,

The Human Trader’s Secret Weapon

The following is an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot. ~ Joel Greenblatt

Investing is hard.

It’s a game of relative comparisons. We have limited capital and nearly unlimited opportunities to deploy it. Our job then as traders/investors (I use the terms interchangeably but will use investor from here on out) is to use our tools to sift through the thousands of stocks, bonds, and currencies to pick and select the handful of assets we think will give us a higher return than the market. This is obviously no easy feat…

The question we get from readers more than any other is about the framework we use to identify these asymmetric opportunities. They want to know how to sift through all the noise and numbers and find the stocks that are going to make them money!

A big piece of this puzzle is by first defining what exactly it is you’re looking for so you’ll know it when you see it. Once you’ve defined it, you can create a framework and process for identifying it. Then rinse and repeat…

That’s what we’re going to do in this month’s report. We’re going to discuss the different classifications of equity investing opportunities and then focus on our favorite, that of the long-term compounder. We’ll walk you through the first principles of value investing and then go through the step-by-step process of our framework for identifying stocks with massive long-term compounding potential.

You may be asking, aren’t you guys macro traders? Why are you writing about fundamental value investing?

That’s a fair question… You see, the key point about being a macro trader is that we’re not constrained by a rigid and narrow approach to markets. Our sole guiding philosophy is to make high risk-adjusted returns using whatever means necessary.

This is a flexible and opportunistic approach. We care only about positive asymmetry and not about what tools or mental frameworks (ie, technicals, fundamentals, classical macro etc…) we need to use to find them.

In reality, nearly every investment includes some combination of different factors and drivers. The best trades are the ones where the entire Marcus Trifecta of technicals, sentiment, and fundamentals align together in a fat pitch setup.

Like a warrior going into battle we don’t see the utility in limiting ourselves to a single weapon or style of fighting. Similar to Bruce Lee’s Jeet Kune Do, we aim to use anything and everything that works to help us win.

Value investing and understanding how to discover and identify long-term compounders is an essential tool in the macro trader’s toolkit. And that’s what we’re going to give you a master class in today. We’ll conclude by using this framework to analyze two stocks that we believe have long-term multibagger potential.

And hopefully after reading this report you’ll never feel like you’re running through a dynamite factory with a burning match again…

Breaking it down to the principle level

I believe there are an infinite number of laws of the universe and that all progress or dreams achieved come from operating in a way that’s consistent with them. These laws and the principles of how to operate in harmony with them have always existed. We were given these laws by nature. Man didn’t and can’t make them up. He can only hope to understand them and use them to get what he wants. ~ Ray Dalio

Every investing framework and process we build needs to be built upon clear, simple, and universal principles. Let’s discuss what some of these are.

An investor can have any combination of the following three edges:

  1. Informational: They can be privy to information that the market is not; through proprietary data (ie, using satellites to track foot traffic at stores) or by extreme due diligence in less watched areas of the market (really digging into the micro cap space) or by less scrupulous methods (insider knowledge).
  2. Analytical: They can look at the same data but come to different and superior conclusions through greater due diligence and/or better frameworks for understanding the world.
  3. Behavioral: They have better understanding and control of their own nature and thus exploit behavioral anomalies that arise in markets largely due to short-term emotional overreactions.

We briefly touched upon in last week’s note how the informational advantage has largely been arbed away due to the wide scale availability of powerful quantitative tools and screeners and information dissemination in general. At least for the retail investor, who doesn’t have access to proprietary credit card and store receipt data, and can’t plug into their satellite that’s tracking Walmart North American store traffic, they are left with the final two edges of analytical and behavioral — we can use this fact to our advantage.

The talented hedge fund manager and value investor Scott Miller said recently in an interview that he welcomes the proliferation of quantitative investing, remarking (emphasis mine):

I actually want quantitative strategies to proliferate. I want money to pile into them, gobs and gobs of it. The more money into quant strategies the better, as I think they are likely to create distortions that I can take advantage of over time. You can have your backward looking quantitative data and use that for the foundation of your decisions. I would rather understand the product, market, and management team of the companies I am investing in.  

We agree with Scott.

Our analytical edge needs to be in seeing the same data but assembling the pieces differently, in the hopes of creating a truer representation of the underlying business and its intrinsic value.

Joel Greenblatt often mentioned in his investing class at Columbia that he believed he was only average at valuation work (he had little edge there), but where he excelled — where his edge lay — came in being able to put the information together in context; view things from the bigger picture and pinpoint the factors that really mattered.

He was quoted as saying:

Explain the big picture. Your predecessors (MBAs) failed over a long period of time. It has nothing to do about their ability to do a spreadsheet. It has more to do with the big picture. I focus on the big picture. Think of the logic, not just the formula.

He only had access to the information everyone else had but he was able to piece it together to come to a completely different and more true conclusion — develop a variant perception. This is what an analytical edge is.

So we know that our value investing framework needs to include mental models for viewing and interpreting data in a more useful way. It needs to help give us a variant perception of reality and strengthen our analytical edge.

There are a number of ways to think about the behavioral edge. One being the emotionally driven overreactions to certain events (could be a missed earnings, negative press, or a broader market selloff) that create large valuation gaps. Long-time hedge fund manager, Bill Miller, puts it like this:

The securities we typically analyze are those that reflect the behavioral anomalies arising from largely emotional reactions to events. In the broadest sense, those securities reflect low expectations of future value creation, usually arising from either macroeconomic or microeconomic events or fears. Our research efforts are oriented toward determining whether a large gap exists between those low embedded expectations and the likely intrinsic value of the security. The ideal security is one that exhibits what Sir John Templeton referred to as “the point of maximum pessimism.”

Which brings us to another foundational principle about value investing: The best value investments will always have a well articulated and very convincing logic as to why they’re priced the way they are. These bearish arguments will always be predicated on a certain amount of truth. It’s this convincing narrative that creates the large mispricing. The thing is, these narratives tend to build on themselves. As they become more popular they tend to extrapolate the negative data points on which they’re built, further and further out the left tail, driving the price lower and further away from probable outcomes.

And like Howard Marks likes to say, there’s no such thing as a good or bad stock just good or bad prices.

A value investor must use their analytical edge to develop a variant perception in order to capitalize off the market’s behavioral overreaction.

Another aspect of behavioral edge is one of timeframe. The market which is becoming increasingly quantitatively focused has gotten very good at predicting earnings 1 to 2 quarters out. But with this short-term quantitative edge, comes the loss of long-term context and so the players in the market have become more and more myopic and short-term focused.

This trend towards market myopia widens the behavioral edge for those willing to peer a little further into the future and play the long game in their investing. This is a kind of time arbitrage that allows a patient investor to capitalize on the market’s broader short-termism.

To turn back to Bill Miller who said this about time arbitrage:

For the market broadly, the recent trends are toward shorter investing time horizons and less active stock selection, which gives us confidence in our competitive advantages of long-term, actively managed investing. The average holding period for mutual funds is now down to just six months, compared to our time horizon of three to five years. We believe that the one constant in the markets is the behaviors of groups of people and the advantages provided by a focus of behavior inefficiencies. The broad features of human behavior have not changed, and social psychologists have mapped pretty well how large numbers of people behave under various conditions. We try to arbitrage between perception and reality in behavior.

