When I was starting a hedge fund 18 months ago, I knew right from the beginning that I needed to build a consistent, positive track record that would allow me to demonstrate my ability to successfully manage risk, while creating alpha. Investors and fund allocators typically look for a superior risk adjusted return – what this means is they not only want to know how high your return is but also how much you can lose and how long it will take you to make it back.
All money managers have their own thing, their edge, method and a way to look at markets. But they also have their own flaws, mistakes they tend to repeat. It is because of the discipline and the ability to manage these flaws that successful managers learn, evolve and become better.
My own problem is not that I get it wrong often. I usually tend to get it right and when I don’t I am quick to recognize that I am wrong. My own flaws are timing and what I call “overtrading”. Every single trader I know bitches and moans about timing. You can’t ever get it consistently right, it’s just impossible to get in at the low and get out at the high – better accept that now. But it is the “overtrading” – the tendency to always try and hop on a trade and not being flat often enough – that is by far the bigger problem. Let me explain…
The Federal Reserve Bank – an 800 pound gorilla at the poker table
The FED’s QE policies over the last few years, while positive and necessary to pull the US economy back from the cliff in 2008-09, have essentially changed the nature of financial markets, altered long held asset correlations and smoothed any signs of excessive volatility. By arranging a steady rally in equities over the last five years, coupled with an amazing decline in volatility, the FED has forced the hands of one too many traders into trades they don’t particularly like, thus creating an overtrading habit.
Overtrading is basically the same as the inability to fold your hand. When you are a systematic trader, what this means is your system may not be giving you enough signals to enter a sufficient number of trades, which explains the constant decline in trading volume (and performance). For a discretionary trader like myself, this simply means that I have to keep on folding my hand, more often than I used to. The patience is the singular most important trait of a successful trader in 2013-14.
When I tell people what I do for a living, they say “oh you must have done really well the last two years with the stock market up 30%”. First I tried to answer that and now I just smile and try to change the subject. The reason why so many hedge fund managers have not made 30% in the last year is because they recognized that the FED’s policies are wrong and unsustainable and they can’t bring themselves to ride on the “crash train”.
It suffices to look at some of the biggest and most successful managers out there. Why is Renaissance Technologies, the $25 billion investment firm founded by Jim Simons, down 2% in July and 4.9% this year? Why is Third Point, Paulson & Co. or Tudor Investment Corp struggling to make any significant amount of money this year? Why is David Einhorn from Greenlight Capital, who by the way finished 18th at the World Series of Poker main event in 2006 and regularly makes it to the last table at poker events, saying that he struggles to find any value after a five year stock market rally?
Strength of your convictions
There is a difference between knowing when to stop out of your losing position and having the strength of your conviction. As it stands right now, many money managers – those that people tend to call “smart money” – are simply convinced that the stock market rally is overblown, the US yields overly depressed and the dollar still too weak given the expected rates rise sooner rather than later.
People like Stanley Druckenmiller, the former golden boy of Soros’ Quantum Fund and the mastermind behind the $1 billion winning trade against the Bank of England in 1992, David Einhorn and many others now believe that the FED is behind the curve. And so they keep folding their hand, like a good poker player would do. They simply acknowledged the fact that there is an 800 pound gorilla at the table and they have to quietly fold their hand, despite knowing that they hold an excellent hand to play. Just not against that gorilla.
One of my investors quipped to me last week “it’s amazing you have done so well considering you have been shorting the S&P for so long”. It’s true. I have been shorting the S&P since about 1625 and I guess my timing was just lucky to average it out and always be flat before the next 100 points leg higher when I tried to short it again. And again 100 points higher telling myself at every turn that the gorilla’s hand is wrong and that I am playing the right one. Like many investors and managers out there, I patiently learnt that folding against the FED is smarter and ultimately more profitable. Until the time is right, and I am convinced that it is around the corner.
Take Marc Faber for example, the publisher of the Gloom Boom & Doom Report newsletter. People are tired of listening to him now when after a five year market rally he still, in his heavily accented English, warns us of the financial armageddon around the corner. People somehow develop caution when hearing advice in heavily accented English; unless you are a Brit and people automatically assume you’re smart because you sound so (this is not to insult anyone – the author of this article also has an accent and actually likes Marc Faber). But the truth is, Marc Faber has an unbelievable courage of his convictions and as any successful investor who’s been in this business for so long, he knows not to overtrade and how and when to play his hand.
Looking for the big themes
Brandon Adams, a top poker professional who teaches behavioral finance at Harvard’s University’s Department of Economics, says professional poker players and successful traders have a lot in common. It’s the rare combination of the ability to push ahead when you know you have the edge and knowing how to protect your positions when you don’t have the edge. And this is what it really comes down to. I learnt that I perform much better when I am flat more often and wait to be dealt the right hand. Because I don’t always have to be in the market. It clouds my vision and analysis because my positions influence my judgement.
That doesn’t mean being flat all the time – it’s perfectly acceptable to have limited positions when you think that a price action is overdone here and there for example. But the real P/L is made by playing out the big themes, the big hands, while continually folding the small and uncertain ones. I believe the big theme for the next 6 months is a quick and sharp sell-off in stock markets in autumn, a rise in volatility, US yields and the resurgence of the US dollar.
We are finally arriving at an important crossroads with the FED ready to normalize its policy, and let the market play it out again. And so it’s almost time to stop folding and start playing that hand again. Next time I am sitting at a poker table, I will have the FED on my mind and remember not to overtrade. Because sometimes, less really is more.
Martin Zeman
Bohemia Capital Management
Special contributor to aiSource