enron. And I looked at that deal. They eventually went with UBS, and I was very intricately involved in the negotiations and the due diligence process of that. But decided that I, at the rip old age of 26, had enough confidence that I wanted to go do my own thing. I wanted to be in control. I wanted to have responsibility for developing a desk, either running natural gas trading, or energy trading for the makeup of that. And for have the economics accrue to me, that being in control would mean.
Josh King:
So you, the grizzled veteran at age 25, 26, you begin Centaurus. In addition to setting up an actual trading desk, the other much more perfunctory rote aspects of opening up a business in your mid 20s and everything from human resources to client acquisition, that goes along with it, were you prepared? What were some of the sort of mountains that you faced? You knew in your head how to trade, but did you know how to run a company?
John Arnold:
This is one of the first questions I ask people who come to me with the idea of starting a hedge fund is, do you want to run your company? Do you want to be dealing with lawyers? Do you want to be running office space, and dealing with investors and auditors, et cetera? And yeah, at the time I did. I wanted that control. I wanted to have it all. And I quickly realized that wasn't my strong suit, and needed to bring in reinforcements to help on that. But at least at the time, I wanted to have full control.
John Arnold:
So, I started in August of 2002. And that six months between when I decided to start and when I actually did start, was a crazy time when there seemed to be a new story on Enron every week in the paper. The rhetoric got very bad. And the questions came up not only about what improprieties may or may not have happened there, but who was involved in that. And so, while I had had $50 million soft circled from my start and I was cutting people back, the investors naturally all pulled back and said, "Why don't you get started? We'll see how this goes. Whenever it quiets down, call us then." So, my $50 million of day-one capital that I was allocating people back, turned into $8 million, 5 million from a bank in New York that gave me the money in exchange for my clearing business, 2 million of mine, and then a million from a random fellow, a trader in Chicago Board of Trade who had read about me and called me, and I think wrote a check without signing a doc.
Josh King:
So, my thought goes to like NFL draft day. And you're either given like Bill Belichick's HR fund from Mr. Craft, or you have whatever the Cleveland Browns has to offer. You go from 50 million down to 8 million. Talk to me about the first couple draft picks you made, and why you thought those people were going to be integral to the success of Centaurus.
John Arnold:
Very quickly after Enron's bankruptcy, the whole merchant model fell apart. Wall Street became concerned about how the accounting standards of all the energy merchants. And so, you had this line of dominoes who had all copied the Enron's energy merchant model, who then all fell when Enron fell as well. And so, the inefficiencies and the availability of people, were off the charts. You could hire anybody. And the market was just terribly inefficient. But again, I only had 8 million in the fund, the quarter of that was mine. I had a little bit of money to run the business on my own.
John Arnold:
So, I started small. I had rented office space. I had bought computers. I had bought furniture. And as I'm doing this, as I'm making all these commitments, my money, my day-one money keeps declining. And so, it just became, I got to get started. So, might as well just start with $8 million and we'll go from there. And because part of the business was market making and arbitrage, and part of the business was position taking, and the inefficiencies that were there, and then nobody was making markets, you could just arb from one call to the next, there was a lot of fee income, a very low risk money I could make just by manning the phones.
John Arnold:
So, first month I'm up 30 something percent, but even defining it as a percent is a bit deceptive, because there was really just, I could make a few million dollars a month with my eyes closed, just picking up the phone.
Josh King:
All of us can't, really.
John Arnold:
It was a different time then. The first three months I have 30% plus returns each month, which compounds you over 100% in the first three months. And now those investors who had said, "Hey, we'll see how it goes," they call me after things died down. "Let's see if this is real."
Josh King:
The phone starts to ring.
John Arnold:
The phone starts to ring. And so, from there, the amount of money under management escalated very quickly.
Josh King:
So, you had some banner years, including 2006, when you made a huge investment on the price of natural gas going down. And then on the other side of those trades, Amaranth Associates and Brian Hunter lost $6 billion in natural gas, leading to the intense scrutiny of the natural gas markets. Take me through what happened.
