Hedge Fund Titans - The Good, the Bad and the Ugly...

Ok I am biased.  I have been associated with the hedge fund industry since the early 90's. In the early days I was a complete believer in true active portfolio management verses long only asset managers who were glorified benchmark huggers. I was proud to work for a hedge fund manager, trying our best to make money for our clients. We were driven by passion of investing in an unconstrained manner. I guess we were too successful; as our returns compounded investors money verses the equity market more money flowed into the industry and more institutional clients came. This growth led to our industry developing a breed of hedge fund titans, most were great investors or traders and their fortune and fame started getting public attention. Their firms grew exponentially in line with their wealth and unfortunately media attention. So today as I assess the last few month news in the hedge fund industry I feel the need to both to defend and attack these investment gurus. Lets start with the Ugly. It is not so much a person but a situation that is developing. SEC's relentless assault on Steve Cohen and SAC is an ugly situation. It is a data point that should worry the whole industry but especially large firms. Their is a clear message: the regulator is worried about the power of large hedge funds. Do not get me wrong, I am not saying that some form of insider trading did not happen at SAC or that the firm should not be fined and improve their internal systems but their attack on Steve Cohen is bordering on vindictiveness. There is no doubt SAC is a competitive environment but do you really believe this firm is any worse than the likes of Deutsche Bank, JP Morgan or Goldmans. Did the regulator play such hard ball with JP Morgan when there CIO office racked up immense losses that hit shareholders that include pension funds. Or did the regulator really go after Goldmans when they breached the principals of fair treatment of clients when they were selling structured credit products to insurance companies and then helping Paulson structure short credit products with exactly the same positions in them. So the message is simple, beware big hedge funds the SEC is after you. If I were Izzy Englander at Millenium I would be nervous. His smoothed returns on the back of Millenium's variable expenses could be on their radar screen. Now for the bad. You see money is a funny thing, it can lead you to take yourself too seriously. Once that happens and your ego inflates you can be a victim of your own propaganda. Paul Tudor Jones is a great investor. Hi style is one I admire as a fellow macro trader. But his comments about women, which are completely inaccurate statically anyway,  show a ego that only a man who believes he is verging on immortality would make. He also made comments about the lack of hedge fund talent. Here I would tend to agree with him but Tudor as a firm is as guilty as anyone. You see I would not be offered a job at Tudor as a macro manager, even though I have outperformed over the last 15 years. Why? Because I am not educated in the Ivy league, I do not have a mathematics or science degree. I learnt to trade the old fashioned way, by losing money and then working out how to make money. This takes hubris which many graduates who get a job at hedge funds do not have. They are as egotistic as Paul Tudor Jones but without the trading skills or experience. So Mr Jones if you really want to find hedge fund talent, employ me and I build a desk for you the old fashioned way: more about the individual's passion for trading, willingness to learn than their school. I finally and rightly so the good. You see the hedge fund industry still has a lot of good in it. Ray Dallio and his firm Bridgewater is an example as the largest hedge fund manager. His strong moral code, his unique investment philosophy, has led to great returns and he has developed a firm with a great working environment. Likewise Daniel Loeb. Sometimes confrontational but never for the sake of it. In Europe Michael Hintze of CQS is a role model for any investor, hard but fair, intelligent and has built internal procedures that not even the SEC with an itch could fault. Thankfully these hedge fund titans still prove the industry has a lot to offer.