Our value investing framework needs to capitalize on our behavioral edge by objectively exploiting market overreactions — letting the fundamentals dictate our actions and not be reactive to short-term price moves —  and arbitraging time by peering further into the future and being more patient with our investments.

And so we have some clear foundational principles on which our framework can be built. We need to:

  • Utilize an analytical edge to arrive at a variant perception.
  • Exploit behavioral driven market overreactions that result in large mispricings.
  • Arbitrage time by playing the long game of peering further into the future and practicing infinite patience.

Moving on…

In our quest to further define what it is we’re looking for we can bucket equity investments into two broad categories:

  1. Macro: These are trades where the primary driver of returns is from macro inputs and not due to individual stock specifics. Cyclical commodity stocks fall under this category where their returns are driven by the capital cycle and the price of the underlying commodity. Market timing and sentiment driven trades also fall under this category.
  2. Fundamental Value:  These trades are primarily driven by the conditions and valuation of the underlying company. Fundamental value trades can be bucketed further into three separate categories.
    1. Classic value: These are the deep value sum of the part investments and the classic Graham net-net plays where the investment thesis rests on the mispricing of the company’s current intrinsic valuation; a valuation which depends less on the company’s future growth and more on the price given to its current assets and earnings stream.  
    2. Special situation: These are Joel Greenblatt style anomalous mispricings caused by spinoffs or a host of other reasons. These aren’t typically long-term plays but are held until the valuation gap caused by an event is closed.
    3. Long-term compounders: These are the real money makers. These are the special stocks that grow in value exponentially over long periods of time. They are run by skilled capital allocators, typically with large amounts of skin in the game, and are companies with wide moats that allow for enduring returns above the cost of capital.

These graphs below from Hayden Capital show the different intrinsic value growth curves and stock price path.

It’s the graph over on the right hand side where we want to focus the majority of our time and which we’re going to discuss today.

Long-term compounders are the stocks that can create generational wealth — if held on to. The problem is that they can be difficult to identify a priori but that’s what we’re going to solve for today.

First, let’s start with a simple math exercise from Scott Miller that shows the incredible power of compounding.

Example:  We underestimate the power of compounding and the impact of difference in return rates over a long period of time.

Question: What is the difference in ending capital between $100K that grows at 10% for 30 years vs. $100K that grows at 20% for 30 years?

Answer: $21M+

10% -> $1,744,940

20% -> $23,373,631

$21M+ dollars is quite a lot from just a 10% difference in annual returns over a long period. George Soros and Stanley Druckenmiller are both worth billions of dollars because they compounded money at an average of 30% return over decades!

This brings us to another foundational principle in markets and the people who play in them:

Humans are inherently bad at understanding the scale of exponential growth and the power of compounding…

We’re linear creatures who think in logarithmic terms. But if we want to harness the 90/10 distribution of market returns and put the power of compounding to work then we need to think in and seek out exponential growth opportunities for our capital.

Investing in a long-term compounder is essentially like allocating your capital to a compounding wizard like Druck or Soros. You can think of these companies almost as the best private equity firms, but ones with access to niche markets and the best information and deal flow available; along with an appropriate incentive structure that creates the opportunity for extraordinary alpha.

William Thorndike’s excellent book The Outsiders is a case study of the 8 best long-term compounders and the operators who ran them. Below are graphs to show the difference in returns over long periods of time that identifying and investing in a long-term compounder, an Outsider stock, can provide.

The differences in return outcomes are extraordinary… they’re exponential…

The market’s inability to properly comprehend and analyze exponential growth is one of our biggest analytical edges. It’s the reason why you have many self proclaimed “value” guys shorting high growth stocks — stocks with super high ROICs — and essentially throwing themselves on the burning pyre as sacrificial lambs because they’re doing linear math in a geometric world *cough Einhorn cough*…

Hopefully, you now get my point about the power of long-term compounding and exponential growth and how finding these stocks can be life changing. Understanding the power of compound growth and factoring that into your value analysis makes for a big analytical edge.

Okay, great! So now how do we find them… What makes one stock a long-term compounder and another just average?

For the answer, click here to sign up for the MIR. The latest issue includes our Macro Ops Long-term Compounders Identification Framework (MOLCIF) that you can use to find exponential growth.

 

 

,

The Principle of Bubble Rotation

In the book Business cycles: history, theory and investment reality, the author Lars Tvede talks briefly about a cycle phenomenon he calls The Principle of Bubble Rotation. He writes:

There is one further common aspect of all these asset classes. We have seen that business cycles from time to time create monetary environments that are conductive to asset bubbles. However, people will recall past crashes for a while, and this means that whatever asset people bought in the last bubble will rarely be chosen for the next. This leads to a systematic bubble rotation. There was a bubble in precious metals/diamonds in 1980, for instance, and then in collectibles (and Japanese land) in 1990, and then in equities in 2000.

Essentially, what Lars is saying boils down to, “what outperformed in the last cycle will not outperform in the next.”

Since trading and investing is a game of comparisons, we evaluate all assets on a relative basis and then choose to buy one thing over another. Using The Principle of Bubble Rotation we can underweight assets/sectors/industries that may look attractive at first glance but are unlikely to outperform for the simple reason that they did so in the prior cycle.

Let’s look at the outperformers from the last cycle and see how they’ve done in the current one.

The top performing assets/sectors/industries in the 02’ to 08’ cycle were:

  • Emerging markets
  • Homebuilders
  • Financials
  • Commodities

So far each of these assets/sectors/industries have adhered to The Principle of Bubble Rotation.

The reasons why this cycle skip exists are three fold:

  1. Psychological: Investors who were burned buying into a bubble in the previous cycle are likely to be hesitant to buy into those same assets in the next. We call these “event echoes” where the psychological scarring from a jarring market event affects investor behavior well into the future. This usually takes two cycles to reset because most investing careers don’t last much longer than that.
  2. Capital Cycle: Asset bubbles are born from overoptimism. This optimism attracts capital and competition which leads to large amounts of capital expenditure into future supply. This leads to over-capacity which takes the subsequent cycle to clear.
  3. Regulatory: There’s a regulatory cycle that is always fighting the last war and which typically goes into motion following the bust process where many investors were hurt or financial instability occurred. Take banks following the GFC or cryptos following the current bust process as an example. These regulations typically take the completion of another cycle before deregulation occurs.

The Principle of Bubble Rotation isn’t a hard and fast rule. There’s examples where it didn’t hold true and certain industries are susceptible to their own unique capital cycles which affect the length of their boom/bust process.

Still, it’s a useful heuristic to use for filtering down your universe of potential trades. It would have kept you from buying financials this cycle, which has been a popular but dead money trade. Also, it would have alerted you to areas of the market that were more likely to outperform since they underperformed in the previous cycle; the technology sector being a perfect example.