John Arnold:
I've always thought if I ever wrote a book on those Brian Hunter Amaranth days, that I would start with the prologue and with the story being the follows. So, I'm in New York for vacation, September of 2006, with my then girlfriend now wife, with a ring in my bag, was going to propose to her on that Sunday. On Friday night, I get a call from Brian, and this is late September of '06. And he says, "I'm having a bad run of it. I'm wondering if you had interest in buying my book." And I had done this several times in my career. And so, I said, "Sure." And I had my belief as to what the size was. And then he sends over the position the next day on Saturday. And I think I fell out of my chair because there was three X what I thought it was. I just started thinking about you, what price do I do this at? And how much he had deviated market away from fair value.
John Arnold:
So, to take a couple steps back the backstory on this. So, in 2005, he had been long. And the hurricanes starting with Katrina in August of '05, but really Rita in September of '05, which hit-
Josh King:
One-two punch.
John Arnold:
... the Texas-Louisiana border, and really shut down a lot of the offshore production as well as processing facilities. So, kept some gas off for months, the market spiked and he had done very well. And then there was this thought in the market that this was a structural change in how hurricanes were going to hit, and the strength of hurricanes prospectively. So, in 2006, again, kind of piecing together from what I've learned after the fact, as well as what I could figure out seeing the flow was his strategy was get very long, especially this spread March-April in the summer of 2006. He'll wait until some of the hurricane skiers come in. And because he owns so many of them making the market short, he will get to set the price, or to some extent.
John Arnold:
And go through 2006 when he had gotten the benefit of the exogenous weather shock in 2005, 2006 was an incredibly quiet hurricane in season.
Josh King:
And started several years of benign weather as well, right, up until like '12 and Charlie.
John Arnold:
It has, yes. The risk premium associated with these positions that he was counting on for the hurricane to hit, started ticking away. And then it got to a point where it got the attention of the higher up with Amaranth. And I think about how was this position allowed to get put on, and what were the risk parameters? And the difference is that for a macro hedge fund that's used to trading interest rates and currencies and other commodities besides the energy that you can have easy storage of, the spreads especially deferred spreads aren't very risky. And especially if you do butterflies, then they're very-
Josh King:
What's a butterfly?
John Arnold:
... low risk. So, you're long one spread. So, say you're long month five, you're short month six, and then you're also short month six, long month seven. So, you're long one spread, short another spread. The only risk is that if the kink in the curve develops. Well, natural gas has this kink. So, if you have a risk department that doesn't understand this specific commodity, it doesn't know how to measure the amount of risk that one's taking. So, again, I think there was some negligence from higher up there.
John Arnold:
But fast forward. So, as the risk premium starts eroding in the market with no hurricane, and then this spread that I think I valued it as worth 30 cents on a true expected value basis, throw in something for the risk premium, which was significant, maybe 20 cents, it was probably worth 50 cents. It had hit close to $2 in the summer of '06. And was just a very destructive spread for the industry, but it turned out, and I think it's evidence that whenever one person tries to take too big a position, it ends up going wrong.
John Arnold:
And so, the question is the market self correcting in that way? That anybody who tries to take too big a position and deviate things away from fair value for too long, that it's going to self correct, and you're going to blow up? Or should the CFTC get involved and set limits on to not create a carnage in the meantime?
Josh King:
You identified some writing a couple days ago. I think one of Matt Levine's piece is to say that people can't time the market, but in reality, it's just that you can't time the market.
John Arnold:
I've become very bearish on hedge funds, ironically.
Josh King:
Which is, so we're going to get to this, because you closed Centaurus, it was widely reported that the fund was the most successful energy hedge fund in history. And if you have to look back at the history of it, that has not yet been enshrined in a book, what would you say was the fundamental key to its success?
