Lessons from Hedge Fund Market Wizards - Jack Schwager

Jack Schwager comes out with yet another outstanding book - "Hedge Fund Market Wizards". He is best known for his best selling books - Market Wizards (1989), The New Market Wizards (1992), and Stock Market Wizards (2001). These books are worth reading because it contains experience and learning of investors/traders who have skin in the game i.e. they are accountable for their views/bets/opinions. Unlike most experts/economists who aren't accountable of their reckless statements and predictions.  Though I haven't read the book "Hedge Fund Market Wizards",below summary is sourced from www.financetrends.blogspot.in. The blog is run by David Shvartsman and below is part of continuing series wherein other chapter's summary will be published subsequently on the blog. 

Lessons from Hedge Fund Market Wizards - Ray Dalio

1). Dalio is the founder and former CEO (now "mentor") of Bridgewater Associates, a fund that has returned more money ($50 billion) for investors than any hedge fund in history.  

2). Bridgewater still manages to achieve excellent returns on a huge base of capital and has done so over a long period of time. It is among the few hedge funds with a 20-year track record. 

3). Dalio believes that mistakes are a good thing, as they provide an opportunity for learning. If he could figure out what he (or someone else) was doing wrong, he could use that as a lesson and learn to be more effective.

4). His life's philosophy and management concepts are set down in a 111 page document called, Principles, which drives the firm's culture and daily operations. Identifying and learning from mistakes is a key theme. It also advocates "radical transparency" within the firm; meetings are taped and employees are encouraged to criticize each other openly.

5). "The type of thinking that is necessary to succeed in the markets is entirely different from the type of thinking required to succeed in school". Ray notes that school education emphasizes instructions, rote learning, and regurgitation. It also teaches students that "mistakes are bad", instead of teaching the importance of learning from mistakes. 

6). If you are involved in the markets, you must learn to deal with what you don't know. Anyone involved in markets knows you can never be absolutely confident. You can't approach trading by saying, "I know I'm right on this one." Dalio likes to put his ideas in front of other people so they can shoot them down and tell him where he may be wrong. 

7). "The markets teach you that you have to be an independent thinker. And any time you are an independent thinker, there is a reasonable chance you are going to be wrong."

8). Ray learned in his early working years that currency depreciation and money printing are good for stocks. He was surprised to see US stocks rise after Nixon closed the gold exchange window in 1971 (effectively ending the gold standard). The lesson was reinforced when the Fed eased massively in 1982 during the Latin American debt crisis. Stocks rallied, and of course, this marked the beginning of an 18-year bull market.

9). From these earlier experiences, Dalio learned not to trust what policy makers say. He has learned these lessons repeatedly over the years (much like our previous "Market Wizard", Colm O'Shea).  

10). Dalio vividly recalls a time when he was nearly ruined trading pork bellies in the early 1970s. He was long at a time when bellies were trading limit down every day. He didn't know when the losses would end, and every morning he'd hear the price board click down 200 points (the daily limit) and stay there. The experience taught him the importance of risk management - "I never wanted to experience that pain again".

11). "In trading you have to be defensive and aggressive at the same time. If you are not aggressive, you're not going to make money, and if you are not defensive, you are not going to keep money.". 

12). Bridgewater views diversification and asset correlation differently than most. As Dalio puts it, "People think that a thing called correlation exists. That's wrong.". Instead, he describes a world in which assets behave a certain way in response to environmental determinants. Correlations between say, stocks and bonds, are not static, but are changing in response to "drivers" (catalysts) that can cause assets to move together or inversely.

13). By studying how asset prices move in response to certain drivers, Bridgewater looks to build portfolios of truly uncorrelated assets. By combining assets that have very slight correlations, they are able to diversify among 15 assets (instead of 100 or 1000 more closely linked assets). This helps them cut volatility and greatly improve their return/risk ratio. 

14). We are currently in the midst of a "broad global deleveraging" that is negative for growth. Since the United States can print its own money, it will do so to alleviate the pressures of deflation and depression. The effectiveness of quantitative easing will be limited, since owners of bonds purchased by the Fed will use the money to buy similar assets. Dalio elaborates on our future economic course and possible policy approaches to these problems throughout the interview. 

There's a lot more in Schwager's chapter with Ray Dalio. These notes just scratch the surface on Bridgewater's process and their quest for the Holy Grail of investing. 


Lessons from Hedge Fund Market Wizards - Colm O'Shea

1). Colm O'Shea began his career as a young economic forecaster. He was kept behind closed doors by his firm, who did not want clients to know their research reports and forecasts were written by a 19-year old who had landed the job before starting at university.