 

 

,

Probabilities Not Predictions

The following is an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

Markets are context dependent, their behavior is a function of the particular circumstances that exist and how those circumstances are expected to or do change. The trick is not to predict an unknowable future, but to try to understand the present and the probabilities of the various paths that may evolve from it. ~ Bill Miller

We often write that we’re not in the business of making predictions. Rather, our job is to gauge the asymmetry of outcomes.

We do this by determining what the consensus beliefs and positioning are by triangulating the macro, sentiment, and technicals. This helps us paint a picture of what expectations are already embedded in the price. Then we just weight these against possible future paths.

The larger the disparity between consensus and potential outcomes, the greater the asymmetry and the more attractive the bet (trade).

There are additional benefits to using this mental model versus the typical one of making predictions.

  1. It helps protect you from yourself. Certainty is a killer in this game. When we play the prediction game, we put ourselves at risk of becoming champions to a cause and slipping into the pull of our ego driven tribal nature. This distorts our perception of the world and blinds us to new information.
  2. Prediction making is linear and bimodal in nature. Markets are non-linear and endlessly dynamic. This fact causes prediction makers to live in friction and disharmony with markets — think the perma bears who’ve been on the wrong side of the market for years. They become stuck when their view of the world does not match up with how things actually are.
  3. Focusing on asymmetry of outcomes versus predictions frees the speculator from the psychologically destructive game of trying to be right over wrong. Instead, the speculator lives in a world of various shades of grey (50 shades maybe?) where they’re always some mix of both right and wrong. In this way, the objective becomes not to form an opinion and stick with it. But rather, to apply Bayesian analysis and continuously update their views as new information comes in — this puts the focus on making money versus being right.

Bennett Goodspeed put it like this, “Why do investment professionals get such poor marks? The main reason is that they are victims of their own methodology. By making a science out of an art, they are opting to be precisely wrong rather than generally correct.”

This year, we’ve been more generally correct than we’ve been generally wrong. We’ve handedly beaten the market, as a result.

But we can’t rest on our laurels. We must constantly check for holes in our own assumptions. Like a good writer, we must be willing to kill our darlings and be ready to flip our positioning should the triangulation of the macro, sentiment, and technicals tell us to do so.

The above was an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

 

 

,

Yield Curve Inversion!? Flattening Yield Curve Explained

The Yield Curve Inversion Secrets! Understanding the Flattening Yield Curve is crucial for any trader or investor!

Today we’re going to talk about the yield curve. Recently the financial media has been raving about the yield curve getting closer and closer to inverting and how it’s a signal that a recession is right around the corner. In this video we’re going to go over what the yield curve is, how to use it, and what it’s really signalling about the market.

The yield curve is basically just a line that plots the yield of US treasury bonds (TLT) with different maturity dates. The curve lets you easily compare rates on short term bonds versus long term bonds. When long term bonds are yielding more than short term bonds, the line rises from left to right. And when this is the case, it’s called a normal yield curve. This is signal that the economy and market are doing okay.

When you start to see the yield curve flatten or even invert, meaning short-term rates become equal to or higher than long-term rates, and the line either becomes flat or sloped lower from left to right, then that usually signals trouble ahead in terms of a recession and lower market prices.

Two things happen for the yield curve to become like this. First, the Fed starts raising short-term rates. Based on their mandates, they may see the economy overheating and decide to raise rates to slow it down. Higher rates hurt economic expansions.

Second, investor expectations for the future become negative. And because of that, they buy up long-term bonds, lowering their yield. Those two together you a flat or inverted yield curve where short term bonds yield the same or even more than long-term bonds. And like this signals trouble ahead.

According to our analysis, yes the curve is beginning to flatten and invert, but we still have a lot of time left before this bull iis done. Make sure to watch the video above for more!

And as always, stay Fallible investors!

,

High Quality Trading Is Episodic, Not Continuous

There’s two types of market returns. Alpha and beta. Beta is what you get for diversifying and passively holding the market. Alpha is the opposite. It requires an edge, of which there are three: informational, analytical, and behavioral.

And as Ray Dalio says, “Alpha is zero sum. In order to earn more than the market return, you have to take money from somebody else.”

Harvesting alpha takes significant work because it involves separating someone else from their capital. And that someone else is trying to do the same to you. Most traders and active investors are in the game to produce alpha.

The competition among alpha players is what creates mostly efficient markets.

Once in awhile, Mr. Market throws a tantrum (or gets too excited) and a mispricing occurs. This opens up an opportunity for alpha players to profit. These opportunities often don’t last long. Other alpha players swarm to take advantage the second they detect blood in the water. Once enough catch on the market returns to an efficient state i.e. random forward returns.

Using this mental model of the game we can deduce that high quality trading is episodic, not continuous.

Trying to capture alpha continuously would be like playing every starting hand in Texas Hold’em. Expert poker players know that it’s virtually impossible to win long-term with the bottom 80% of starting hands no matter how good your post-flop play is.

In trading, it’s impossible to harvest alpha every single day. The market is highly competitive and Mr. Market rarely screws up with such high frequency.

Being a trader, you need to learn to patiently sit through long stretches of getting dealt duds. In poker we call this “sitting in Siberia.” This is when you have to sit and fold for hours and hours waiting for cards that have a positive expectation while the rest of the table has fun pushing chips into the middle. Trying to trade during these “Siberia moments” in markets is a profitless endeavor over the long haul.

Continuous trading creates subpar performance because exposure to inefficient market states get mixed in with exposure to efficient market states.

If you take the right side of the market during an inefficient state you will make money long-term. But when you initiate a trade in an efficient market your expected return is 0. And you still have to suffer through the volatility of each trade. It’s a waste of time, resources, and energy. You have to go through all of the work for no reward.

That’s why it’s important to think of trading episodically and not continuously. You don’t want to mix the good with the bad. Structure your trading similar to how a sniper goes about his business on the battlefield — a series of high impact and deadly episodic strikes.

The corollary to “high quality trading is episodic not continuous” is the rarer the market dislocation the greater the edge.

There’s a few reasons for this.

First off, an event that occurs seldomly is less understood than an event that happens frequently.

Uncertainty and confusion in the market is what creates an edge for the alpha players who are able to make sense of things.

Second, the professional quant community ignores rare events as sources of edge — which creates less competition.

Conventional quant techniques look for statistical significance. That means quants need to see lots of historical occurrence to prove that their trading methodology is legit. If there aren’t enough historical occurrences, they will write off the approach as spurious.

The ‘professional’ quant methodology guarantees that they won’t and can’t act on the highest alpha opportunities in the marketplace, leaving the lion’s share to human traders utilizing intuition and experience. Trader intuition and experience is powerful because it enables traders to identify rare alpha opportunities despite a low number of historical occurrences.

So if you’re an independent trader who

  1. Believes that high alpha trading is episodic not continuous
  2. The rarer the dislocation the more alpha

Here’s what you can do to shift your approach to produce better risk adjusted returns.

Start by weed wacking your trade “setups.”