John Arnold:
Time was hugely valuable. Starting right when I did. I think there was an advantage of being the first hedge fund that was able to get superior economics from investors, which then allowed me to both hire the best people, as well as invest the most money into the research side of the business. We've always been a fundamental based shop, counting the molecules, counting demand, counting supply, seeing where they cross, which where in the future does the market become imbalanced, and then overlaying that with really good trading talent. Because if you just have the fundamentals or if you just have the trading talent, you don't get much. It's overlaying the two. And I think that was our secret sauce.
Josh King:
You were quoted, John, in 2014 in a piece in TIME magazine is offering this advice. Find a career that suits you well and try to make a lot of money at it, and then have an exit strategy concerning a passion of yours. Why was 2012 the right time for that exit strategy?
John Arnold:
That was certainly the career path I chose. I'm not sure if it's right for everybody, certainly in retrospect. Now that I have a broader view of the world. But I started three days after I graduated from college in energy trading. And for 17 years, that was the only thing I did. And it's a field that is highly competitive. If you don't give 100% of your passion and interest to it, I don't think you can be successful. By first 14 years of my career, I lived it and breathed it. I would dream about it. I'd be thinking about it in the shower. Year 15, I started to kind of go back and forth. And year 16 and 17 was, I didn't like going into work anymore. I had lost the passion for the business. And the question is, why did I lose the passion? And there's lots of sub answers to that.
John Arnold:
The market opportunity had changed dramatically. My personal life had changed dramatically. I had gotten married, Laura and I had started this foundation. She quit her day job as a corporate lawyer and went full time at the foundation. I've started spending some of my day at the foundation. And again, I realized that I couldn't be successful at the trading business without giving 100%. And I was more interested in the foundation's activities.
Josh King:
And after the break, John and I will talk about the passions that led him to commit his full efforts to the Laura and John Arnold Foundation, right after this.
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Josh King:
Welcome back to inside the ICE House. Before the break, I was talking to John Arnold, co-founder of the Laura and John Arnold Foundation about the early success with Centaurus Advisors. John, in 2012, you took Centaurus from that initial $8 million investment, to around $5 billion in assets under management. You walked away to take the helm of your foundation full time. The foundation started the same year you signed the giving pledge. And let's listen to Warren Buffett explain that pledge, and get your reaction to why you chose to sign it and begin the foundation, right after this.
Warren Buffett:
So I have these little pieces of paper in a safe deposit box, which I bought about 40 or 45 years ago. And they've grown in value enormously. And what they are is they're claim checks on something in the future. I don't have anything I need in the future. All kinds of other people have all kinds of needs. And it's a way of cashing those claim checks in a way where people's lives are changed for the better. Mine's already changed for the better. I mean, it couldn't get any better. And if those little pieces of paper can translate, whether it's into children avoiding diseases, becoming better educated, whether people having a better life in their old age, whatever it may be. That's terrific. And I think a lot of people feel the same way.
Josh King:
And that's Warren Buffet, the Oracle of Omaha talking about his shares of Berkshire Hathaway, and what he's going to do with them. John, you've also talked about how important it is that you not burden your children with wealth. Was that your concern?
John Arnold:
Yeah. We've had the benefit of looking at 100-plus years of significant wealth accumulation in this country. And it's kind of starting in the late 19th century, and get to see those case studies of what money has done both positively and negatively to families. And we think about what are our goals for our kids, which is summed up to be happy and productive in life. And we've seen no evidence that giving them significant money as an inheritance, makes them happier or makes them more productive in life. And the question now is once you get over that and say, "I don't want to give it to the kids. What are we going to do with it?"
John Arnold:
And we've also had the benefit of watching lots of case studies of wealthy people decide what they want to do with the money in their will after they pass. And there's been some great instances of that. And also some areas where I think those funds were not used in the most efficient way. So, we thought we're both of these turning points in our career. We're young enough to be able to do this. We're both interested in it. Let's focus our efforts for the next whatever, hopefully until we die, on deciding where to give this money away. And as principal is doing it, we think we can make better decisions.
Josh King:
How did you build the foundation from 2008? And did you use the same strategies that you learned from running Centaurus?
