Following “Inside the House of Money“, this is the 2nd book by Steven Drobny on global macro hedge funds. This book, “The Invisible Hands“, focus on the 2008 global financial crisis, how some of the managers survived and why others did not. It pointed out the fundamental flaws in real money funds and how it continue to fail in future crises.
The traditional real money funds are still significant in today’s world as they have the largest managed assets in the world.
“Real money funds comprise a majority of world’s managed assets, which totaled $62 trillion at the end of 2008. Within this grouping, pensions are by far the largest category, at $24 trillion, with U.S. pensions at $15 trillion, or almost one-quarter of total managed assets.”
The 2008 crisis did not spare the famous endowment funds of Yale and Harvard. The universities have been dependent on the returns from the funds, and were forced to delay construction projects, layoff staff and freeze teacher salary.
“Yale University saw its endowment assets fall from almost $23 billion to $16.3 billion for fiscal year 2008-2009, a decline of almost 30 percent….”
and “Harvard University saw its endowment assets decline from a peak of $36.9 billion to $26 billion over the same period, also a decline of almost 30 percent.”
The author suggested 4 reasons for the dismal performance.
- Although the funds held different stocks from various industry, the risk is still the equity basket.
- The real money managers loaded up too many illiquid assets (which did well in the past as the assets were chased up under a low interest rate environment).
- By investing with other managers, they indirectly assumed leverage.
- Annual liquidity is required from these endowment funds and the time-frame is not congruent with investing in illiquid assets that may take years to see gains.
Drobny proposes the right direction to real money management is to address the ‘risk’ side of the equation.
Yale endowment chief David Swensen said,
“One of the difficulties of this current crisis is that we have to think about securities markets more from a top-down basis or macro basis than is the case when we’re not facing the type of crisis we lived through in the past six or nine months or a year. I am religiously bottom up in everything we do… but the crisis forces you to think top-down in ways that would, I think, be unproductive in normal circumstances, but are absolutely necessary in the midst of a crisis. You have to think about the functioning of the credit system. You have to think about the potential impact of monetary policy on markets over the next 5 or 10 or 15 years.”
After the introduction chapter, he went on to the interviews with the various hedge fund managers. I have quoted parts of the conversations that I think are useful pointers to help traders and investors improve their approach to the market.
Pg 90:
“Alpha seeking is, however, a positive sum game for society. You need to have people in there chasing alpha to make markets more efficient. And by efficiency I am not talking about providing liquidity to the market. Rather, you need to have people constantly trying to evaluate the right price, who are ready to trade on that belief, pushing the market towards equilibrium in a price discovery process. That way we get better allocation of resources in the real economy and fewer bubbles.”
Pg 114:
“I was always fascinated by how people made money, and I would try to reverse engineer their processes, although my results were often quite different from theirs. Sometimes their self-awareness was lacking, whereby they did not understand that their ability to take money out of a market was in part due to their trading style being conducive to the particular market environment. This is why you often see people have a stellar two- or three-year run, then never make money again. I learned early on from a study of my peers that it is useful to have a variety of styles to be able to adapt to and profit in all types of markets. The biggest macro question is always: “What type of market are we in?” If I know that, then I can implement the style and type of trading that suits that specific market.”
pg 116:
“… what other people believe will happen is just as important as the eventual outcome. A market is not a truth mechanism, but rather an interaction of human beings whereby their expectations, beliefs, hopes, and fears shape overall market prices.”
pg 118-119:
“But by sentiment I do not mean some kind of vague general feeling or emotion. I mean the reflection of people’s beliefs, which are based on something real and tangible, which will change their actions. Although beliefs tend to be driven by fundamentals, people and markets are very slow to fully incorporate macro information, and when they do the results can be overly dramatic. The uncertain nature of the economic future and our flawed attempts to understand it are a permanent source of market mispricing. The economy is not easily predictable, but the reactions of policy makers and the persistent errors in expectations are. The natural human expectations are. The natural extension of Keynes’ beauty contest is that animal spirits are not irrational and because they are not irrational they can be anticipated… We are particularly bad at understanding low probability events, which we tend to think of as either inevitable or impossible. Therefore, a very small change in the underlying fundamental probability can sometimes cause wild swings in sentiment because the potential outcome went from impossible to inevitable, whereas the underlying fundamentals did not move substantially. Shifts in sentiment cause markets to move much more frequent;y and violently than shifts in fundamentals do.”
pg 163:
“Each style has its advantages and disadvantages, and at different times one or the other might be optimal. Being aware of different trading styles and deciding when to use one or another is very important.”
pg 187:
“On one hand, if a trade is highly crowded, unanchored, not in some huge liquid market like EUR/USD, and people are involved for macroeconomic reasons, it is probably close to fair value, so my guess of expected return would be low. On the other hand, if a trade is very crowded because people are looking at the same instrument through non-macro goggles, it could be driven far from fair value, which to me is an ideal situation to think about going the other way.”
