Jun

22

Two weeks ago in Chicago I presented the anchor leg of three different presentations on How to Identify and What to Pay for True Alpha.

Jason Roney of Bluegrass Capital Management and Marat Molyboga of Efficient Capital preceded me. Marat brought forth a very impressive presentation on assessing if manager skill actually exists and Jason showed how despite having a lower sharpe ratios, understanding a managers "regime robustness" is critical when making an allocation.

I concluded by presenting an incentive structure which one may use after they believe they have found an active manager worthy of investing in. My idea is "Risk-Factor Compensation". It's meant to be a very simple way to contextualize the profits a manager generates against not only the volatility the account had, but how much predetermined risk said investor was willing to lose. The resulting ratio then corresponds to a chart which tells what percentage incentive fee the manager is entitled to given their "Netto Number".

The bottom line is the current compensation structure of 20 percent of all profits without having a mechanism to contextualize how the return relative to drawdown or how much actual risk capital was at stake is woefully inadequate. I will post the link to the video when Terrappinn makes it available.

Given the sophistication of this group, I would like to hear anyone's comments on either the current 2 and 20 pay structure in hedge funds or my idea to have a score which balances out the focus between both the numerator and denominator as right now the only thing which matters when a manager gets paid is the numerator.

Here is the formula:

Profits / (Risk Budget + max negative drawdown/2)

So if someone made 400k and they had a risk budget of 800k and max negative drawdown of 400k then it would look like this

400k/ 600k

Which would equal .66. A Netto Number of .66 equals a 13 percent incentive fee, or 52k for the manager vs the traditional 20 percent of all profits, which would be 80k. So the investor saves about 28k in fees based on a lower Netto Number.

Now if the manager makes 1 mm and the denominators are constant then he has a Netto Number of 1.66 and now earns 32 percent of profits or 320k. But either way the investor wins because in order for a manger to get paid that the investor receives a SUPERIOR risk-adjusted return on a net basis.

I can email anyone privately the complete presentation upon request.

Jun

16

When the numbers look too good, there is an analogy for when one hires a specialist doctor (based on mortality/morbidity stats) or a lawyer (based on courtroom win/loss stats). If a doctor or lawyer has stats that look too good, it is often because he/she doesn't take the toughest cases.  

Ed Stewart writes: 

I wonder to what extent this applies in trading or evaluating traders. Do extraordinary numbers imply something is not what it seems. Certainly the obvious (fraud). but what about situations where it is not that. Do numbers that are too good at times suggest no real money is being made because no risk is present in the program? Reverse engineered to "look good" by metrics but not actually make any money.   

anonymous writes: 

There is a certain quantitative fund led by a renowned mathematician who has supposedly generated persistent returns in excess of 30% for many years.  That fund is not open to outside investors and is (supposedly) available only to employees and partners of the renowned mathematician.  The principals have a number of other funds which are open to outsiders, which have billions under management, and which have produced unremarkable results.

If one were going to set up a clever marketing scheme  one might use this sort of model. One would use the internal fund (with word of mouth only / no audited returns) as the bait.  And then sell the public fund which is vanilla to gather assets.  I am not a lawyer and have no opinion as to the legality.

Another scheme uses the survivor bias:  A manager sets up a series of funds and then closes the worst performing ones. The surviving ones have stellar track records. The manager then markets new funds using the track record of the surviving one. If the funds are segregated, it also produces large amounts of fee income.  A former Salomon Bros forex trader based in Connecticut got in trouble with regulators when he took this to the extreme by opening separately capitalized hedge funds that ran offsetting positions. When one of the funds blew up, the creditors sought to grab assets in the other fund.

A final scheme is what private equity and VC folks always do.  They segregate each series of fund.  They harvest fees from the winning funds but don't give back fees on the losing funds.  Of course if their track is dismal, the game ends. 

John Netto writes: 

Having spent many years living off of my P and L and working closely with quite a few in the Chicago Prop community who have done the same, there are simply strategies which lend themselves to personal wealth generation b/c they have significant capacity constraints and don't scale well. The reality is if you tried to run these at a higher scale it would decay the returns significantly and potentially alter market behavior around those respective trades.  I can say personally that when I'm trading an event with low liquidity getting out a 25 lot on the euro FX futures has a much different dynamic than getting out of a 1,000 lot. A trade which can make 20-30 ticks on the yen can have it's risk-reward profile altered considerably when factoring in liquidity and the velocity of trades around that liquidity.

