I’ve been saving the above image in a stubbed-out blog post I’ve wanted to write since a conversation I’d had in Jerusalem last fall. The recent attention to high frequency trading and all of its attendant evils has reminded me that the topic is relevant and so I relate various thoughts at the risk of jumping on a cacophonous bandwagon of rumbling misinformation.
First of all, the conversation. It was with a talented guy who acted as the CFO for a variety of companies including a small startup hedge fund which traded US equities at a high frequency. Although he was a part-time cfo, he seemed pretty plugged-into their trading operations and noted that they use an agency-only brokerage service for automated traders I’m familiar with and that they were “looking at full data for many” hundred stocks concurrently. He remarked that their trading was going well but that their hit rate was something like 4% and dropping. By hit rate, he meant that they were placing limits frequently and generally pulling the orders if they didn’t get hit immediately. He didn’t specify, but I imagine that “immediately” might range from milliseconds out to a second or twenty. If the market is composed of makers and takers, then these guys were definitely makers of liquidity in the strict sense that they were placing limits and making markets.
At the time I thought it was interesting because it seemed that so many people were focused on the very, very short term trade that the frequency was becoming saturated. It looked like a reminder that trading frequencies populate a spectrum; in this case, this part of the spectrum was becoming so saturated that returns were becoming increasingly difficult to obtain as more players crowded into it. I’m not sure how this hedge fund has fared, but at the time I remember thinking that they were going to have a tough time competing if they were only geared for high-frequency trading as the space becomes increasingly expensive to play in as the inevitable talent and technology arms race marches on.
Lo and Khandani provide the below image illustrating this phenomenon happening to a class of contrarian strategies Lo & MacKinlay had described in 1990. The strategies stop working as people squeeze out the alpha.
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hedge funds, our managed markets, startup, strategy development, technology
A reader of this blog (hey – I’m as surprised as you are!) sent me an email recently detailing a strategy they’d developed. While the details of that strategy aren’t relevant here, they sounded good and they got me to thinking about the process of selling a trading strategy. This is an activity that I’ve spent some time on and have decided just isn’t for me.
There are a lot of difficulties with selling a trading strategy. One of them is a consequence of the foundational problem of back-testing about which I first started posting on this blog. For any given period of time (that has already elapsed!), it’s not difficult to generate a good number of pretty impressive strategies. All you have to do is try a good enough number of random strategies and some of them will prove to be too good to be true.
Presumably, any credible person who might be listening to your pitch will be at least intuitively aware of this fact and will thus be highly suspicious of any back-tested results you might present. For this reason, it’s impossible to sell a strategy on the basis of back-tested results. Only auditable, real-world returns will be considered valid by any serious person. Of course, you might find someone who’s less particular, but then you’re flirting with fraud rather than a legitimate sale.
So let’s say you have impressive, verifiable results. You still have to answer the question:
If this strategy is so good, why are you selling it? Why not just trade it yourself?
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hedge funds, startup, 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
I’m delighted that Scott Johnston once again allows me to share one of his excellent monthly newsletters. Scott’s an experienced hedge fund exec who’s currently a PM and principal at the Belstar Group, an asset allocator and fund-of-funds. Contact him at sjohnston {AT} belstargroup [DOT] com.
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Dear Partners and Friends,
The Madoff scandal has so many facets, it is difficult to know where to start. The sheer size of it is mind boggling. Many thought that the initial $50 billion number, which came from Madoff himself, was likely an exaggeration, but as of this writing, it may not be. I think back to Ivan Boesky, the singular scammer of the 1980s. I think he managed a few hundred million
Is this a hedge fund scandal? I think you’d have to say that it is, despite the fact that Madoff did not, himself, run a hedge fund. He accepted brokerage accounts, which he then managed through his own brokerage firm. But many formed de facto hedge funds around Madoff for the sole purpose of feeding money to him.
Scammers will always be with us. It should not be shocking to anyone that there are those willing to lie and cheat to make money. Bernie Madoff is simply the latest of a long line of con men: Charles Ponzi, Bernard Cornfeld, Ivan Boesky, Sam Israel, Dana Giachetto, Raffaello Follieri (Anne Hathaway’s boyfriend)…it’s a long list.
