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.

My conversation in Jerusalem mostly made me think that we were seeing a similar phenomenon amongst HF strategies.

What does it mean for a strategy to be high-frequency?  First of all, it’s a large class of strategies which probably shouldn’t be treated uniformly.  What they have in common is an intention to trade in and out of positions on a frequent basis where frequent will range from sub-seconds out to perhaps several seconds or even minutes in particularly felicitous cases.

Aside from the fact that one can trade at various frequencies, one can mix them and one might even be only peripherally aware of doing so.  A long-only, fundamentally-driven mutual fund (ie, not an algo or high-frequency trader) might call/fax/email/ftp/fix etc their trades into their brokers who might then execute the trades with their in-house or outsourced/white-labeled execution-quality algos.  Those algos might use some very clever close-to-the-market analytics to provide great execution for the client.  Or they might be traded profitably against.  Or both.

In any case, to me it seems clear that there is nothing intrinsically wrong about high-frequency trading itself.  People will always try to react to information as quickly as possible.  Why wouldn’t or shouldn’t they?  They also like to be clever.  Again, why wouldn’t this be expected and good?  I remember Lefevre recounting the use of personal teletypes by big speculators at the turn of the (prior) century.  Not your everyday household item at the time.  I also remember him recounting strategies for moving large positions which involved both buying and selling to hide one’s hand.  Why wouldn’t algos do the same and more?

That the loudest critics have been old-style execution traders “talking their book” to me tells the story here.

One other thing that my conversation evinces is the kinds of biz models being employed by brokers.  Like I said, this little hf hedge fund used an agency-only brokerage that caters to algo/hf traders.  Why is it important to note that it’s “agency only”?  Because, as the Goldman/Aleynikov story illustrates, strategies are organizationally porous in the sense that their value drips away as the human capital behind them moves from organization to organization and understanding of the strat’s internals become understood more broadly outside the organization.  This is likely the dynamic that drove Lo’s example above – more and more traders were employing similar strategies as the knowledge of the strategy leaked further and further from its original source(s).  Likewise, if I see all of your trading activity in sufficient detail, I might be able to reverse-engineer your strategy and work to steal your alpha.

Thus, traders are happy not to advertise their strategies’ behaviors.  So an agency-only broker – a broker who doesn’t engage in prop trading themselves – should inspire trust in a potential client.

Great!  What an honest business model!  But there’s an irony here and it points to the real kinds of problems we should be bugging our regulators to be addressing.  The specific agency-only broker I mention wasn’t self-clearing.  That is, they were using another broker (Goldman in this case) to handle their backoffice duties.  And guess what?  Goldman is anything but agency only.  So, clients who feel warm and fuzzy that they are dealing with an agency-only shop are actually exposing all of their activities with a particularly sophisticated and arguably predatorial prop trader.  It’s like the Guiness ads.

It’s funny to me that while there sits a multi-trillion dollar hole in our fed’s balance sheet which such hippies as fox news and bloomberg (suing to find out) and our US congress (asking politely) can’t seem to tease an explanation for out of the relevant authorities, the blogosphere and regulators seem to focus their invective on short sellers, hedge funds and high-frequency traders.

secret meeting at 85 broad?

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?

I suppose one answer might be that you have insufficient capital, but I just don’t think it’s a very satisfying answer.  It’s hard not to think that everyone can borrow money somewhere or run up credit cards or somesuch.  Another, possibly better, answer might be that the strategy requires more favorable commissions than you can obtain, thus you’re looking for an organization that’s either an exchange member or just trades in sufficient volume to have significantly lower costs than you can muster.  Again, not totally satisfying, particularly given that you really need a track-record to have gotten to this point.

Another impediment to selling a trading strategy is that it’s just an idea and ideas can be stolen.  You have to somehow give enough information to make your story credible, without giving away the strategy itself.  This can be harder than it sounds as the person listening to you presumably knows something about the relevant markets and might have some good understanding about the kinds of strategies that can be effectively deployed.  As a minimum, you have to convey the relevant performance characteristics of the system in good detail.  Even this can be revealing as the returns will often tell a tale about the strategy that generated them.  Additionally, most will want to hear a compelling “story” about how/why the strategy works.  What inefficiencies are the strategy capitalizing on?  This can be even more revealing as it will be in the form of a free-form discussion followed up with questions etc.  In the end, you might find that you’ve told a number of people revealing characteristics about your strategy – enough at least for them to do some digging of their own – without getting any closer to your aim.