Also, by exposing the strategy to the public and allowing for the returns to be analyzed you now open the possibility for the Intellectual Property to be compromised through reverse engineering.
So when I hear stories of funds or traders having return profiles like this I'm not surprised at all, even less surprised when they are not available to the public. Analogous to paying $25 for twitter on it's IPO when it traded in the 40s.

Stefan Jovanovich writes: 

What John wrote (thank you!) made me think about its truth regarding war. The big deployments usually produce terrible returns while the small units win the battles.

In the American part of the D-Day landings the mass bombings of the air forces were utterly useless (except to kill French civilians who, to this day, have been remarkably generous about not mentioning the stupidity and honoring the Americans' graves).

The "plan" was to have amphibious-enabled Shermans breach the fortifications. But only half of them even made it ashore; the rest foundered. Of the 66 tanks, 32 made is ashore (27 on Dog, only 5 on Easy). Against those 75 mm barrels the Germans had a roughly equal number of artillery and anti-tank barrels; the problem was that theirs were in reinforced concrete bunkers and pillboxes. Still worse, the artillery was supplemented by 40 rocket-launchers and 85 machine gun nests; against those the men on the beach had only their M-1 Garands.

For an hour and more after landing (H-Hour was 0630) the 1st and 29th Divisions were literally shredded because the Shermans and the combat engineers could not find a way to get them past the fortifications. What saved them was the fact that some individuals followed John's Rules. Even though all naval gunfire support was supposed to end at H-Hour, the 5 destroyers that were part of the Amphibious Assault Group - the Frankfort, McCook, Doyle, Thompson and Carmick - were ordered to close to the beach. (The order could easily have gotten the Destroyers' commander Sanders and the overall Group commander Hall fired for insubordination; under the assault plan all naval gunfire support was to end at H-hour.)

After the battle, James Knight, a Sergeant of the 299th Combat Engineer Battalion, wrote a letter to James Semmes, Captain of the Frankfort: "There is no question, at least in my mind, if you had not come in as close as you did, exposing yourself to God only knows how much, that I would not have survived the night. I truly believe that in the absence of the damage you inflicted on German emplacements, the only way any GI was going to leave Omaha was in a mattress cover or as a prisoner of war." The Chief of Staff of the 1st Division, Colonel S.B. Mason, confirmed as much in the report he wrote after inspecting the German defenses. "I am now firmly convinced that our supporting naval fire got us in; that without that gunfire we positively could not have crossed the beaches."…

Sometimes, good deeds are rewarded. When Hall, the Amphibious Group Commander, retired in 1953 he was still ranked only a Captain, but Eisenhower had him advanced to Admiral "in recognition of his battle honors". To Eisenhower Hall was "the Viking of Assault" (and a fellow football player). Eisenhower undoubtedly knew that, without Hall's, Sanders', Semmes' and the other Navy men's actions, the American part of the landings would have failed.
 

Jul

16

 I found there are many similarities between trading and playing poker (Texas Hold'em).

1. In both games, at first one is presented with an opportunity. In trading, this is the time one starts to decide whether one should make an entry; and in poker, this is when one is dealt with the first 2 cards. One calculates at this time the chances and the expectations and makes a decision on whether to proceed and how much money to put in.

2. While holding, one is constantly presented with the potential possibilities to win or to lose. In trading, this is reflected by the ups and downs of the equity value; and in poker, every new card coming to the table alters one's chances. During this time, one constantly calculates the chances and the expectations and makes decisions on whether to continue holding and whether to add or reduce one's position (in poker one can't reduce).

3. At closing, in poker, this means the final showdown; and in trading, this is when one has to close out the position. Only at this point, the possibilities to win or to lose are realized.

Probably one crucial difference is that in trading one does not have a way to bluff, unless one is a heavy weight in the market. But it is quite the same in both games that one is often bluffed at.