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guests, hedge funds, our managed markets
With all due respect to the auto industry and the worthies in washington, the big news this morning is about Bernard Madoff. Although it’s been very well covered by the always insightful and acerbic Cassandra as well as a variety of more traditional news outlets, this bit of news has a particular personal irony for me.
I had visited the offices of Madoff back in May. Situated in the striking “Lipstick” building, his multi-level offices were really gorgeous and impressive. His trading floor was large, modern and immaculate. You could trade there, perform open-heart surgery, make sushi or fab chips. Immaculate.
I was there as I had a trading strategy that I wanted to capitalize and I was hoping some sort of a deal might be worked out. Although they were extremely nice and gave me a fair hearing and asked good and detailed questions on the model, they ultimately declined the opportunity and sent me on my way. Nonetheless, I came away impressed by them and their remarkable money-generating enterprise.
Under-capitalized but game, the strategy I’d pitched them has made us over 200% since that May meeting.
You only find out who is swimming naked when the tide goes out. – Warren Buffett
hedge funds, 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
The always excellent Wilmott Magazine has recently posted a series of articles by Ed Thorp (pictured) in which he describes his experiences developing and evolving a statistical arbitrage product. Part I provides some insights into his current operation, revealing that he maintains a dollar-neutral portfolio as I’d discussed in another post, they trade some 1.5 billion shares / year, and that they limit position sizes to 2.5% on the long side of the portfolio and 1.5% on the short side. In Part II, he explains why a stat arb system is considered an “arbitrage” and how, with the help of a talented team and led by the insights of Gerry Bamberger, they developed the first iteration of a stat arb product. Part III details the evolution of the system from a set of dollar-neutral sector-oriented portfolios to the more general sets of portfolios generated through statistical factor analysis. He concludes with some anecdotes including the emergence of David E Shaw. Very recommended.
dereferenced, hedge funds, portfolio management, strategy development
I recently had a pretty visceral encounter with the forces of friction. No, I didn’t fall off my bike – I’m talking about the friction inherent in trading activities. I’ve mentioned Andrew Lo’s market-neutral long-short algorithm before and it sees service as my blogging muse once again. I’ve modified his original algorithm such that it behaves reasonably well though, as he observes, it’s a strategy in long term decline. My recollection was that one might expect 15-20% from an unlevered deployment of the strategy.
Recently, I went to play with it and to my shock and horror it had become a wretched loser. In fact, an incredible loser. What had happened? I looked throughout my code and couldn’t find changes; this was corroborated by my CVS repository – no changes had been made to the strategy in a long while. Any coder is familiar with the natural entropy of software systems known pejoratively as “code rot” but this seemed an especially extreme case.
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back-testing, hedge funds, performance analysis, strategy development
I’m very pleased to present our first guest blogger to this space – Scott Johnston. Scott’s an experienced hedge fund exec who’s currently a PM and principal at the
Belstar Group, an asset allocator and fund-of-funds. This post has been excerpted, with permission, from his monthly newsletter. Contact him at sjohnston {AT} belstargroup [DOT] com.
The biggest single impediment I see for investors contemplating an investment into hedge funds is “blow up” risk. How can they think otherwise, with all the hype? The media enjoy little more than the self-immolation of a hedge fund – Rich Guys Get Theirs! Blow-ups score a 10 on the CNBC schadenfreude scale. (Note: for institutional investors, blow up risk translates more specifically into “headline risk,” which is basically the risk of losing one’s job if a hedge fund you invested in ends up in the papers for the wrong reason.)
How common are hedge fund blow-ups? How often do they happen? What do they do to returns? These are questions I wanted to get to the bottom of.
Fishing around, I found surprisingly little research on the subject, so I thought it might be useful to conduct a survey of our own. Specifically, we will look at hedge fund blow-ups through the years to see what kind of conclusions we can draw. For the sake of argument, we will call anything greater than a 50% loss a blow-up.
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books, guests, hedge funds, portfolio management