But let’s say that you’ve managed to find someone who is interested.  Now the real difficulties begin!  How do you structure the deal?  I suppose you could sell the signals if the system trades sufficiently infrequently, but this obviates the entire class of higher frequency strategies.  It’s also a bit of an asymmetric deal in the sense that you presumably sell the signals on some kind of a fixed subscription basis whereas the purchaser can use an arbitrary amount of capital on the strategy.  In spite of these difficulties, this seems the cleanest kind of deal and I’ve seen it done in institutional contexts, so it’s not beyond the realm of possibility.

Another option, particularly for high-frequency systems or in cases where commission structures or trading infrastructure are a key element of the viability of the deal, is to partner in some concrete way through a partnership or a formalized joint venture.  This, too, is something that I’ve seen and have even engaged in, so it’s not too fanciful, but at the end of the day it ends up being like any other partnership or business: it fundamentally requires a deep level of trust.

(Another possibility, of course, is to wrap the strategy into a hedge fund, etf, structured product or other salable instrument and market it in a normal way.  But that’s another discussion as it requires significant capital upfront which means you could, if you chose, monetize your strategy directly by trading it.  So, it’s really a different issue entirely…)

Thus, if one can overcome the myriad difficulties, it is possible to sell a trading strategy.

That said, I wouldn’t recommend doing it and it’s not something that I’m interested in as a business model.  Why not?  Ultimately, it’s about what interests you and how you want to spend your time. Do you want to be a salesperson and spend your time preparing and smoothly delivering presentations, networking and glad-handing &tc?

Or do you want to research, develop and trade your algorithms?

ultimately, it's about what you want to do...

"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

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.

-

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.

Charles Ponzi. Is he smirking?

What’s different here is how large this one got before it folded. What made this possible? Answer: the enablers. These were the large feeder funds set up by others who sold access to the Madoff money machine. What culpability do they have in all this? A lot, me thinks. It comes down to reasonable expectations for due diligence.

I should say that no one is ever going to be 100% immune from the possibility of fraud, including us. But there are two basic lines of inquiry in this business that will keep you out of 90% of the frauds:

1. Who is the auditor? Have you ever heard of them? Do they have other reputable clients? Are they independent of the hedge fund?
2. Who is the prime broker? Are they a recognized name in the industry? Are they independent of the hedge fund?

A weak answer on either of these issues is enough for any smart investor to walk away.

Remember Bayou? They owned their own accounting firm, which made it easy to issue false audits. While cross ownership may have been difficult to uncover, it was a simple matter to determine that the accounting firm, “Richmond Fairfield Associates,” was an unknown entity. Also, Bayou owned its own broker-dealer, through which it did 100% of its trading. This is a problem in two ways. First, you don’t have an independent third party verifying and custodizing the assets. Second, it’s a trading conflict-of-interest. Is the fund getting best execution? Unlikely.

Let’s add to these red flags a yellow flag: overly smooth returns. I say yellow because there are one or two reputable ways to make money that produce fairly stable returns (most of the time), but these are in the lending area, not trading. Any trading strategy that produces month after month of steady returns is a blow-up waiting to happen, either from a shift in markets or because it was just a fraud to begin with. Bayou, naturally, had very smooth returns. The point is, smooth returns should, at a minimum, evoke some very pointed questions about the underlying strategy. My personal recommendation: How the heck do you do that?

How would Madoff have stood up to these questions? Well, Madoff’s auditor, Friehling & Horowitz, is complete unknown. But wait, it gets better. They operate out of a single 13 x 18 foot office located in a strip mall in Rockland County, NY. I looked it up on Google Earth:

They apparently had three employees, one of whom was 80 years old and another was a secretary.

Madoff owned his own broker dealer and charged a commission on every trade. He was, in fact, quite open about it. It was how he said he made all his money. He left the management and 20% incentive fees, incredibly, to the feeders.

Madoff had insanely smooth returns. Here’s what one of the feeder funds looks like:

Only five down months in two decades. Pretty good for a trading strategy, assuming it was possible, which it isn’t. Not even with $1 million, let alone $50 billion.

Which brings me to the feeders. The feeders are the truly remarkable part of the story, since there were a number of them, and the level of negligence is breathtaking.