John Arnold:
Philanthropic interest started probably late '90s, early 2000s when I first started to make some real money. And I had always felt this need to give back. And I remember being in a supermarket at the checkout counter, and there's this issue of a magazine that's America's Top Charities. And I picked it up and started thumbing through it, and threw it in my cart, took it home. And immediately went to education, which I think a lot of younger people who are looking to give away money, are interested in. And there was an organization that was in Houston, and not too far from where I lived. And so, it was very easy to give them a call, say, "I want to do a tour."
John Arnold:
I went down there. And what struck me was what was happening in that building, which was a KIPP school, was very different from what was happening to a school right down the street. And that started on a long journey for me as to why is that happening, and thinking about what's the policy reason and the government response as to why this is happening at small scale, it is not growing terribly quickly, and it's not influencing the broader education system quickly enough.
John Arnold:
So, spent that next 10 years mostly focused on education. And we still have that focus in the foundation, but have spread to a number of various public policy areas, that all have this public policy component that we're finding a market or political failure. Find an idea that somebody has that has some level of evidence that it's a successful one, and going and testing it at broader scale, piloting it, testing it, and then trying to create policy or process out of that idea.
Josh King:
I want to go around the horn a little bit on some of the policy issues that you're focused on, but back to the origin of the foundation, and that trip to the supermarket, and that magazine article, and the KIPP school. I mean, Texas is an amazing sort of laboratory for social issues generally, if you think about what's happening in Houston and Dallas and down to the border. Did you begin to think about your impact from a very local basis, or did you already know you were scale outside of Texas?
John Arnold:
One of the first questions any philanthropist has to ask is what is my group? How do I define my group of people? And so some people, a lot of people choose to do it as their city. Some people choose a religion or a specific interest or a health area. Some people have chosen the world globally. We made the very specific decision to do focus nationally. We felt that our allegiance was to our country, first. And it was also what we knew. So, we knew how things worked in the United States. Arguably your money can go further in Africa, but if you don't know how that system operates there, then those dollars, which theoretically can go further, might not be used efficiently. And I think that's been played out by a lot of the efforts of trying to do good there.
Josh King:
So focusing in on education, John, you've given, I think about $200 million to help failing schools across the country, such a broad, but in incredibly important area. Take us through what the portfolio model of school governance entails, and why you believe this is the best way to educate the next generation?
John Arnold:
So this had been an idea on paper, through Katrina. And when Katrina happened, New Orleans, which was one of the lowest performing school systems in America, the state had stepped in, took control of the system. They decided that they wanted to bring in a bunch of third-party operators, the charter school management organizations, to run the schools. And so, the idea is that government, as a monopoly, doesn't do a great job of innovation or quality control on schools. And that government's primary focus should be on providing tight regulation, but that school delivery should be done by a competitive sector. It is not a natural monopoly. So, let nonprofits compete to have the opportunity to have the resources and the building to educate kids, and let government serve as the decider about who gets those resources.
John Arnold:
So, when it happened in New Orleans and now New Orleans is a hundred percent charter, and the results there were dramatically different today than what they were. And the number of cities have looked at that model and have tried to replicate parts of it. Now, luckily we don't have the same type of natural disaster that happen in New Orleans happen someplace else. So, you don't have the dramatic shift from one year to the next that happened in New Orleans. But there's a number of steps that cities can take. And so, we support that change in governance. And cities that are taking those steps to making government more the regulatory agency and allow third party operators
Josh King:
Let's move onto healthcare. Your team within the Laura and John Arnold Foundation is working to bring down the skyrocketing costs of prescription meds, while keeping in place, the necessary systems that allow for innovation and discovery. You're working on this first by expanding access to information about the quality and cost of care provided by local doctors and medical centers, and also by funding Healthcare Cost Institute the HCCI, and the Harvard Healthcare Markets and Regulation Lab, two organizations that are analyzing health reforms across the United States. What spurred you to take on this massive industry?