Take the bottom 50% of your trading opportunities and cut them out. Then take the remaining trade setups and cut them by 50% again. This will align you with the philosophy of rare events (the most optimal setups) and make your trading episodic rather than continuous.

Then consider trades that make logical sense to you but don’t have many historical occurrences.

These trades will always have the fattest edge and the least amount of competition because other traders will pass them up.

Finally, expand your playing field as much as possible.

This is in line with our global macro approach at Macro Ops. Because high alpha opportunities are rare, a particular market will only generate a few quality signals a year. That puts a cap on your earning potential. The only way to make more money is to increase your discovery space. That means getting involved with other markets like currencies, rates, grains, meats, softs, volatility, crypto, energy, micro-caps and metals. Hopefully over the course of the year these markets will generate additional rare alpha opportunities that you can capitalize on.

 

 

The Art of Totis Porcis
,

The Difference Between Great Traders and Good Traders: The Art of Totis Porcis

The following is an excerpt from Barton Bigg’s book, Hedgehogging, where he relates a conversation with “Tim”, a successful macro investor (emphasis mine).

Tim works out of a quiet, spacious office filled with antique furniture, exquisite oriental rugs, and porcelain in a leafy suburb of London with only a secretary. My guess is he runs more than $1 billion, probably half of which is his. On his beautiful Chippendale desk sits a small plaque, which says totis porcis—the whole hog. There is also a small porcelain pig, which reads, “It takes Courage to be a Pig.” I think Stan Druckenmiller, who coined the phrase, gave him the pig.

To get really big long-term returns, you have to be a pig and ride your winners… When he lacks conviction, he reduces his leverage and takes off his bets. He describes this as “staying close to shore… When I asked him how he got his investment ideas, at first he was at a loss. Then, after thinking about it, he said that the trick was to accumulate over time a knowledge base. Then, out of the blue, some event or new piece of information triggers a thought process, and suddenly you have discovered an investment opportunity. You can’t force it. You have to be patient and wait for the light to go on. If it doesn’t go on, “Stay close to shore.”

What separates the great traders from those who are just good?

The answer is knowing when to size up and eat the whole hog.

Let me explain.

To become a good trader you have to master risk management. Managing risk is the foundation of successful speculation. It’s the core of ensuring your long-term survival.

After risk, there’s trade and portfolio management. These are not wholly separate from managing risk. But they have the added complexity of things like thinking about when to take profits on a trade or how the drivers of your book correlate across positions etc…

Risk and trade management are absolute critical skills to becoming a good trader. All good traders are masters in these two areas.

But the thing that makes great traders head and shoulders above the rest, is the skill in knowing when to go for the jugular. In sizing up and aggressively going for Totis Porcis, the full hog.

Great traders know how to exploit fat tail events — the large mispricings that only come around once in a blue moon. They swing for the fences when fat pitches come across their plate.

Examples of this are Livermore making a fortune shorting the 29’ crash. PTJ doing the same in the 87’ rout and the Nikkei fallout in 1990. Druck and Soros when they took down the Bank of England in 92’. Buffett, who’s a master of exploiting fat tails, did it when he put nearly half his capital into AXP when it was selling for dirt cheap prices.

This is something we at MO call FET which is just short for Fat-tail Exploitation Theory.

Markets and investor returns follow a power law. Similar to Pareto’s law, returns adhere to an extreme distribution of 90/10. This means, that amongst great traders and investors, 90% of their profits on average come from only 10% or less of their trades.

Let’s look at the following from Ken Grant (who’s worked with traders such as Cohen, PTJ et al.) in his book Trading Risk (emphasis mine):

Some years ago in my observation of P/L patterns, I noticed the following interesting trend: For virtually every account I encountered, the overwhelming majority of profitability was concentrated in a handful of trades. Once this pattern became clear to me, I decided to test the hypothesis across a large sample of portfolio managers for whom transactions-level data was available. Specifically, I took each transaction in every account and ranked them in descending order by profitability. I then went to the top of the list of trades and started adding the profits for each transaction until the total was equal to the overall profitability of the account.

What I found reinforced this hypothesis in surprisingly unambiguous terms. For nearly every account in our sample, the top 10% of all transactions ranked by profitability accounted for 100% or more of the P/L for the account. In many cases, the 100% threshold was crossed at 5% or lower. Moreover, this pattern repeated itself consistently across trading styles, asset classes, instrument classes, and market conditions. This is an important concept that has far reaching implications for portfolio management, many of which I will attempt to address here.

To begin with, if we accept the notion that the entire profitability of your account will be captured in, say, the top 10% of your trades, then it follows by definition that the other 90% are a break-even proposition. Think about this for a moment: Literally 9 out of every 10 of your trades are likely to aggregate to produce profits of exactly zero.

This power law for investment returns is ironclad. Like Grant notes, it’s consistent “across trading styles, asset classes, instrument classes, and market conditions.”

And here’s where we get to the crux of the matter. Good traders don’t know how to harness this power law. While great traders do. They exploit it, using it to their full advantage.

Here’s Druckenmiller on the subject (emphasis mine):

The first thing I heard when I got in the business, from my mentor, was bulls make money, bears make money, and pigs get slaughtered.

I’m here to tell you I was a pig.

And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you… The mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.

But how can one be a pig while still being a good manager of risk. It kind of seems like a paradoxical statement doesn’t it?

Here’s how.

Your average trader picks trades that have symmetrical potential outcomes. This means that the market pricing is on average, correct. It’s efficient. And the distribution of returns for these trades will fall randomly within the cone of future possibilities.

On average, these trades don’t produce alpha.

Using trade and risk management, a good trader can take this symmetric futures cone and produce positive returns by reducing the downside of return outcomes through trade structure and stop losses. But their upside is limited to the average distribution of outcomes.

But great traders and investors are different. They are skilled at identifying highly asymmetric outcomes.

These trades have the potential to massively reprice in their favor. The distribution of future outcomes for these trades looks more like this.

And not only are they skilled at identifying these skewed setups but when all the stars align they go for the whole hog and exploit the market’s error. They know that these rare asymmetric opportunities don’t come around often.

Great traders have this ability not because they are any better at predicting the future. Prediction is a fool’s errand.

It’s because they have built up a store of knowledge and context and pattern recognition skills. This allows them to more effectively assess the range of possibilities for an outcome set and identify one’s that are highly skewed to the upside.

They have the experience base that allows them to aggressively size up while at the sametime properly manage their risk. Simply put, they’ve earned the right to have conviction. And the vast majority of good traders haven’t earned this right. So they’re better off sticking with consistent and manageable bet sizing.

Tim from Hedgehogging stated it perfectly in saying that “the trick was to accumulate over time a knowledge base. Then, out of the blue, some event or new piece of information triggers a thought process, and suddenly you have discovered an investment opportunity.”

The evolutionary process of a trader should be to focus on mastering risk management. Then trade management — riding winners to their full potential. All the while building up a library of experience and useful context that will give them tools to identify asymmetric opportunities down the road. And once they’ve earned the right to have conviction, they can go for Totis Porcis.

Until then, “stay close to shore”.

Some final words from Druckenmiller.