The largest feeder was the Fairfield Greenwich Group, with about $7.5 billion in Madoff through its Fairfield Sentry Fund. Here’s what it says about due diligence on their website:

FGG’s due diligence process is deeper and broader than a typical Fund of Funds, resembling that of an asset management company acquiring another asset manager, rather than a passive investor entering a disposable investment.

A number of areas of inquiry are examined by a team of FGG professionals who specialize in evaluating respective areas of risk. Typically, a manager has been investigated and monitored for six to 12 months before that firm can be accepted onto the FGG platform. Long negotiating periods enable FGG to be more confident of its decisions before proceeding with a manager. Areas of examination are centered around the following:

1. Portfolio Evaluation, Investment Performance, and Financial Risks:

A core area for further analysis is to attempt to dissect and further understand investment performance, how a manager generates alpha, and what risks are taken in doing so. As portfolio management and risk management incorporate elements of both art and science, FGG applies both qualitative and quantitative measures. FGG:

· Examines independent prime broker trading records

· Conducts detailed interviews to better understand the manager’s methodology for forming a market view, and for selecting and exiting core positions

· Analyses trading records

· Conducts a number of qualitative and quantitative tests to determine adherence to risk limits over time

· Confirms portfolio loss risk controls, diversification and other risk-related control policies, as well as any experience regarding unexpected or extreme market events

· Reviews the risk and return factors inherent in the strategy

· Evaluates capacity issues, which may affect alpha, as well as expected opportunities going forward within each candidate’s strategy

· Analyses the various drivers underlying a particular portfolio’s risk

· Evaluates credit risk and market risk both at the instrument and portfolio level

· Assesses the extent to which leverage is used by a manager, as well as how it is used, the funding sources, and the impact on the risk profile of the fund

· Investigate whether or not private or special registration securities are held, and determine how the daily trading volume and inventory held compares to the float and/or daily trading volume for a given security

FGG also conducts many quantitative reviews of investment performance in light of:

· Fees and fee structure

· Historical draw-downs

· Return volatility

· Commissions earned

· Performance return in calm versus volatile markets

· Current/historical correlation of the fund under consideration with standard industry benchmarks, peer groups, and other FGG or competitor funds used as benchmarks

FGG attempts to understand the return attribution for individual securities in the portfolio, and conducts a full suite of VaR analyses and stress tests to model the loss distribution function under extreme market scenarios. Leverage, concentration limits, and long/short exposures are examined over time to assess whether they have remained within operating guidelines.

Style fidelity is another key area of inquiry; the manager’s trading pattern over time and through various market environments, FGG determines whether the manager is prone to trade outside of their area of expertise.

2. Personal Background Investigation:

FGG examines the abilities and personalities of the individuals involved in managing the fund through extensive interviews, as well as background investigations.
FGG verifies:
Education
Personal credit standing
Litigation and regulatory background
Track record
Other indicators

FGG explores the manager’s experience and qualifications relative to the strategy being managed. Prior professional associations of a manager’s key personnel can be crucial in understanding a person’s experience and character and how they run their investment management business.

3. Structural and Operational Risk:

“Operational risk” refers to the risk of loss resulting from inadequate or failed internal processes, human resources, or systems, or from external events. Operational failures, including misrepresentation of valuations and outright fraud, constitute the vast majority of instances where massive investor losses occur. Other operational risks include staff processing errors, technology failure, and poor data.

Pricing models, as well as the adequacy, independence, and transparency of valuation procedures, contingency plans, and other trading and settlement procedures are all matters for close scrutiny by FGG professionals.

FGG seeks a sound understanding of whether a hedge fund possesses key controls in the areas of portfolio management, conflicts of interest, segregation of duties, and compliance. FGG carefully assesses the controls and procedures that managers have in place and seek to determine actual compliance with those procedures, often suggesting modifications, separations of responsibilities, and remedial staff additions.

4. Legal, Compliance, and Regulatory Risk:

FGG’s legal, compliance, and accounting teams specialize in investment management regulation, securities compliance, corporate operations, and tax issues. Hedge fund managers function within an ever more complex legal and regulatory landscape, and the role of this part of the diligence exam is to determine the seriousness of any deficiencies in this area which may cause risk of sanction, loss, or reputational embarrassment.

Both in-house and retained legal professionals interview the management and staff of the manager, research regulatory filings, and review corporate organizational documents, as well as fund memoranda and related material contracts.

