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Too Bad These Guys Don't Run the Banks & Brokerage Firms

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Flickr: thetaxhaven
Flickr: thetaxhaven

Among the best books written on the subject of investing are Reminiscences of A Stock Operator, Extraordinary Popular Delusions and the Madness of Crowds, and the Market Wizards series of books penned by author, trader, and analyst Jack Schwager.

His books have a life all their own among aficionados and the cognoscenti of trading. They are a collection of interviews with both reclusive and public personas and are hence affectionately called "the interview books." Schwager has written four in total and the first in the series was published in 1989.

The newest addition to the family called Hedge Fund Market Wizards has just been published. It includes interviews with traders and managers such as Ray Dalio, Colm O'Shea, Edward Thorpe, and Michael Platt, to name a few. There are 15 interviews in all within this massive tome that runs 520 pages. With that in mind, it's available in ebook as well as hardcover.

Hedge Fund Market Wizards (Wiley) is very pithy in its wisdom and like Schwager's earlier works, this one's contents will find it's way into the trading and investing lexicon. I found the managers interviewed operated on multiple levels of intelligence: they all have technical proficiency in risk management, and were very clever in that regard, but each has a great deal of emotional intelligence to boot -- they are virtually egoless and very unassuming for their talents. Too bad none of them run a bank or brokerage firm...

This unique combination might be at the root of why their trading results absolutely destroy the Efficient Market Hypothesis (most of Schwager's other interviewees have done so as well). Not only do the managers beat any reasonable benchmark, they do so with only a fraction of the downside.

Then, there's the issue of consistency of returns and no one was better than Ed Thorpe and the fund he ran for 19 years, Newport Partners. Schwager calculated the probability of Thorpe having achieved 227 winning months out of 230 as a result of randomness.

The result? "If you assume one billion traders, the odds of getting at least one track record equivalent to or better than Thorpe's would still be less than one out of 10 raised to the 62 power. To put this probability in context, the odds of randomly selecting a specific atom in the earth would be about a trillion times easier."

Without doing so intentionally, the tactics delineated in Hedge Fund Market Wizards throws into sharp relief one of the drawbacks of the Investment Company Act of 1940 is that a mutual fund manager must have at least 75 percent of the overall NAV invested. That means even if the manager is feeling defensive, there's not much flexibility to their approach. He must stay almost fully invested and take it in the teeth. Therefore, investors will too.

What is the most curious of all the managers interviewed is not their seeking profitable investment strategies, but the best way to express their ethos in the marketplace. In one of the interviews, the reader learns that the best way to express a bearish posture on China might not be to sell the Shanghai index short, but to create a spread between interest rates and trade the economic slowdown in China that way. In a spread, the manager is long one interest rate instrument and is short another, trading in effect, the relationship between the two interest rates.

The sole intention for putting on risk in the first place is to create the potential for asymmetric returns. There may be too much volatility attributed to shorting the Shanghai index. Whereas the reward-to-risk ratio for an outright short sale might be calculated as being 1:1, with a spread position it might be 3:1, with the added benefit of being hedged since the manager is simultaneously long and short two similar instruments.

Strategies like this are used the world over to express a posture of the yield curve flattening or steepening, but they can also be used as a surrogate to trade some of the global equity indices.

One thing is clear from reading this book: These managers do not put a single dollar at risk until they can define their exit point as well as the maximum loss they are willing to take. Once that point is hit, they are done and they offset the position. Preservation of capital is the driving force, not "how correct they think they are." The concept of surrender is omnipresent in the managers and it runs throughout the book.

We also get a look inside what it's like to run a 1,400 person firm with $122 billion in assets such as Bridgewater Associates, and how they keep their house in order via the candor and humility of Ray Dalio, Mentor at Bridgewater.

Those of you who've read his Principles, the 11-page document that defines the Bridgewater culture and his 277 management rules, will find this material new, even shocking.

Schwager asked Dalio about the feedback mechanism at Bridgewater: "Criticism is encouraged, including subordinates criticizing superiors. Do any of your employees criticize you?

Dalio: All the time.

Schwager: Can you give me an example?

Dalio: I was in a meeting with a big pension fund... After the meeting the salesperson criticized me for being inarticulate, running on too long, and adversely affecting the meeting. I asked others who had been at the meeting for their opinions. I was given the grade of "F"... I loved it because I knew that they were helping me improve and that they understood that was what they were supposed to be doing."

I couldn't help but to see a stark contrast in management styles between Ray Dalio and Bridgewater with the behavior of Jon Corzine leading to the demise of MF Global. When Corzine got some pushback, the head risk manager left the firm -- or was forced out.

Stringing it all together, you also come to understand that each has a strategy and ethos that is congruent with his personality. In the first Market Wizards book, Ed Seykota was interviewed and said "the goal of the trader is to develop a system with which he is compatible."

In interviewing Schwager for this book review, he underscored that point while we were speaking about how diverse and unique the managers were in their approaches. "The first point I make when I make a presentation is this," Schwager told me. "If you get nothing else out of my presentation today, remember this: to succeed in trading, you have to have an approach that matches your personality." Seykota wrote the Foreword to Hedge Fund Market Wizards.

The study of fundamentals is prevalent in their methodology, but in a very unconventional manner and one you might not expect. Instead of using fundamentals to establish a bullish scenario for going long Apple Inc., for example, these managers watch for a divergence between the price action and the fundamental information that hits the tape. When they diverge, that can be a trading signal itself.

In that regard, the fundamentals are used to establish a contrarian viewpoint, not a supporting position. This is in stark contrast to how the public and some analysts make their picks. Unfortunately, it's also the best way to lose one's objectivity in managing risk. Objectivity and risk management are Siamese twins.

Search the Internet and you're likely to find a plethora of articles and blog posts stipulating the "Top 10 Reasons You Need To Sell Everything And Buy Apple -- Right Now," as opposed to just one that suggests why you might be concerned to own a company with only a handful of products. If you think that's blasphemous, you have lost your edge, if you had one.