Hedge Fund Market Wizards

How Winning Traders Win

Jack D. Schwager

• Publisher: Wiley
• Year: 2012
• Print ISBN: 9781394378074, 9781118273043
• eBook ISBN: 9781118283615
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Fascinating insights into the hedge fund traders who consistently outperform the markets, in their own words

From bestselling author, investment expert, and Wall Street theoretician Jack Schwager comes a behind-the-scenes look at the world of hedge funds, from fifteen traders who've consistently beaten the markets. Exploring what makes a great trader a great trader, Hedge Fund Market Wizards breaks new ground, giving readers rare insight into the trading philosophy and successful methods employed by some of the most profitable individuals in the hedge fund business.

• Presents exclusive interviews with fifteen of the most successful hedge fund traders and what they've learned over the course of their careers
• Includes interviews with Jamie Mai, Joel Greenblatt, Michael Platt, Ray Dalio, Colm O'Shea, Ed Thorp, and many more
• Explains forty key lessons for traders
• Joins Stock Market Wizards, New Market Wizards, and Market Wizards as the fourth installment of investment guru Jack Schwager's acclaimed bestselling series of interviews with stock market experts

A candid assessment of each trader's successes and failures, in their own words, the book shows readers what they can learn from each, and also outlines forty essential lessons—from finding a trading method that fits an investor's personality to learning to appreciate the value of diversification—that investment professionals everywhere can apply in their own careers.

Bringing together the wisdom of the true masters of the markets, Hedge Fund Market Wizards is a collection of timeless insights into what it takes to trade in the hedge fund world.

Part One

MACRO MEN

Chapter 1

Colm O’Shea

Knowing When It’s Raining

When I asked Colm O’Shea to recall mistakes that were learning experiences, he struggled to come up with an example. At last, the best he was able to do was describe a trade that was a missed profit opportunity. It is not that O’Shea doesn’t make mistakes. He makes lots of them. As he freely acknowledges, he is wrong on at least 50 percent of his trades. However, he never lets a mistake get remotely close to the point where it would provide a good story. Large trading losses are simply incompatible with his methodology.

O’Shea is a global macro trader—a strategy style that seeks to profit from correctly anticipating directional trends in global currency, interest rate, equity and commodity markets. At surface consideration, a strategy that requires participating in directional moves in major global markets may not sound like it would be well suited to maintaining tightly constrained losses, but the way O’Shea trades, it is. O’Shea views his trading ideas as hypotheses. A market move counter to the expected direction is proof that his hypothesis for that trade is wrong, and O’Shea then has no reluctance in liquidating the position. O’Shea defines the price point that would invalidate his hypothesis before he places a trade. He sizes his position so that the loss from a move to that price level is limited to a small percentage of assets. Hence, the lack of any good war stories of trades gone awry.

O’Shea’s interest in politics came first, economics second, and markets third. His early teen years coincided with the advent of Thatcherism and the national debate over reducing the government’s role in the economy—a conflict that sparked O’Shea’s interest in politics and soon after economics. O’Shea educated himself so well in economics that he was able to land a job as an economist for a consulting firm before he began university. The firm had an abrupt opening for an economist position because of the unexpected departure of an employee. At one point in his interview for the position, he was asked to explain the seeming paradox of the Keynesian multiplier. The interviewer asked, “How does taking money from people by selling bonds and giving that same amount of money back to people through fiscal spending create stimulus?” O’Shea replied, “That is a really good question. I never thought about it.” Apparently, the firm liked that he was willing to admit what he did not know rather than trying to bluff his way through, and he was hired.

O’Shea had picked up a good working knowledge of econometrics through independent reading, so the firm made him the economist for the Belgian economy. He was sufficiently well prepared to be able to use the firm’s econometric models to derive forecasts. O’Shea, however, was kept behind closed doors. He was not allowed to speak to any clients. The firm couldn’t exactly acknowledge that a 19-year-old was generating the forecasts and writing the reports. But they were happy to let O’Shea do the whole task with just enough supervision to make sure he didn’t mess up.

At the time, the general consensus among economists was that the outlook for Belgium was negative. But after he had gone through the data and done his own modeling, O’Shea came to the conclusion that the growth outlook for Belgium was actually pretty good. He wanted to come up with a forecast that was at least 2 percent higher than the forecast of any other economist. “You can’t do that,” he was told. “This is not how things work. We will allow you to have one of the highest forecasts, and if growth is really strong as you expect, we will still be right by having a forecast near the high end of the range. There is nothing to be gained by having a forecast outside the range, in which case if you are wrong, we would look ridiculous.” As it turned out, O’Shea’s forecast turned out to be right, but no one cared.

His one-year stint as an economist before he attended university taught O’Shea one important lesson: He did not want to be an economic consultant. “As an economic consultant,” he says, “how you package your work is more important than what you have actually done. There is massive herding in economic forecasting. By staying near the benchmark or the prevailing range, you get all the upside of being right without the downside. Once I understood the rules of the game, I became quite cynical about it.”

After graduating from Cambridge in 1992, O’Shea landed a job as a trader for Citigroup. He was profitable every year, and his trading line and responsibilities steadily increased. By the time O’Shea left Citigroup in 2003 to become a portfolio manager for Soros’s Quantum Fund, he was trading an exposure level equivalent to a multibillion-dollar hedge fund. After two successful years at Soros, O’Shea left to become a global macro strategy manager for the multimanager fund at Balyasny, a portfolio that was to be the precursor for his own hedge fund, COMAC, formed two years later.