John Arnold:
So, we get very attracted to areas of philanthropy where others are not playing. So the area of diseases and of trying to find new cures for diseases is hugely important, but there's a lot of people playing in that area. So, we look at it, where is our value add? And one of it is things that don't elicit passion from the typical person. Our passion is fighting these market failures, fighting special interests that have led society to some bad equilibrium, either one that it just costs too much, or one where the quality that's coming out of the government or from a group doing business with the government, is not good enough.
John Arnold:
So, within healthcare, we're really interested in this issue of pharmaceutical pricing, in which you have a company that makes a life saving drug that is hugely important, but is granted a regulated monopoly. And every other industry that's given a monopoly, has tight regulations on what price it can charge. Because of the politics associated with pharmaceuticals, largely due to the amount of money spent on advocacy and lobbying by the industry, Congress has found itself unable to act on this issue. And so, the industry's had to Jerry rig this crazy system of trying to provide a counterforce to pharma, that's led to a totally irrational pricing system. So, we support a number of efforts to think up, what would a more rational system look like, and then trying to test and implement those ideas.
John Arnold:
Another area in healthcare that we have interest in is trying steer the industry to this concept of value. So, we should think about value the same way we do in any other field, which is quality divided by price. That you want high quality and you want low price. There's a lot of procedures and even pharmaceuticals that are done today, where the quality relative to the price, is very low. So, if the system can steer or fixed resources, which I think a fundamental component of this work, you have to start with this assumption that society has a fixed amount of resources. So, how can we use that most effectively?
Josh King:
Some of the projects that you've supported have focused, John, on improving and leveraging the emergency response to drug overdoses, people in mental healthcare crises, or other issues such as homelessness, where the conduct at issue is more related to health or service needs than criminal intent. Do you see these issues that as part of the health insurance issue or how the country continues to rely on police and emergency responders to provide the social safety net, the idea that the cops are riding around with injections to stop an overdose in mid-flight versus more societal ways to address the opioid issue?
John Arnold:
One of our fundamental tenets is we're trying to find better solutions without spending more money. Because the reality is that most states and localities are very constrained for resources. And that's where the financing for these programs comes from. So, to do that, we have to do broad evaluation of new ideas and of ideas that are in existence today. We fund a lot of randomized control trials, of social programs of social responses, trying to figure out what's the best way to deal with some of society's toughest problems. An area like drug addiction is one where evidence on what works, what's the best way to treat somebody, is very weak. And for good reason. It's hard to do randomized control trial with a control group and with people that are in the toughest parts of society.
John Arnold:
It's so important for us to know again, how do we spend these fixed amount of resources, such that we end up with better solutions? So our work on opioid addiction, our work on minimizing unintended pregnancy, our work on how do you deal with homelessness and some of the ramifications of that, is all centered around which programs work, which are the most cost effective, where can we use society's fixed resources to deal with this?
Josh King:
John, your wife, Laura, was quoted in a recent news release, announcing a $20 million grant to the Rand Corporation. She said, "Understandably gun violence is a deeply emotional issue, but arguing about the proper response will not solve the problem. Our goal is to provide objective information, to guide a rational fact-based response to a national crisis. We need data, not politics or emotion to drive our decisions." It sounds like the approach you might have taken at Centaurus.
John Arnold:
There is a broad overlap on how I look at problems, of trying to look at the data, try to figure out what is the data point, and react to that. So, without approach problems with as minimal bias as possible, both when looking at a trading scenario, as well as looking at a political scenario or a policy scenario. So, with regards to guns, as I mentioned earlier, we get interested in these market failures or political failures. And I think the issue of guns is certainly a political failure. Now, those that are more supportive of the Second Amendment, rightly point out that a lot of the policy proposals presented likely don't have an impact on gun violence. So, we need to figure out what are the high value policies that can maintain the spirit and integrity of the Second Amendment, but also minimize the collateral damage that are associated with guns.