The way to build superior long-term returns is through preservation of capital and home runs…When you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig.

 

 

The Management Principles of George Soros

The Management Principles of George Soros

The following is straight from Operator Kean, a member of the Macro Ops Collective. To contact Kean, visit his website here.

In the first and second articles of this 3-part series, we covered the philosophy and the investment principles and strategies of the famous Quantum Fund ran by billionaire investor George Soros.

In this third article, we will cover the management principles of this legendary firm.

(I) Be Part Of A Global ‘Intelligence Network’

One advantage that the Palindrome had was his ‘intelligence network’. His rise from obscurity in the early 1960s to commercial stardom on Wall Street brought him the powerful perks of wealth and fame. With this, he realized that he could access vital people from the upper echelons of government or commerce, and hence, worked hard to develop a professional network.

With this professional network, he could get the opinions of very informed people to ‘stress test’ his own views and alert him to new trading opportunities.

This is one reason I joined the Macro Ops Collective last year, as I wanted to be a part of a global ‘intelligence network’ and hopefully contribute to its growth. The MO Collective is a community of savvy macro traders from all over the world. It’s a place where I can gain perspectives and insights on markets as exotic as South America. It’s a place I can ‘stress test’ my investment strategies or ideas as well.

Widen your circle as much as possible. Network with as many people as possible — you’ll never know when and where your next best idea will come from.

Iron sharpens Iron Do you have a global ‘intelligence network’? Or are you part of one?

(II) Constantly Source For Talent

This may be a clichéd point, as it’s intuitive to any business person. Without competent and capable people in your firm, there can be no real progress. By allowing talented individuals to flourish and develop, you also allow them to contribute to the overall growth of your organization.

Time must be devoted to finding talented individuals. This process is continuous.

As the Quantum Fund got bigger due to its meteoric rise and stellar performance over the decades, Soros had to expand the organization and train up future successors and leaders of the firm. He was constantly on the lookout for talented macro traders such as Stanley Druckenmiller, Nicholas Roditi and Scott Bessent.

(III) Leverage External Expertise

Soros relied on external expertise to generate the best returns.

In the 1990s, Soros delegated some of his firm’s equity to Victor Niederhoffer after recognising his trading talent.

More recently, Soros allocated a substantial amount of his family office’s assets to bond king Bill Gross when he left PIMCO.

Soros doesn’t care if he’s actually placing the trades. Once he identifies an opportunity, he’s perfectly fine with sourcing outside expertise to help him capture it.

The trading universe is massive. There will be certain markets or segments that are niche, requiring expertise beyond your field or competency. You only need to identify the opportunity, and then find a way to leverage on external expertise.

Take these management principles and lessons from the world’s most famous hedge fund manager. It could take your own investment business to the next level!

 

 

Another Lesson In Position Sizing From The Volpocalypse of 2018
,

Another Lesson In Position Sizing From The Volpocalypse of 2018

Most famous fund failures have leverage at their core. That’s the true culprit for disaster —  not the actual trade ideas. Bad position sizing kills.

Long Term Capital Management’s strategy involved scanning the world for bond spreads that diverged from historical values — something known as convergence trading. When spreads diverged from their means, LTCM would buy the cheap and sell the expensive bond. Then wait for prices to revert back to their “theoretical efficient” market price and make a small profit.

But LTCM wasn’t satisfied with the tiny profits on the spread. They were “Masters of the Universe” and wanted to put up bigly numbers that smoked the S&P. So they took this simple strategy and leveraged up to high heaven.

Before LTCM was incinerated they had a portfolio market value of $129 billion. Of which, $125 billion was borrowed money. That’s a leverage ratio of 32:1.

Once old lady volatility hit the market, those bond spreads that LTCM had leveraged to infinity betting that they would quickly converge just like all previous times… kept diverging… and diverging.  Until eventually LTCM was forced into liquidation.

Leverage and crowding caused the forced unwind of the trade. Not the strategy of buying cheap bonds and selling expensive bonds. LTCM had a good strategy that they ruined with excessive leverage.

The exact same leverage issue happened to Victor Niederhoffer in 1997.

After suffering from a huge loss on Thai stocks during the Thai Baht crisis, Niederhoffer turned to aggressive S&P 500 put writing in order to “make back” his losses.

Over the summer of 1997 he shorted out-of-the-money November 830 puts for prices between $4 and $6.

By October these puts were trading for just $0.60 and Niederhoffer had a large gain. But the Asian Contagion spread and eventually hit the S&P.

On Thursday October 23rd, 1997 the puts rose to $1.20. On Friday the S&P dropped further but closed well above Niederhoffer’s option strike. Niederhoffer still wasn’t worried — his puts were trading for $2.40.

Over the weekend Asian markets continued to sell off. Hong Kong dropped 5% during its session which triggered a risk off move in the US markets driving stocks down 7%. This rout continued into the next morning sending the S&P spiraling into the 800s.

Volatility skyrocketed. And Niederhoffer’s puts shot up to $16. That’s 300% higher than the price he sold them for.

Refco, Niederhoffer’s broker at the time, was not happy. They called in his puts mid-morning on Tuesday October 28th for a loss of $90 million. Niederhoffer’s $70 million fund turned into a capital blackhole of -$20 million.

The market bottomed right after Niederhoffer was margin called. By November, the market was back near highs. His 830 puts went on to expire worthless — meaning his trade, had he been able to hold on, turned out to be profitable.

But his leverage forced his liquidation. He was oversized and couldn’t ride the trade out.

Niederhoffer had shorted so many puts that a run of the mill two-day market selloff sent him out on a stretcher.  

If he had sized the trade correctly, he would have survived the ride and took home a small profit. But the guy was playing on tilt, got greedy, maybe a bit arrogant, and lost all of his client’s money. (Here’s an interesting clip of him post blow up)

With the trading history books filled with examples like these where hubris and stupid sizing led to catastrophe you’d think trader’s today would maybe, learn from the past. But of course that’s not the case. Human nature is after all, human nature. And “easy” money is quite effective at clouding our better judgement.

The Volpocalype of 2018 showed us that both amateur and professional traders are still making the same mistakes with position size and leverage.

LJM partners, a mutual fund that sells options just like Niederhoffer did and whose tagline was “superior returns for the patient investor” followed the LTCM playbook.

A not-out-of-the-ordinary 10% fall in the S&P forced the fund to close positions at extremely unfavorable prices.

And then there was this amatuer XIV trader from Reddit who lost nearly $4 million dollars in XIV.

XIV goes up over time. But it also has incredibly nasty drawdowns that can exceed 90%. XIV trades more like an option than a stock. It has the ability to go up 100s of percent but also the ability to go down 90-100%.

Knowing this it’s crazy to think that anyone would allocate 100% of their portfolio into this exotic product.

So why did this Redditor do it?

Why did LTCM, and Niederhoffer and LJM carry such large positions?

Why do we constantly have a steady stream of stories about traders leveraging to the hilt and blowing out their accounts?