O’Shea has never had a losing year. The majority of his track record, spanning his years at Citigroup and Soros, is not available for public disclosure, so no precise statements about performance can be made. The only portion of this track record that is available is for the period at Balyasny, which began in December 2004, and his current hedge fund portfolio, which launched in June 2006. For the combined period, as of end of 2011, the average annual compounded net return was 11.3 percent with an annualized volatility of 8.1 percent and a worst monthly loss of 3.7 percent. If your first thought as you read this is “only 11.3 percent,” a digression into performance evaluation is necessary.

Return is a function of both skill (in selecting, implementing, and liquidating trades) and the degree of risk taken. Doubling the risk will double the return. In this light, the true measure of performance is return/risk, not return. This performance evaluation perspective is especially true for global macro, a strategy in which only a fraction of assets under management are typically required to establish and maintain portfolio positions.1 Thus, if desired, a global macro manager could increase exposure by many multiples with existing assets under management (i.e., without any borrowing). The choice of exposure will drive the level of both returns and risk. O’Shea has chosen to run his fund at a relatively low risk level. Whether measured by volatility (8.2 percent), worst monthly loss (3.7 percent), or maximum drawdown (10.2 percent), his risk metrics are about half that of the average for global macro managers. If run at an exposure level more in line with the majority of global macro managers, or equivalently, at a volatility level equal to the S&P 500, the average annual compounded net return on O’Shea’s fund would have been about 23 percent. Alternatively, if O’Shea had still been managing the portfolio as a proprietary account, an account type in which exposure is run at a much higher level relative to assets, the returns would have been many times higher for the exact same trading results. These discrepancies disappear if performance is measured in return/risk terms, which is invariant to the exposure level. O’Shea’s Gain to Pain ratio (a return/risk measure detailed in Appendix A) is a strong 1.76.

I interviewed O’Shea in London on the day of the royal wedding. Because of related street closures, we met at a club at which O’Shea was a member, instead of at his office. O’Shea explained that he had chosen to join this particular club because they had an informal dress code. We conducted the interview in the club’s drawing room, a pleasant space, which fortunately was sparsely populated, presumably because most people were watching the wedding. O’Shea spoke enthusiastically as he expressed his views on economics, markets, and trading. At one point in our conversation, a man came over and asked O’Shea if he could speak more quietly as his voice was disrupting the tranquility of the room. O’Shea apologized and subsequently dropped his voice level to library standards. Since I was recording the conversation, as I do for all interviews—I am such a poor note taker that I don’t even make the attempt—I became paranoid that the recorder might not clearly pick up the now softly speaking O’Shea. My concerns were heightened anytime there was an increase in background noise, which included other conversations, piped-in music, and the occasional disruptive barking of some dogs one of the members had brought with him. I finally asked O’Shea to raise his voice to some compromise level between his natural speech and the subdued tone he had assumed. The member with the barking dogs finally left, and as he passed us, I was surprised to see—although I really shouldn’t have been—that it was the same man who had complained to O’Shea that he was speaking too loudly.

• • •

When did you first become interested in markets?

It was one of those incredible chance occurrences. When I was 17, I was backpacking across Europe. I was in Rome and had run out of books to read. I went to a local open market where there was a book vendor, and, literally, the only book they had in English was Reminiscences of a Stock Operator. It was an old, tattered copy. I still have it. It’s the only possession in the world that I care about. The book was amazing. It brought everything in my life together.

What hooked you?

What hooked me early about macro was . . .

No, I meant what hooked you about the book? The book has nothing to do with macro.

I disagree. It’s all there. It starts off with the protagonist just reading the tape, but that isn’t what he developed into. Everyone gives him tips, but the character Mr. Partridge tells him all that matters, “It’s a bull market.”2

That’s a fundamental macro person. Partridge teaches him that there is a much bigger picture. It’s not just random noise making the numbers go up and down. There is something else going on that makes it a bull or bear market. As the book’s narrator goes through his career, he becomes increasingly fundamental. He starts talking about demand and supply, which is what global macro is all about.

People get all excited about the price movements, but they completely misunderstand that there is a bigger picture in which those price movements happen. Price movements only have meaning in the context of the fundamental landscape. To use a sailing analogy, the wind matters, but the tide matters, too. If you don’t know what the tide is, and you plan everything just based on the wind, you are going to end up crashing into the rocks. That is how I see fundamentals and technicals. You need to pay attention to both to make sense of the picture.

Reminiscences is a brilliant book about the journey. The narrator starts out with an interest in watching numbers go up and down. I started out with an interest in politics and economics. But we both end up in a place that is not that far apart. You need to develop your own market experience. You are only going to fully understand what the traders in your books were saying after you have done it yourself. Then you realize, “Oh, that’s what they meant.” It seems really obvious. But before you experience it and learn it, it’s hard to understand.

What was the next step in your journey to becoming a trader after reading Reminiscences?

I went to Cambridge to study economics. I knew I wanted to study economics from the age of 12, well before my interest in markets. I wanted to do it because I loved economics, not because I thought that was a pathway to the markets. Too many people do things for other reasons.

What did you learn in college about economics that was important?

I was very lucky that I went to college when I did. If I went now, I think I would be really disappointed because the way economics is currently taught is terrible.

Tell me what you mean by that.

When I went to university, economics was taught more like philosophy than engineering. Since then, economics has become all about mathematical rigor and modeling. The thing about mathematical modeling is that in order to make problems tractable, you n...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Dedication
• Foreword
• Preface
• Acknowledgments
• Part One: Macro Men
• Part Two: Multistrategy Players
• Part Three: Equity Traders
• Conclusion
• Epilogue
• Appendix A
• Appendix B
• About the Author
• Index