John Arnold:
And that's what this particular initiative is set out to do. We had the benefit of getting to look at the national academy that came out with a whole research agenda several years ago, saying that these are the unanswered questions in the field that can help shape policy. And they've been waiting for the federal government to allocate money, to go investigate those questions. Again, we have this political failure that seemingly should be somewhat objective of funding research to see how we can minimize gun violence, but we just can't get any movement on it at the federal level. So, I think this is an example of an area where philanthropy can step up and substitute for something that government should be doing.
Josh King:
And maybe that's why Laura wrote this piece in the Houston Chronicle that was titled You Want To Fund Gun Research, Ask For Private Donations. Why do you both feel the issue requires civilian investment? And what do you hope to achieve at a local state and federal level that the government won't do?
John Arnold:
Many of the problems that we look at, have a special interest component to it where if you pool people broadly, they agree that something should happen, that a policy should be advanced, but yet the electeds don't move forward forward because of the influence of special interests.
Josh King:
Paralyzed by fear.
John Arnold:
Exactly. So, again, we get drawn to those issues and think about where can philanthropy step up and provide a countervailing force to those special interests? Sometimes we do that in a political or advocacy space, other times like with the gun violence measure, where Congress is just frozen, we will substitute what the federal government should be doing, and use philanthropic dollars to do so.
Josh King:
You tweeted a couple days ago-
John Arnold:
You've been reading my Twitter account.
Josh King:
I have been. I mean, I'm sure you, like I, follow Real Donald Trump. You're one of the 55 million who do. He tweets something the other day in which he basically sticks his nose up against the Koch brothers. And in a sort of complimentary way you say, "Well, this was sort of the promise of the Trump administration that a guy who's worth, however many billions he's actually worth, has the ability to say he's not beholden to the sort of forces on the left or forces on the right that would push him in that in one direction or another."
John Arnold:
There's a book I read recently entitled It's Our Turn To Eat. And it's referencing, I believe Ghana, about how the political system there, that whenever a political party from a certain region of the area that represented a certain ethnic group took power, it's quote unquote, their turn to eat. That they get the spoils of it, and that all the rewards from government should go to them. And I feel like on both sides of the political spectrum now, we have that philosophy of it's our turn to eat. So, both from the left and the right.
John Arnold:
And I really think that the way to solve this is to get a president who can stand above that partisan divide and do things that's not beholden to special interests and can stand above it and provide or do things that are just good for the country. It's unlikely.
Josh King:
Mike Bloomberg was able to do that in New York when he was mayor, but our billionaire in the White House is having some challenges.
John Arnold:
It would be interesting seeing a New York billionaire succeed a New York billionaire.
Josh King:
Another initiative that you're involved in is sustainable public finance, talking about a New York billionaire following a New York billionaire namely tax policy and pension reform. Let's dive into both of those areas, starting with tax policy, the foundation funds the PEW Charitable Trust's economic development and tax incentives project, as well as the tax policy center, a joint venture of the Urban Institute and the Brookings Institute. Explain for our listeners what each of these programs is researching, what the ultimate end goal is.
John Arnold:
So, I got interested in public pensions back about 2009. And there's this saying that whenever the sea recedes, you see who's not wearing the swimsuit. And that's what happened with public pensions in 2009. That a lot of flaws had developed in the system, but a strong stock market had hidden it. And whenever the stock market retraced, you saw these flaws, both on the benefit design, as well as funding design. So, benefit design is the person who worked for the state or the city, what is the formula in that determines what their pension is? And the funding design is, how much should the city or state be putting away today to meet those obligations that are going to happen in the future?
John Arnold:
This tenet of fiscal sustainability runs through all of our efforts. Because if you don't have a sustainable government, you don't have a responsible fiscal government, then the ability to provide the normal government services in the future gets severely compromised. And we saw this in a number of cities and states, and we still see it today, even with strong economic times, good stock market returns, is that the pension obligations are just eating away at localities. And it's really going to compromise our ability to provide these services in the future.