It Is All About Risk Management

I am not one that usually likes to gloat, it tends to always be a precursor to losing money, but at times I feel for the sake of common good one must express their views in the most powerful way. Here is the reality, since 2005 I have not had a negative returning year. I am a macro investor, who has the fortunate position of being able to invest in a variety of liquid asset classes. Given I do not consider myself an expert economists or a quantitative genius, the question should be asked why I can do this when banks and other hedge funds could not. The only answer I can come up with, by analyzing myself as an investor, is I use a mixture of common sense and risk management. If we presume that common sense, given it is common, is not something that makes me special, it leads to the conclusion that what distinguishes me from the so called elite in the financial industry is risk management. Here I am referring not just too Chief Investment Officers, Portfolio Managers, Traders, Risk Managers but also Regulators. In fact the problem the world finds itself in economically is due to poor risk management from global regulators. Simply they did not set the appropriate risk capital boundaries for financial institutions. So lets focus on the way regulators view risk, which by the way is effecting how all institutions view risk. They believe an appropriate calculation of risk can be done by looking at a model that comes up with a number representing what an institution could lose over a given time for a certain probability. This is known as Value at Risk. One of the most important components of this calculation is a correlation matrix. In layman terms this number defines the so called relationship between 2 asset classes or positions. The simplest way to think about this is the old adage when equities go up bonds go down. In this case the two assets are negatively correlated. If we hold the same amount of these two and they move in exactly the same amounts with same velocity then they would be perfectly negatively correlated. In my view, this belief and reliance on this relationship is where regulators go wrong in setting the boundaries. You see asset classes, like bonds and equities are like people, they are influenced by many things and at different times what influences them changes in priority. Therefore you can not average or assume how they act over history, all you can do is make a best assumption for today. In fact if we look at the history of Value at Risk this exactly the view of the academics who first brought this model to the general public's attention. I suggest anyone interested should read Markowitz original paper on the subject. In fact the original way of using this model by a regulator was probably the best, known as the SEC model, it just asked bank to calculate how much they could lose over a given time for each asset class and then totaled the risk rather than using a correlation calculation. However this method was hijacked and developed to include a correlation matrix, and the SFA in the UK were the main proponents of this. As ever in life much of this was due to personalities. The SFA regulatory model team was led by an academic and practitioner called Dr Andrew Street. An extremely intelligent, yet arrogant individual. The team he headed were populated ultra intelligent indivduals yet none with any trading or market experience. A recipe for disaster.  SFA's development in using this correlation matrix resulted in lower capital charges for banks. Basle in Europe adopted this and hence when Basle II  rules, which codified this form of calculation of risk, came into print the US regulators had no option but follow or lose a considerable amount of trading in New York.  The story in reality has a few more sub-plots, which include JP Morgan's development of the model, known as RiskMetrics. I am more than happy to provide the details for private requests, however for the purpose of this article lets focus on the regulator.  So now Value at Risk, as promoted by global regulators, with its correlation matrix now becomes the standard for risk management in the finance industry. And yes was also the base for calculating structured credit risk. This leads into 2007 when of course the model proves complete ineffective to prevent the credit crisis. So what do I do that so different from a risk management perspective that has allowed to make money in all market environments. Well it starts with philosophy. I do not just view risk management as a way of assessing how much money I could lose. I view it from perspective how much money could I lose and what money do I have left after this calculated loss to make the loss back. You see by adding the latter to risk I also take into account how much money I need in the future. Common sense, no? Then in calculating this loss amount I do not use a correlation matrix but a causation matrix. Basically I use common sense to work out the relationship between asset classes. I analysis historical relationships only as a reference and then consider what is different in todays world. You see risk management should not be driven by quantitative individuals. It needs to be executed by individuals who are sensitive to the way humans behave. As much as I enjoy their company, and have a great deal of respect for them, quantitative individuals are generally not people persons. I think they are better to focus trying to make money especially in light of how ultra high frequency trading is increasing. Risk management is better left to individuals that question from a more qualitative fashion. This is exactly what I do and if global regulators came my way the financial world would be a safer place be. But not only safer but better equipped to make profit in the future. You see it is all about risk management. Risk management is about survival and recovery.

Hedge Fund Insider: Germany: You Should Know Better !

Hedge Fund Insider: Germany: You Should Know Better !: March has been an extremely interesting month as far as analyzing the psychology of world markets. I do not normally like to get politically...

Germany: You Should Know Better !