John Netto responds: 

I feel compelled to respond given I have used both mediums as a way to make a living. No comparison between poker and trading is complete without examining the ancillary issues such as transactional costs and liquidity.

In poker, the house takes a rake on every pot and for every orbit (time the dealer button goes around the board), a player must post a big blind and a small blind. The rake can be as small as 5% and as high as 20 percent given the venue and size of the pot.

In trading, one might pay a small fee for software or data, but on a percentage basis, this is substantially less. Overall, these are real factors for a number of professional cash game players in computing their positive expected return.

Liquidity is another issue. You are at a table with 8-9 other players and the higher the stakes go, the more seasoned and experienced the players are.

Therefore, assessing the "volatility" of a table is critical as a trader who likes to be long a lot of gamma, I like to be in games where the players are looking to gamble and mix it up in a lot of pots and chase down their draws at bad payouts.

May

20

This chart of 10 Yr Treasuries reminds one of the very kind companionship that Mr. Pitt provided to Aubrey and myself up the lazy river in Disneyworld Orlando a year ago. One wonders whether there are any regularities in it. vic

Anatoly Veltman comments:

One may observe the consecutive higher lows throughout the multi-year uptrend. One concludes that any first lower low will serve to produce technical downtrend of significance; at that time get out. Easy money!

Jeff Watson adds:

I'll say it again, the mistress never gives away, "Easy Money," and there is no such thing as easy money for the non-Flexion.  One suspects that those who make "easy money" in the market have some kind of Faustian Bargain in effect. I have to fight  tooth and nail for every quarter cent.

John Netto says:

Jeff- start studying market positioning and how the market is structured before large Econ data releases and Fed announcements. Being aware of this will point out asymmetrical situations which tend to provide profits at a much higher  velocity.

Jeff replies:

John, thank you very much for the most enlightening market lesson I've had in 35 years of trading.

Vic Niederhoffer is skeptical:

One is content to eke out any profit let alone one at a higher velocity. When I can unravel the meaning of Mr. Netto's post, I mite be poised to become a wealthy man.

John Netto clarifies:

The Chairman has asked me to provide further detail on what specifically i'm referring to by putting oneself in trades where  the velocity of P and L can appreciate at a greater intensity based on identifying market asymmetries.  Take the most recent nonfarm payrolls number. During the beginning of the week we saw estimates around 150,000. The day before  we saw ADP miss … estimates were then lowered for the nonfarm payrolls number from 150,000 to 140,000 by the Street.

We saw a rally in the bond market and some weakness in equities with the S and P sitting around 1585. This was the first sign  of how the market was positioning for what was believed to be a weak jobs report.

The number beat consensus coming in at 165,000 and with the market surprised by the results and positioned the opposite way,  bonds sold dramatically and equities put in a gap up, go up day - with neither of those markets returning to the scene of the crime since. As a professional trader supporting myself from my trading P&L, understanding market positioning is one of the  big ways I generate P&L. The aforementioned example was particularly lucrative.

Jun

17

 Rocky asked this question once a year or so ago about the outlook for the Euro after one of the many EU/peripheral events, and I thought it was a good one. So how might we measure and estimate, and what are people’s expectations for moves on Sunday-Monday following the Greek elections?
I am of the opinion in the medium term the elections don’t even matter. But, that is a different topic and exclusive of any short term opportunities.

Anatoly Veltman writes: 

A quick note on S&P: I think current risk is enormous (due to recent complacency).

Paolo Pezzutti writes: 

I think that we have to be aware that if Germany accepts the eurobond concept, Europeans will buy a lot of time although will only delay to pay the bill. That may have a significant impact on eurusd and equities. Not sure how likely is that, but as the situation worsens pressure on Germany increases. Especially after that in France, an important player, it prevailed the idea that socialists can improve things by increasing public spending.

John Netto writes: 

Long gold / short silver. I've been working this position for most of this week and it is telling us about some of the macro variables at play. This ratio is currently shy of 57 and can ascend to 60 given all of the global macro variables at play. Silver has been trading very heavy and under most circumstances I put together, the long gold short silver one helps me take on the sort of risk-adjusted exposure I like…

GL in the markets…
 

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