Wow, sure sounds good. No stone left unturned there! Except for the fact that they couldn’t have done any of these things. Clearly, no one ever made the one hour drive from New York to Rockland County to visit “Friehling & Horowitz,” although perhaps they were waylaid by the Dunkin Donuts next door. Frankly, I’m amazed FGG’s website is still up because it’s a plaintiff attorney’s dream.

The true winner of the Bozo the Clown award for Dysfunctional Investing must go to Fred Wilpon. His company, Sterling Stamos, was in both Madoff and Bayou. Ask yourself, wouldn’t the Bayou experience cause you to ask some basic questions about your due diligence process? Wouldn’t you then make a change or two? Maybe? Perhaps the annual collapse of the New York Mets proved too great a distraction.

Lots of people got into this scam because they assumed, with so many seemingly reputable people involved, that someone, somewhere, had done actual due diligence. While in a perfect world everyone does their own homework, the practical matter is that individual investors rely on intermediaries. Those intermediaries failed them horribly and have given the whole industry its greatest black eye ever.

A few other thoughts on this. I find it highly unlikely that Madoff’s sons didn’t know about the scam. This was simply too big an operation for one person to pull off. Think of the paperwork alone. When the writing was on the wall, I think Madoff let his sons turn him in to give them the veneer of innocence. I could be wrong, but I doubt it.

Also, from the return stream, as well as some very early red flags that some investors threw, it was clear this was a scam from the start. In most of the investment scams that I have seen (see my letter from March), the manager starts out honestly but goes awry. At some point he decides to lie in the hopes of making the money back (I’ll do it just this once…). Madoff was a liar and a cheat right from the start.

Lastly, Madoff’s golf game is as suspiciously consistent as his investment returns:

Source: ghin.com

Rest assured we know all of our funds’ accountants and prime brokers. They are all prominent institutions and completely independent of our underlying hedge funds.

On a completely different note, in my next letter I will forward an argument on why we may be entering a golden age for hedge fund returns. If this seems incongruous with everything that’s going on, stay tuned.

- Scott Johnston

]]> http://www.puppetmastertrading.com/blog/2008/12/15/ship-of-fools/feed/ 7 http://www.puppetmastertrading.com/blog/2008/12/12/swimming-naked/ http://www.puppetmastertrading.com/blog/2008/12/12/swimming-naked/#comments Fri, 12 Dec 2008 14:32:01 +0000 tito http://www.puppetmastertrading.com/blog/?p=214

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

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…

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.

To make a long story short(er), I eventually realized that the code hadn’t changed and the data hadn’t changed, but that my configuration defaults had changed – specifically those governing trading commissions and fees for equities. We’d recently done a client project in which the client had a pretty inefficient/expensive trading platform that made up for its cost by virtue of its facility for conveniently handling large numbers of managed accounts. In any case, in developing that client’s trading strategy I had set costs for trading equities out to a penny a share a trade to ensure that we had a system robust enough to withstand the costs inherent in their trading platform.

The difference this made on Dr. Lo’s strategy is pretty remarkable and so I’ll share it with you.

Without friction, my modified version of Dr Lo’s strategy yielded the following (back-tested) results since last May 1st:

Now, it’s a bumpy ride, no doubt, but a potentially rewarding one for those who can handle the volatility. With returns like that, one could conceivably seek to dampen the vol and then lever the strategy. Of course, this is assuming that one can actually execute the strategy profitably.

Assuming that every trade costs $.01 / share totally reverses the results of the strategy:

That looks pretty bad, right? This is what I returned to upon revisiting this strategy. In my effort to determine what had happened, I inverted the strategy to see how it’s inverse behaved. Corroborating observations I’ve made here previously, this didn’t help and so we had the degenerate case where a strategy and its inverse were both terrible losers. It’s a lot less bizarre than intuition might suggest!

Assuming somewhat more realistic friction for a sophisticated hedge fund, we get results more in line with what my recollection had suggested. It’s very possible for a fund to bear costs of somewhat less than 1/10 of a penny per share traded, but in keeping with a conservative approach, I illustrate the returns with costs pegged at 1/8 of a penny per share traded:

It’s a pretty remarkable difference and it illustrates the knife’s edge upon which one must dance to profitably execute an entire class of potentially fruitful quantitative strategies!