Competition has forever been fierce and at times may not be entirely fair. Thus, a student of the market must be ever aware of the trends around them so they can promptly identify growing areas of opportunity which haven’t yet been revealed to the majority. Mr Madoff made a very good living (while it lasted) offering clients a steady ~10% return on their investment. Bush league stuff, it turns out. The real maestros of money are doing rather better.
Accounting and legal researchers at the University of Kansas have identified a bull market in influence-peddling: returns on the order of 22,000% for firms who “invested” in lobbying efforts to favorably modify the tax code. These people obviously learned that it’s important to play by the rules.
I’ve written some decent strategies and have been blessed with moments of great luck, but I’m ashamed to note that I’ve never gotten remotely close to these kinds of returns. Can you imagine the sharpe ratio these guys can claim? And it’s a repeatable process. Although the Kansas researchers don’t mention it, there are many other cases of such legal arbitrage as pointed out in an AP piece on the subject:
The nonpartisan group recently released a study comparing the amount spent by bailed-out banks on political contributions and lobbying with the amount of money they got from the Wall Street rescue fund, known as the Troubled Asset Relief Program. The results produced eye-popping rates of return, an overall 258,449 percent for the $114 million they spent on campaign donations and lobbying.
Now this number – ~260,000% ROI – is clearly a bit inflated as $114M barely covers what Citi paid out to Mr Rubin for his services over the relevant period, but we’re probably in the ballpark. Perhaps the banks only made 100,000% on their investment, but we can still see why they’re “the pros.”
I’m wracking my brains trying to figure out how to shoe-horn this marvelous alpha-generator into my trading algorithms. I confess that I haven’t yet figured it out. But I take solace in the knowledge that, as an American, I have the best government money can buy!
dereferenced, our managed markets
rebranding opportunity?
A friend of mine pointed out an article he came across on his bloomberg terminal today which reminded him of a strategy I’d described to him sometime back and which we’ve been trading over the past year or so with good results.
To the great chagrin of some of my partners, I even wrote a few posts about the phenomenon underlying our strategy and its evolution as we capitalized on it. Eventually, they persuaded me to shut up already, but the outline was there for all – including Goldman! – to see.
My first post on the topic, “unsung virtues of a dynamic hedge” published June 4th of last year, was pretty coy and didn’t mention the source of alpha itself but talked about enhancing it with a dynamic hedge.
My next post on the topic, “to dream” was published July 14th of last year and laid out the exploitable discrepancy of the market’s behavior. Interestingly, the data I provided in that posting went back the same amount of time as in Goldman’s piece.
I explicitly wrote one last time about the strategy in “evolution of a strategy” wherein I detailed the process by which we’d been evolving the strategy.
Now, one of the more entertaining things about having a blog is that you get to see who is viewing your content. I’m happy to note that all of the major IBs are represented including a variety of distinct IPs within Goldman.
Now, I’m not accusing them of stealing my ideas or anything untoward like that… but I’ll admit that I am wondering how long it’s going to take them to make similar observations across markets beyond US Equities…
Read on for the Bloomberg article…
Read more…
back-testing, dereferenced, strategy development
During some recent travels, I read William Poundstone’s ramblingly entertaining Fortune’s Formula. It had been sitting on my shelf after I’d originally gotten it, perused it and offhandedly discarded it as yet another of these science-is-fun-and-full-of-wacky-characters books for the butch humanities student. My initial impression was a bit harsh as the book proved entertaining and covered a lot of ground including significant coverage of Ed Thorp and his stat arb alchemy (see here for his own papers on the topic).
One of the more compelling segments of the book relates Claude Shannon’s demon which is a nice thought-experiment / trading-strategy which illustrates the tractability of the problem of trading on a random walk market with fixed properties. I wrote the above applet to explore the impacts of applying friction and otherwise modifying the behaviors of the market and the demon.
The original demon posited a world with no friction in which the market contains one instrument which doubled or halved in value each day. Shannon’s demon looks to take advantage of this volatility by maintaining a portfolio which was rebalanced each day to ensure a 50/50 split between cash and the market. The applet implements a very simple monte-carlo test-bed for Shannon’s Demon. You can configure the demon and the marketplace along a variety of parameters, and then run many instances of the demon, each on its own self-contained random-walk market.
Although Shannon’s demon is a highly “stylized” case in the sense that it operates on a very synthetic, unrealistic and favorable formulation of a random-walk marketplace, it has spawned a great deal of interest and serious research.
Most of all, it’s a revealing illustration of the kind of reasoning one must embrace in order to address stat arb strategy development. Enjoy.
—
Updated: March 4th – made price axis logarithmic to better reveal mc paths.
books, dereferenced, monte-carlo methods, strategy development
one view on the important stuff
There seem to be two kinds of economists in today’s world.
Keynesians and Austrians? Freshwater and saltwater? Macros and micros? Voodoos and uh well-adjusted?
No. These may be valid distinctions ordinarily, but in today’s debate on how to solve the great self-inflicted wound known as the credit crisis the only two that matter are those who’ve worked for prop trading outfits (or perhaps more broadly, those who would someday like to once their time of public service is up) and those who just practice economics, typically academically.
Among the former, the solution is uniformly, as Mish so memorably put it, “to patch the busted dam with water” and to do it now or the consequences could be incomprehensibly bad.