At the end of the day it all comes down to greed and hubris. It’s because traders want to turn a sound strategy that can produce 10% per annum returns into something that generates 30% per annum. And of course the only way to do this is to leverage the capital.

But as we’ve seen time and time again, the more you leverage the higher your chances are of ending the game bankrupt. And at a certain level of leverage your chances of going bankrupt actually converge to 100%.

That’s why it’s crucial to get position sizing right alongside a solid trading edge.

The late John Bender explains this perfectly in his interview inside Stock Market Wizards.

It might seem that if u have an edge, the way to maximize the edge is to trade as big as you can. But that’s not the case, because of risk. As a professional gambler or as a trader, you are constantly walking the line between maximizing edge & minimizing your risk of tapping out. ~ Market Wizard John Bender

I can illustrate this concept with a simple example.

Here’s a decent “good enough” trading strategy that starts with $10,000 in account equity.

From mid-2004 to mid-2010 it did pretty well. $10,000 turned into around $33,000.

Now here’s the exact same trading strategy, with the exact same starting equity, but with 10x the position size.

The allure of leverage is obvious. The 10x model at its height had a 1000x gain. $10k turned into $10 million. The prospect of outsized returns is what lures traders to lever.

But it’s a farce. Using this amount of leverage guarantees a blow up will occur at some point. And unfortunately for this trader he didn’t stop and ended the game with a $3 million debt to the broker.

To position size correctly you need robust risk management assumptions. That means assuming any product can trade at any price at any time.

If your trading VIX for example, assume it can go from 10 to 100 overnight. That might sound asinine but in reality it keeps you safe. Because at the end of the day anything can happen.

By putting extreme scenarios in your universe you can devise a way to survive should it occur. This way of thinking will keep you from botching position size.

Traders that blow up and over lever don’t think like this. Instead they use models that rely on past data to estimate “probable” risk.

Throw those methods out. Historical data means nothing when it comes to risk management. The future will always bring something more intense than the past.

Another thing to be cognizant of is that strategies with negative skewness (frequent small wins and large rare losses) are especially tricky to position size correctly.

LTCM, Niederhoffer, LJM, and that XIV Redditor were all implementing strategies with negative skewness.

If you’re strategy has these characteristics it’s even more important to run extreme stress testing on your process and assume that your trading vehicles can trade at any price at any time. Size your positions from that extreme stress test. Never rely on past historical moves to define your risk in a negative skew trading strategy. The traders that rely on past data to size up risk always blow up.

Please think deeply about your position sizing process. If you don’t get it right you’ll end up in Taleb’s Turkey Graveyard with the rest of the traders who flew too close to the sun.

 

 

Hedge Fund Letters For Generating New Equity Ideas
,

Top Ten Hedge Fund Letters For Generating New Equity Ideas

I’m often asked how I come up with trading ideas. My usual response is that I do a lot of reading, talking to other traders, and thinking.

I don’t have a single funnel for sourcing trades. This is partly because we’re interested in all types of trades (ie, value, classic macro, special situation etc…) and don’t limit ourselves to a particular approach. What were concerned with, is asymmetry… the greater the convexity the better.

Since I can’t give you my network of traders and HF managers I talk shop with, I thought I’d do the next best thing and share with you my go-to reading list of quarterly fund letters, sites, and blogs that I read regularly for idea generation. There’s a lot of fund managers out there, and most aren’t worth their salt. The selection below includes the few I believe have the most talent.

You’ll notice this list is skewed heavily to small-cap value managers. The reason is that these are the ideas that I’m most interested in from others. I don’t read a lot of other macro work because that’s the world I live in. And many of these value fund managers can devote a lot more time to investigating a single company, than I ever could. We always do our own due diligence, of course. But when you have a stable of great value fund managers doing the initial filtering for you, it’s a big help.

Like Picasso said, “Good investors borrow, great investors steal”… or something along those lines.

Here are my quarterly must-reads. The few reports that I never miss and from which I have stolen many great ideas from. Also, reading these letters is like receiving a masters in value investing. Some great nuggets in all of them (links to report sections included on all names).

  • Greenhaven Road Capital: This is a small-cap value fund run by Scott Miller. Miller is kind of an unknown. He keeps his AUM small and maintains a low profile. But the guy knows how to value a business and his reports always make for a great read.
  • OakTree Capital – Howard Marks’ Memos: Marks is an investing legend and there’s not much else to add to that. You won’t find stock ideas in his memos but you’re almost certain to learn something.
  • Greenwood Investors: This fund is run by Steven Wood who’s also a relatively new up and comer. He’s got a similar style to Scott Miller and is a good resource for contrarian value plays.
  • Cable Car Capital: Is run by Jacob Ma-Weaver who’s a sharp value oriented investor. He always presents unique and interesting investing ideas in his letters. He also occasionally posts some great stuff on his blog.
  • Arkto Investors: Is run by Peter Rabover and focuses on value and special situations. Another great resource for the undiscovered stocks. His letters are hosted on Harvest, so you’ll have to create an account if you don’t have one already (it’s free).
  • Miller Value Funds: Run by Bill Miller, who’s another investing legend, though his record was tarnished in the GFC when his fund took a serious beating. But he’s back, with his own fund, and he’s putting up good numbers again. I really enjoy his thinking and writing and posts/letters found on the site are a great source of idea generation.
  • Horizon Kinetics: Horizon is a larger shop that specializes in bottom up fundamental research. Their quarterly letters are always an insightful and fun read.
  • Peters MacGregor Capital Management: Is another large shop, but with a global focus. It’s a great resource for stock/market idea gen outside of U.S. markets. They also regularly share decent video presentations where they talk over an investment their in.
  • Laughing Water Capital: Run by Matt Sweeney, LWC is a long-term value oriented shop.
  • Saber Capital Management: A value focused fund by John Hubner. Quarterly letters always include some great thoughts on investing theory/wisdom, along with some great investment ideas.

So these are the quarterly letters that I make sure to at least skim through each quarter if not read in their entirety. For idea generation I also find sites like Value Investors Club, MOI Global, and SumZero useful. VIC and SZ are free as long as you submit an approved idea.

Some other sites that are worth checking out are The Patient Investor’s Blog (Longcast Advisers), Wiedower Capital is pretty good, and so are Dane Capital and Breach Inlet Capital on Seeking Alpha.

Shoot me a message at alex@macro-ops.com if you’ve got a letter/resource you use that I didn’t mention here.