2). Colm realized he did not want to continue publishing consensus-hugging forecasts, and he landed his first job as a trader at Citigroup after graduating from Cambridge. He went on to work for George Soros' Quantum Fund before founding his own firm, COMAC Capital.

3). O'Shea view his trading ideas as hypotheses. Moves counter to the expected direction are proof that his trade hypothesis is wrong. O'Shea is quick to liquidate these positions when they reach a pre-defined price (a level at which his trade hypothesis is invalidated). He risks a small percentage of his assets on each trade - position sizing. 
4). Received early lessons in trading and macro thinking by reading Edwin Lefevre's classic, Reminiscences of a Stock Operator. Colm points out that the character, Mr. Partridge teaches the protagonist (a thinly-veiled Jesse Livermore) to size up general conditions - "it's a bull market, you know!".

5). Price movements take place in the context of a larger fundamental landscape. O'Shea believes one must pay attention to both the fundamentals and the technicals (price as seen through technical analysis) to make sense of the picture.

6). In his first week as a trader, the British pound was kicked out of the ERM (the famous Soros trade), much to his surprise. Recalls Colm, "I had absolutely no comprehension of the power of markets vs. politics. Policy makers [often] don't understand that they are not in control...it's the fundamentals that actually matter."

7). You can't be short just because you think something is fundamentally overpriced. In the example of the Nasdaq bubble, you should have been selling Nasdaq at 4,000 on the way down, not on the way up. Wait until the market turns over, or until you can see a turning point (a la George Soros shorting the pound).

8). Being short credit in 2006-2007 was the same as being short Nasdaq in 1999. Bubble pricing was evident and the problems were obvious. However, being short was a negative carry trade (in which one must pay a certain cost to maintain a speculative position through instruments such as credit default swaps) and credit spreads went lower (the trade went against you) before a turning point was reached.

9). All markets look liquid in a bubble. It's liquidity afterwards that matters. Can you get out?

10). There does not have to be an identifiable reason for every trade. O'Shea cites the LTCM blowup in '98 as an example. At the start of the '98 crisis, there was no LTCM story in the press, but T-bond futures were limit up every day. "Once you realize something is happening, you can trade accordingly.". Trade hypothesis = something big is happening. I will participate, but do so in a way that I can get out quickly if wrong.

11). Most great trades are incredibly obvious to everyone after the fact. O'Shea points to his bearish turn at the start of the financial crisis in August 2007, when money markets seized up and LIBOR spiked. To this day, equity people wrongly point to March 2008 (Bear Stearns collapse) as the start of the crisis. The great trades don't require predictions, but you must see what other market participants won't.

12). Big price changes occur when people are forced to reevaluate their prejudices. Crisis (such as the inflationary threat from growing U.S. debt) may hit in the future when people notice and start to care. Bond yields will only signal there's a problem when it's too late. Fundamentals underlying the trade/event exist all along


Lessons from Hedge Fund Market Wizards -  Steve Clark

1. Steve Clark was "brutally honest" in his interview with Schwager. In the opening, Clark describes his background; raised in a council house on the outskirts of London, no father in sight, no university degree, and no initial trading experience. Clark was installing stereo systems when a friend told him about trading jobs in the City.  Sometimes interest and motivation are more important than "pedigree".

2. He worked a series of back-office jobs and assistant roles before getting a shot at running a market-making book. He got his first chance to trade the book while filling in for a trader on holiday...during the week of the October 1987 crash. Trial by fire situation.

3. Steve learned a valuable lesson making prices on October 19, 1987: the price is where anyone is prepared to deal, and it can be anything. Steve found he had to quote prices so low until sell orders dried up. He still lost several million pounds on his book that day.

4. Eventually he became the most profitable trader in his group. Steve credits this shift to his ability to cut positions that were down or "wrong". He also traded around news to orientate himself on "the right side of the market". Plus, he was inexperienced and didn't have the fear that cripples people who've been in the business for a long time. 

5. Traded on order flow info and screened for stocks making moves on big volume. He also used charts to see what happened when stocks reached certain levels in prior periods. Clark cautions that he is not a big believer in predictive chart analysis. 

6. Clark left his market-making job at top-rated Warburg for a better salary offer from Lehman Brothers. He soon found that he couldn't make money at his new firm, having left behind an environment that was rich in order flow information. It was a shock to his ego and caused him to doubt his ability as a trader. It happens to the best of us. 