Among the latter, the views are many and divergent, but they at least agree that throwing trillions of dollars about is a serious bit of work and should be undertaken with deliberation, transparency and a long view.
I’m not qualified to opine on which type of economist has a better chance of saving us from ourselves. But I can observe that the only kind sitting at the decision-making side of our president, pre- or post- January 20th 2009, is the prop trader.
Read more…
dereferenced, our managed markets
One of my favorite tools for strategy development is the distribution of returns a strategy will generate. As I’ve discussed before (and here and here), it’s an easily quantifiable characterization of a strategy’s “underlying nature” and can be used to engineer strategies that fit appropriate markets.
Given the enduring value of return distributions, I found this morning’s post in ft.com/alphaville especially interesting. They cite a Dresdner study examining the distribution of returns for Goldman Sachs’ prop trading in 2003 and 2008. Eye opening stuff.
normal
not so much
dereferenced, performance analysis, strategy development
"We've run out of Federal Firearm Licenses"
Yesterday I read this article in the New Yorker: The New Paranoia: Hedge-Funders Are Bullish on Gold, Guns, and Inflatable Lifeboats.
In his book Wealth, War, published last year, former Morgan Stanley chief global strategist Barton Biggs advised people to prepare for the possibility of a total breakdown of civil society. A senior analyst whose reports are read at hedge funds all over the city wrote just before Christmas that some of his clients are “so bearish they’ve purchased firearms and safes and are stocking their pantries with soups and canned foods.”
It reminded me of my experience on 9/11 and my thought that a really handy item for the paranoid Manhattanite in uncertain times might be a conveniently inflatable raft.
Yes, I was a little warped by the experience. Evidently I’m not the only one, though…
These guys would prefer to be in a high-speed boat or ex-military vehicle, heading off toward their fully provisioned compounds in pursuit of the ultimate goal: to win the chaos.
Then today I came across the above notification from the ATF indicating that we’ve literally run out of firearms licenses. I guess the optimistic interpretation is that there’s “always a bull market somewhere…”
I was gambling in Havana
I took a little risk
Send lawyers, guns and money
Dad, get me out of this
- Warren Zevon
dereferenced, hedge funds, our managed markets
Back when Microsoft was considered a very smart company, they inspired the phrase “eating one’s own dog food“. This meant that they used their own products and was understood to be a superlative practice.
As a small algorithmic trading shop, we certainly eat our own dog food. As we develop StratBox, we continuously trade on it. If we introduce bugs, we pay for them – quite literally and immediately. Believe me, we are highly motivated to ensure that it’s a bug-free environment. Likewise with our models. If we think a model is worthwhile, we trade it. If we’re not sure, we trade it in small size to see. We eat our own dog food – trading and software models alike.
One of the great attractions of wall st has always been its “eat what you kill” mentality which suggests potential for both great reward and, well, hunger. Motivation is clear. Interests are properly aligned.
Thus, the news we’ve been bombarded with out of wall st has been depressing indeed for finance professionals. The culture we admire about our industry has been perverted. After months of solidly horrible and generally worsening news, Credit Suisse’s bold move yesterday was a real ray of light. Their move to “feed” their top management the slop they’ve been creating is a sadly unique example of a finance firm ensuring that interests are ethically aligned.
And it’s the first genuinely good piece of news out of wall st that I can remember in a very long time. Happy Holidays, Credit Suisse!
dereferenced, our managed markets
I hope you’ll forgive me a post as off-topic as the picture accompanying it is peripatetic. As far as I can tell, it has no algorithmic trading application. But I’ve spent my life around software and it’s pretty rare that I find something that truly wows me.
And Shazam is one of those rare beasts.
I don’t know how they do what they do, but what they do is really something else. Install a free iPhone application (I think there are other implementations available as well), start it up and point the phone’s mic at the source of some music. In a few seconds, the software will identify the song, download its album cover and assorted info, and point you to where you can purchase the song. It’s not perfect – it couldn’t identify the beginning of Beethoven’s 5th, but it was able to identify Carmina Burana and had no problems with any popular music I pointed it at.
I’m certain that if you had a contest between this system and your favorite neighborhood audiophile, Shazam would win hands down for speed and accuracy. It’s really something else.
dereferenced, startup, technology
"all the way down"
This post from the financial times both evokes an earlier post I’d written and pretty uniquely captures the zeitgeist of our times…
It’s good to see that the cast of usual suspects haven’t gone gun shy from losing billions and are still out there innovating.
For those looking to answer the question:
Q: How do we improve upon layers of opaque, illiquid and unregulated financial instruments?
The good people who brought us the “credit crisis” have engineered an answer to this puzzle:
A: just add another layer!
dereferenced, our managed markets
Photoillustration by: Ji Lee
This afternoon I read by far the best and most interesting article yet on “The End” of wall st by Michael Lewis. Of course, as I was reading this engrossing tale on the inevitable failure of greed to create a perpetual money machine, the market rallied some 6%…
While the hero of Lewis’ piece found value in effectively shorting the credit bubble just as it reached its shimmering peak, this set of “investors” looks to profit in these tougher times ahead by going long man’s baser tendencies…
dereferenced, hedge funds