Bruce Kovner On Listening To The Market, Politics, & Risk Control
,

Bruce Kovner On Listening To The Market, Politics, & Risk Control

The following is a fantastic speech from Bruce Kovner on Caxton Associates’ 20th anniversary. Kovner shares a plethora of trading wisdoms including the three most important contributors to his hedge fund’s success. You can read the original speech from 2003 here.

~~~~~~

To all my colleagues, to friends and associates who have worked and invested with us over the years, may I say welcome to this 20th anniversary party. This is the first time Caxton has thrown a party for our extended family and I am happy and thrilled to welcome all of you. If we are able to catch Peter D’Angelo in a generous moment, we may not have to wait another twenty years for the next event!

This particular room has always been one of my favorites – combining a modern space with the elegant and mysterious beauty of this ancient Egyptian temple. But this setting also suggests another theme: that nothing is permanent in human affairs, that the apparent solidity of these stones of Egypt counted for nothing as dynasties came and went and especially when the Pharaoh of the 1950’s and 60’s, Gamal Abdul Nasser, now himself long gone, determined that the great Aswan Dam would flood the plains of the Nile, submerging much of Egypt’s history in the vast lake then to be formed.

The World changes. In some small sense, Caxton’s story has its roots in similar observations. Caxton was born twenty years ago amid extraordinary changes in the world of money, finance, and politics, changes that have helped transform the world economy. Tonight, I would like to talk briefly about the circumstances both in the markets and in my own life and experience that have shaped Caxton’s performance over the last two decades. I would like to start with events that predated the founding of Caxton but which are important in understanding the origins of the company. Then I would like to describe important periods in Caxton’s evolution and close with some thoughts about the future.

Caxton was started in a period of economic transition – a time of creative destruction, as fans of Professor Schumpeter would say – when the old order of fixed exchange rates and fixed gold prices ($35 per ounce, I believe) could no longer contain the enormous pressures of the 1960’s and 1970’s. We wanted guns and butter, Vietnam and the Great Society. Around the world there were vast and differentiated changes in inflation, productivity, and wealth. So, the Gold window was shut in 1968. Three years later, Richard Nixon abandoned fixed exchange rates and let the dollar float. A new economic era had begun.

The inflation, volatile exchange rates, rising commodity prices and high nominal interest rates that followed in the 1970’s created an environment in which the old ways of investing no longer functioned well. Long-only stock and bond trading were not the optimum ways to capture the opportunities that the 1970’s created. On the contrary, between 1968 and the early 1980’s, stocks and bonds suffered through a long bear market, destroying the value of equity and bond portfolios and undermining confidence in traditional investing styles. On the other hand, opportunities to profit from being long or short in currencies, fixed income, stocks and commodities abounded. The stage was set for active ‘macro trading’ as the increasingly popular term would label it.

New York, with its long-only equity culture and preponderance of establishment institutions, was not a congenial host for the new trading culture. That had to emerge in Chicago where people like Leo Melamed, a former egg broker, became head of the Chicago Mercantile Exchange and initiated trading of financial futures. The Chicago Board of Trade followed suit with the establishment of a market for trading Ginnie Mae futures. The process of creative destruction operated on the structure of financial markets far more effectively on the frontier in Chicago than it did in New York.

Cambridge, Massachusetts in the 1960’s was also not a bad place to learn that innovation and change are at the heart of survival. I had learned some of that from the history of my family – Jewish refugees from Czarist Russia. But I learned more after I enrolled as a freshman at Harvard College in 1962, reading Schumpeter on “creative destruction”, Keynes and Samuelson on counter cyclical fiscal policy, Tocqueville on the Ancien Regime, Fainsod on the Russian Revolution, Keynes (again) on the Economic Consequences of the Peace (meaning the punitive Treaty of Versailles), and a range of historians on the two World Wars. All were lessons on the impermanence of institutions and on the unintended consequences of government policy.

I did not know that these lessons were going to be put to any practical use by me. I had thought I would enter government service, not the financial world, when I left graduate school in 1970 and began to wander around the world for a few years. When I finally moved back to the United States in 1974, I was not seeking a Wall Street career (and I had no qualifications to begin one). I taught politics during the day and began to study financial markets at night. And by 1977, when I made my first tentative steps into financial markets, the financial world had already begun its remarkable transformation.

In my one-bedroom apartment on 57th Street, down the block from Carnegie Hall, I was only four miles away from Wall Street but a universe away in terms of my approach to markets. The new world of financial futures reduced the barriers to entry to currency and interest rate markets. Perhaps, I thought, efforts to understand what moved these markets might be well rewarded. I speculated on commodity prices, interest rates, currencies and was gratified to make money. And I found my way to Commodities Corporation, started by economists from MIT and Princeton, to learn more of my newly chosen trade. After five and a half years, with the blessings of my former employers, I decided to establish a company that reflected my own particular vision of how to adapt to this new financial world. With $7MM from investors and $5MM of my own funds, I started Caxton in March of 1983.

The new company’s operations were guided by principles and observations that helped us to pursue successful trading.

Barriers to entry to financial markets of all kinds were coming down. New markets were developing for the new financial instruments. Early providers of liquidity and expertise were likely to find excess returns.

Analysis of macro conditions was not being done systematically or well in most large money market institutions! Good analysis would provide excess returns.

Exogenous shocks – say, for example, oil price shocks – to the economies of the world were likely to be numerous. Being a quick responder to these shocks would provide excess returns.

Most investment managers and operators in equity and debt markets had institutional and cultural restraints on the kind of trading they could do – and tended heavily to favor long-only approaches. Few traders were highly skilled in the use of derivatives. Excess returns were therefore more likely to be earned by those who could go short as well as long, and who could use derivatives well.

More generally, Caxton adopted an institutional model that built in more flexibility in the creation of optimal portfolio mix than was normal on Wall Street. We had three structural advantages: First, there were no institutional limits on the range and style of our trading. We would go to any asset class where we saw opportunity, and we would trade in a range of trading styles (long, short, differential based, trend-following, mean-reversion, or arbitrage to name a few). Second, we chose to target risk levels, not nominal dollar levels, to calibrate our trading size. This enabled us to use leverage and portfolio theory to optimize our risk profile. There is plenty of opportunity to do risk management badly, of course; but the advantages of doing it well were enormous. And thirdly, we believed in a process of dynamic risk allocation – that is, we would put more capital at risk when either market conditions or macro economic conditions convinced us of the possibility of excess return. Caxton wouldn’t be stuck with a fixed asset allocation to stocks or bonds or currencies or commodities. We would change our capital allocation with conditions. Do that well and returns would not be a passive captive of the business cycle. On the contrary, dynamic capital allocation could turn what was for more inflexible institutions a source of difficulty into an advantage for a young firm capable of adapting to changing conditions.

The first ten years of Caxton’s existence certainly provided ample opportunity for us to test both premises of our new model and our skills in deploying it. We had macroeconomic shocks aplenty – rising and falling rates, oil shocks, the Plaza accord, the market crash of 1987, the Iran-Iraq War, not to mention the first US-Iraq War. We had new markets, new financial instruments, new Presidents, new Prime Ministers, currency unions … No shortage of fun, for we dyed-in-the wool macro traders. And, fortunately, although we made many, many mistakes, we managed to execute well enough to have good returns. During the first ten years of its existence, starting with about $10MM in capital, Caxton earned some $3 billion in profits, with a gross trading return of 55.6 percent per year. In the same period (although it included nearly all of the first ten years of a great bull market) the S&P 500 grew at the rate of about 15.7 percent per year. And even though Caxton’s trading during those years felt, to me, a little too much like Coney Island’s Cyclone roller coaster, the quality of our return, with a Sharpe ratio of 1.68, was about three teams higher than the S&P’s .54 during the same period.