pg 209:
“All market prices are a function of supply and demand. Exogenous events aside, with most commodities the supply side of the equation tends to trend, especially in energy and metals. In most cases, supply up to 18 months forward is relatively predictable. However, it’s the demand side of the equation that has proven to be volatile in the last 20 years, so our forward macro outlook drives our demand assumptions. Understanding the demand side requires an enormous amount of micro analysis of global industrial production (IP) and global GDP, as well as having a view on the potential for U.S. dollar movements.”
pg 274-275:
“I don’t think you can chase trades or even seek out trades. Rather, I stay aware, stay informed, understand relationships, and wait for trades to come to me… I use my experience to develop themes and identify signals to tell me when a trade is ripe… I form the themes from an awareness of a wide-range of information – everything from demographics to migration patterns to the impact of currency movements on other asset classes.”
pg 277-278:
” I find that most of the time a good trade comes from identifying something that most other people miss and may even consider insignificant. Everything quantitative, everything related to economics, everything numerical that can be number-crunched and is widely available is all in the rear-view mirror. The key is finding a piece of information that people are missing that is relevant for the future. Many trades being with basic observations of changes in supply and demand trends that I subsequently dig into. A good example of this would be when I identified bullish aspects of the natural gas market after learning that my small hometown in Minnesota switched over from 100 percent electricity to 100 percent natural gas. This led me to dig in further and I found great trades related to energy switching…. There is an adage that says: The science of trading ponders the past, the art of trading focuses on the future – a good hedge fund needs a reasonable mix of both.”
pg 281-282:
“First, composition and direction of the portfolio is fundamental, discretionary, and economically driven. I crunch the numbers, estimate supply and demand, and formulate an economic value for a trade. Fundamental reasons can be purely economic, contain some artistic or psychological elements, or represent the identification of a new trend… Once the fundamental economic value criteria are met, I then plug the trade into my price analysis model, … The model helps me find overvalued zones to go short or undervalued zones to go long…”
pg 286:
Making money for the wrong reasons means you are rolling the dice, not trading. We are not here to gamble. Trades have to be making money for the reasons that we have identified and have the proper risk versus reward.”
pg 301:
“I definitely recognize my unformed self in some of the young people I see in the business. Even good traders tend to revert to chasing momentum when they get frustrated or are in a slump. It is easy to lose confidence when this happens because whatever you are doing is not working, and just randomly doing things does not solve the problem. With no method, trading winds up being more emotional.”
pg 305:
“Decisions are always made on partial information and waiting for over-confirmation on a trade is a sure way to miss a big part of the move.”
pg 306:
“… it’s all relative to what you are managing, which is now a few billion dollars. Your emotions correlate with the significance of the amount compared to both your capital and your typical daily swing. Fifty thousand back then was much more painful than significantly larger numbers now.”
pg 307:
“… stocks are driven by supply and demand, and can go absolutely anywhere regardless of what you think the business might be worth.”
pg 314:
“But because politicians are operating under two- to four-year time horizons, they are focused on short-term cash instead of longer-term incentives.”
pg 315:
“Looking through 13-F filings has revealed that a lot of hedge funds owned the same stocks, whether the funds were called long/short equity, global macro, event-driven, special situations, multi-strat, whatever. Everybody was long the same big NASDAQ names and the same big commodity and energy names. Crowding was pervasive. As these funds posted good performance and raised more money, they plowed it back into the same positions, driving them even higher… Crowding in a particular thesis or strategy means that when things start breaking, the break tends to be much sharper, much faster, and much bigger than expected.”
pg 318:
“The ability to adapt to different environments is probably the most important thing in the markets. If I look back at the guys with whom I traded over the years and compare the guys who are still around today and doing well to those that have dropped out, the ones that drop out typically are much more focused. They had a particular style, a particular strategy, something that worked for a period of time…”
pg 330:
Cash is the only thing that saves you in a liquidity crisis – cash or government bonds. There is no other way. You can never hedge a liquidity crisis.”
pg 343:
“In fund management, if you continue to make money the same way, sooner or later you will collapse, not because you are wrong, but because you failed to understand that everyone else had copied you. This was the primary mistake of the endowment model… Success brings emulation, emulation brings leverage, and leverage eventually brings disaster. Disaster comes not because the idea is wrong, but rather because there are too many people in it.”
pg 357:
“The most powerful means of compounding returns is to not lose money in the first place. If you start off with 100 and lose 30 percent, you are left with 70. Before you are truly in the black you have to make back the 30 you lost, which represents a gain of 43 percent! So, if you can minimize your drawdowns, you stand a better chance of compounding money more effectively over time.”
pg 362:
“But if it feels good and is easy to allocate to whatever strategy or instrument is in vogue, then maybe that is a signal to take a step back. The kind of investing that I do, that yields the really big returns, always involves fear and a sick feeling of the consequences of being wrong in isolation, away from the shelter of accepted opinion.”
pg 364:
“Even a true contrarian is only really contrarian about 20 percent of the time; it’s all about choosing the right moment to fight convention. The rest of the time is spent trend following. So I guess I am a trend-following contrarian.”