John Arnold:
Again, an area that very few people are working on, we're really the only philanthropic dollars that got into it. There was broad consensus about what a better system should look like. And the question was, how do we combat the special interests who want to maintain status quo? Now, the question of what to do, is very complicated. I think the easiest is changing the system for new employees. So, before somebody takes a job, it's here is the current system them. What happened in the past, happened in the past. But you can make a decision whether to take the job today based upon this new set of promises.
John Arnold:
The second way to deal with it for states that are, have more severe problems, is to go to existing employees and say, everything we've been promised to date counts. We're going to abide by that. But going forward, you're under a different system. The third way that I think everybody believes is the wrong way, is to wait until you're towards the end of your career or after you've retired and then go change your benefits then. But that's what we saw in Central Falls, Rhode Island, whenever they went bankrupt and you saw current retirees have their pensions slashed by 50%. And at that point, that's too late. If you give people 20 years, 40 years to change their behavior, they can do it easily. But they can't do it whenever they're 70 years old. So, we need to make these systems sustainable, fiscally responsible. And we need to bite the bullet. And that involves both often times changes on benefit design, but it also involves more money needs to be put away by the cities and states today.
Josh King:
We were talking about the success story of New Orleans after Katrina 2005 on, certainly in the education sphere. But if you think about education and police, cities like New Orleans, Houston, Dallas, Chicago, New York, the attractiveness of career path for a cop or a teacher... My wife works for the NYPD in a psychology role, but certainly is thinking about that gig, the pension plan was certainly very attractive. And for generation after generation for cops from families in Staten Island, it is this lifelong pension opportunity that comes after 20 years on the job. How do you sort of draw the line and say, the gravy train ends here?
John Arnold:
It's incredibly hard, and it's unfair. But the problem is the math is the math. And if the money's not there continuing with the current system that nobody's setting aside the right amount of money, it is just stealing from future generations. And that's not right as well. So, cities need to bite the bullet and set aside more money. They need to make the tough decisions on cutting spending or raising revenue today to put more money aside, to make sure that the promises are being made, actually get kept. There's a great Sign Thought episode of where Jerry goes, makes a reservation at a restaurant, shows up, and they don't have his reservation. And he says, the easy part is taking the reservation. The important part is holding the reservation. The easy part is making promises by government, by policy makers, by politicians. The hard part is abiding by those promises.
John Arnold:
And when a policymaker is making promises, that's going to be a generation or two down the road before they have to pay off, it's too easy for them to lie, because they're not going to be the ones who have to deal with the ramifications. And that's what we're trying to provide that counterbalance to is, make promises that you can keep. First, we need to figure out a way to abide by the promises that have been made to date. And that's really hard. But prospectively, only make promises that you can keep, that you're willing to set aside the right amount of money today, that you can make those trade offs. And it's hard as a politician to propose either cutting spending or raising revenue, but that's what some of these cities and states have to do. They need to do it today. And every day that they defer, the problem gets harder.
Josh King:
John Arnold, I know you got places to get to in the rest of the Northeast United States. So glad that you were able to stop by the New York Stock Exchange and spend a little while with us inside the ICE House.
John Arnold:
It's been a lot of fun. Thank you.
Josh King:
Thank you. That's our conversation for this week. Our guest was John Arnold, co-founder of the Laura and John Arnold Foundation and legendary energy trader. If you like what you heard, please rate us on iTunes, so other folks know where to find us. And if you've got a comment or a question you'd like one of our experts to tackle on a future show, email us at [email protected], or tweeted us at NYSE.
Josh King:
Our show is produced by Pete Asch and Theresa DeLuca, with production assistance from Ken Abel and Steven Porter. I'm Josh King, your host signing off from the Library of the New York Stock Exchange. Thanks for listening. Talk to you next week.
Speaker 2:
Information contained in this podcast was obtained in part from publicly available sources and not independently verified. Neither ICE nor it's affiliates make any presentations or warranties express or implied as to the accuracy or completeness of this information, and do not sponsor approve or endorse any of the content hearing, all of which is presented solely for informational and educational purposes. Nothing herein constitutes an offer to sell or a solicitation of an offer to buy any security or recommendation of any security or trading practice.