Our success notwithstanding, by the mid-nineties, several of the opportunities which had facilitated Caxton’s success had changed. A large number of new players – hedge funds, prop desks at banks, speculators – had entered the market, reducing the advantages of early entrants. Macro analysis had become routine in wire houses, investment banks, and prop desks. And Caxton, with $1.6 billion in assets, was no longer small enough to make its returns with quick trades in smaller markets. We felt stale. Our performance – down 2.4% in 1994 – felt awful. It was time for a change. We sent our investors 60% of their funds, reduced our capital to $650MM, and went back to the drawing boards.

Prior to 1994, Caxton was largely focused on top-down macro trading. By 1994, we had concluded that we needed more tools than those that macro trading provided. Nothing works all the time. We wanted a variety of trading strategies across all liquid asset classes. And we didn’t want to be confined to one trading style, such as momentum-based trend following. So we began a systematic process of searching for new strategies, new styles, new markets and new traders. Let 1000 flowers bloom, it was said. But make sure they bloom with good risk management, and with low correlation! In the years since 1995, Caxton has spent a lot of time searching for these techniques, strategies and traders. We kissed a lot of frogs, as my good friend Joe Grundfest might say. (Actually, does say.) And we wound up with some 50 trading centers covering virtually all liquid asset classes, employing a multiplicity of approaches – trend following, of course, but also mean reversion strategies, fundamentals based models, arbitrage, computer-based approaches to markets, discretionary trading of equities, active trading of mortgage markets and related instruments, and many others.

We wouldn’t be here tonight, having this rather wonderful celebration in the Metropolitan Museum, if the results of that effort had not been acceptable. In fact, since January 1995, Caxton has earned $8.5 billion in trading profits, starting with a base of $650MM. Our average annual return has been 33.1 percent, and our Sharpe ratio rose from the first decades 1.68 to just below 2.00. In the same period, the S&P’s annual return was 12.7% for the S&P, with a Sharpe ratio of .50.

Today, Caxton has nearly 50 trading centers, divided among:

Macro oriented centers, which deploy about 35% of the risk of the company;

Equity oriented centers, which deploy about 25% of our risk;

Quantitative systems, deploying another 25% of our risk; and

Fixed income strategies which deploy another 15% of risk.

My own role in all of this has changed substantially over these years. Whereas in the first years of Caxton, I had tactical responsibility for almost everything in the portfolio, my trading accounts for something like 10% to 15% of the company’s risk presently. I spend a great deal of time on strategic development. It is more important for me to help find and develop areas of opportunity than it is for me to trade them. And it is more important to have a robust process of strategic development than it is to have one dependent on one human being. That is why Caxton devotes many millions of dollars a year to research and development aimed at finding new quantitative techniques or new areas of trading likely to yield high returns, and developing information technology and risk control techniques. I spend most of my time on these efforts, and on working with traders when they need advice, encouragement or help.

In these efforts, I try to pass on something of the proverbs, ethos and culture of trading that I have regarded as essential to Caxton’s success. Of these, I will mention three:

  1. Listen to the market. Close observation of price behavior is always necessary for the discipline of successful trading and it is very often very helpful in providing evidence about the nature of current conditions. If we can understand what the market is telling us, we will most likely be able to understand how to trade it. Listen to the market, hear it, don’t tell it what to do. Listen.
  2. Take politics and policy seriously. Changes in policy matter. Changes in leadership matter. Study them seriously. This doesn’t mean that politicians and policy makers will get it right – indeed very often they will get it wrong and these ‘mistakes’ in and of themselves may be important to markets. But ignore them at your peril. Policy matters. Politics matter.
  3. Above everything else, never let the discipline of risk control become lax. Those 100-year storms have a way of coming round every few years. If in real estate it’s “location, location, location”, in leveraged trading it is “risk control, risk control, risk control”. It is surprising how often this focus is lost.

Listening to the market. Taking politics and policy seriously. Risk control – to these we need to add one more on the level of the firm. And that is our old friend “creative destruction”: the process of creative destruction operates on trading techniques (and their embodiment in individual traders) as much as it does on any market structure. Any trading technique has a finite life in which it yields extraordinary returns. As more capital and knowledge are applied, markets become more efficient and rates of return drop – until eventually high risk adjusted returns disappear. Then it is time to retire the technique and move on.

The flexibility and learning that must be applied to trading also should be applied to capital allocation. We can’t be static in how we allocate capital to a particular strategy, nor to all of them together. So Caxton only wants the amount of capital it can deploy successfully. We are not asset gatherers. Despite a long list of investors who want to get in to Caxton funds, we will most certainly send money back to investors again in the near future. Barring unforeseen developments, we will return between 10 and 20% of our capital to investors at the end of this year. Flexible capital allocation. When rate of return drops, send capital back home to our investors.

In the meantime, we will continue to develop new techniques and new trading centers. As they bear fruit, we will nurture them and introduce them into our portfolio as they are proven and as conditions permit.

There is little doubt in my mind that the financial markets will remain as dynamic in the next twenty years as they were in the last. Look at the enormous changes in Asia, where China is emerging as a giant already. One cannot understand world commodity markets today without understanding China – and therein, of course, lies much opportunity as well as risk. Look at the extraordinary long cycle in Japan. Twelve years of recession and decline, of policy mistakes, of opportunities lost. And perhaps now, finally, of some policy initiatives which may finally lift Japan deflation and seemingly unending recession.

And one doesn’t have to look only across the oceans for big structural changes that make markets different in this decade than in the last. Look at the fixed income market, where mortgages and floating rates have changed the character of supply and demand and market behavior in recent years. The mortgage market now dwarfs the U.S. Treasury market. Outstanding mortgage debt now exceeds total marketable Treasury debt to 50 percent. A decade ago that rate was reversed. No one can understand the path of yields in the United States without understanding these new conditions.

And look at the universe of possible exogenous shocks we confront today. Perhaps we all have some sense of the potential disturbance of terror attacks. But have we correctly priced them in the market? How do you price low probability high damage events? And how do you know the right probabilities?

And what about technological change, which still promises to create enormous values (I am thinking now of biotech as well as information technology)? And what about new oil shocks? Or geo-political conflict, such as India-Pakistan?

Clearly, this list could go on and on.

There is no certainty that Caxton will be able to adapt successfully to these and other risks and changes, but we do structure ourselves to be able to analyze such changes and risks and try to respond to them. And certainly those institutions which do not have the capability to respond leave themselves at the mercy of events. The premise of our operational philosophy was always and still is: The World Changes. Nothing is Permanent. Those who fail to adapt to change risk everything. Look around you, here in this beautiful room. Look at the magnificence of the Temple of Dendur and of the civilization of Egypt. The World Changes and nothing is permanent. If that is one of the lessons that family history and education taught me, it is also the lesson that imbues the practice of Caxton. Study the world. Study markets. Listen to the markets. Then, perhaps, with a little luck and skill, you may be able to find ways not simply to be a victim of circumstances but to profit from them.

Thank you.