7. Eventually he bounced back and over time developed contacts with trusted brokers. He used their order flow info to gauge near-term market sentiment on news events. If he was not aligned with momentum he would cut his position. Steve believes in buying on the way up. 

8. Steve gives traders one key piece of advice: do more of what works and less of what doesn't. Dissect your P + L and see what works for you (types of trades, timing, etc.) and what doesn't.

9. Price is irrelevant, it's size that kills you. If you are too big in an illiquid position, there is no way out.

10. Clark discusses a period of professional ups and downs that begins after the initial seed money for his first hedge fund fell through. After seeding a small fund on a shoestring using his own money, he wound up closing shop and went back to work for others. Thus began a hard road which led to some contentious litigation and Clark's disillusionment with The City. 

11. Set up his own fund in 2001 after a successful career move to First New York Securities. Despite his trading success, Clark says he is still waiting to find out "what I want to do when I grow up". A revealing section of the interview follows, in which Clark feels he has nothing to show for his trading career except money. "What have I accomplished?",  he asks. 

It may be worthwhile to reflect on this issue. What are we in this for? Your values and your assessments of the pros and cons of a trading career may vary.  

12. Back to trading. It's the size of your position rather than the price at which you put it on that determines your ability to keep the position. Trade within your emotional capacity. Don't take on a bigger position than you can handle. If you wake up thinking about a position, it's too big.

13. When everything lines up, you need to swing for the fences. However, if the position starts acting in a way you don't understand, you need to cut it because that is a sign you don't know what is going on.  

14. Your job as a trader is to make the line [your equity curve] go from bottom left to top right. That's it. Don't get hung up on other supposed "mandates". Protect your capital and the direction of that equity line. 


Lessons from Hedge Fund Market Wizards -  Scott Ramsey

1). Ramsey started trading in college. He was roped into the OTC metals market via a broker's ad in the Wall St. Journal. The broker charged customers a flat fee to buy and sell as much as they wanted in a particular market for six month. At the time, Scott was a novice and didn't know about futures, so he traded metals in this fashion through the inflationary run-up of the late 1970s.

2). Scott had to rethink his trading strategy after he bought silver at $50 an oz., only to watch it collapse to $26 following a long string of limit-down days. He sold as soon as the market resumed trading, but he lost all the money he had made plus some starting capital.

3). "Losing money was what got me hooked", says Scott. He knew that some 90% of futures traders lost money and he was determined to be in the 10% that profited. This motivated him to succeed. He was so engrossed in trading that he left college 9 credits shy of graduating, despite being an excellent engineering student. -

4). Scott learned to trade first w/ his own money, then by advising clients as a broker. He leased a seat on the IMM and tried trading from the floor. Being on the floor turned out to be a big disadvantage compared to screen trading. Scott felt there was a lack of meaningful info in the pits and he lost his feel from watching other markets. He soon left the floor.

5). Ramsey continued to broker and screen trade, watching every market and updating chart books by hand. He made money in his own account almost every year, but not a lot. Why? Ramsey says it was because he focused only on TA, not fundamentals. Also, because he regularly pulled money out of his account. He stayed a 1-2 lot trader instead of pushing it and increasing his size. 

6). "The evolution of a trader is when you start letting your money work for you and increasing your size."
 
7). Scott is one of those traders who has used his time as a broker to his learning advantage. By observing retail clients, he learned what not to do - everything from holding losers and taking small profits to emotional decision making and chasing market activity.

8). In order to make the big money, Scott realized he had to embrace fundamentals. The transition began when he started thinking about prevailing sentiment in the bond market and why prices were where they were. He thought about how people were positioned and the psychology behind prices. He then initiated a trade that was positioned against the prevailing sentiment, which turned out to be a very profitable move. "I began to look at the market from the perspective of other traders."

9). Discussing market action during the Euro crisis, Ramsey notes, "The market's repeated resilience in the face of negative news tells me it wants to go higher. Chaos creates opportunity. We learn so much about the markets when we have crisis events."

10). Rigorous risk control not only keeps losses small, it impacts profit potential. You must be in a position to seize opportunity. The only way to do that is w/ a clear mind. Don't expend mental energy by managing poor trades. Cut those that are not working.

11). When asked what trading advice he offers to friends, Ramsey tells them that it's not about being right - it's about making money. Taking losses is part of the process, so don't dwell on losing trades. Think about your next trade. Trading is a business. Treat it like one, keep records of your trades and journal your experience.