March has been an extremely interesting month as far as analyzing the psychology of world markets. I do not normally like to get politically or sensational in writing commentary but what has developed in Cyprus, I believe, needs to be analyzed and assessed. German politicians and central bankers need to study history. Their actions are all to similar to a time in history that eventually led to the rise of the Nazi party. There are so many lessons from the boom of 1920's and the great depression of 1929 to 1931 and the then sociological implications of  1931 to 1937 (when the markets crashed again) and the following change in sentiment in the world, especially in Germany. Germany's and Europe's attempt to tax savers in Cyprus is a direct analogy on the fiscal constraints the world put on Germany post World War I. Germany as a country should understand better than any other country that policies that cause unemployment and distress amongst the vast majority of the public while only benefitting the elite are socially a catalyst for the rise of extreme political opinion and parties. By ignoring or not caring about other European countries social implications of austerity they providing a foundation for the rise of a extreme revolution in Europe. Grillo's success in Italy should not be ignored. Any country where the unemployment rate is over 20% for people under 24 years of age is a social problem and one that must be addressed. This is exactly what was not done in the world after 1929 and eventually led to the rise of the Nazi party. This time it will not be in Germany, but extreme politics could give rise in any South European country where the average person is being hurt by austerity, where unemployment is rising, where the wealth gap between the top 1% of rich people and the rest of the population is rising. What this means for the markets is that volatility, uncertainty, and eventually capitulation will occur if the European politicians and central bankers continue on this course. Merkel and Draghi will be remembered in history as the individuals that built the foundations of a social disaster in Europe. The best strategy I believe in dealing with this environment is to be short-term in trading. The world's economies are in a unstable state, political actions today will have ramifications on countries social environments for the next two decades. The more detached politicians and bankers become from the public the unstable the world will be.

Where has all the Talent Gone ?

I started in the hedge fund industry in the early 90's, I was, and still am a supporter of the industry, so what I am about to write is not something that puts a smile on my face. However investors need to know the reality in order for the industry to survive.  We have a quality problem in the next generation of hedge fund managers. Why this is, and how it happened I will explain. Starting my career as a hedge fund manager in the early 90s we were a fringe industry, controlling enough AUM (assets under management) that could make you wealthy by performance but not by earning a management fee. This meant that only the most dedicated of individuals would work in the industry. Our backgrounds were extremely varied, some from investment banks, some from prop trading companies, some from trading their own monies. We enjoyed running portfolios were we had freedom to execute strategies not governed by the long only asset management industry. We were secretly wealthy, never quoted in the press, never mentioned on the the front page of a newspaper. The markets were dominated by large tradition asset management firms that were governed by benchmarks. Investment banks conducted prop trading but due to their capital rules they were not a dominate force in the markets, mostly concentrated on market-making. However life changed as institutional investors started allocating funds to hedge funds, regulators relaxed rules on investment banks. Suddenly the traditional managers with their long-term investment styles became ordinary clients, hedge funds volumes exploded, investment banks became warehouses of risk. This led to a change in the hedge fund model. Management fee became the biggest driver of hedge funds income. At an average of 2% management fee of assets many of us were now becoming insanely rich just by surviving, suddenly performance fee was no longer the driver of our income. Institutional investors had a twofold effect: not only did their money mean due to our larger status we had to change our style but they were less demanding of absolute performance, more interested in returns compared to volatility. We as passionate managers of the 80s and 90s, were smart enough at first to balance the increased assets with still above average performance. We became even richer, our size of position meant now market commentary included our actions.  This extra publicity was not confined to market commentary as we started to find ourselves on Rich Lists, society pages and being investment minded individuals we even managed to gain publicity as we started to invest in other alternative assets like art. Suddenly everyone wanted to work for us. First we employed the senior traders from investment banks. What this meant was the relatively inexperienced traders left were promoted. Suddenly investment banks had lost their intellectual property and experience in proprietary trading. They did not care as other  business areas expanded in importance like product development, sales trading, market making, prime brokerage that directly benefitted from hedge fund volumes. This was the main factor in the demise of the schooling of traders at investment banks. They were no wise heads left to direct the young, raw arrogant talent. This was never really appreciated in a bull market as even the youngsters could produce profit.  However from 2007 -2012 it has became blatantly transparent, and explains why the investment banks are more than happy to quickly close down their prop trading in all asset classes.  So if the investment banks were not cultivating the trading talent then you think surely the hedge funds were but this was not the case. The main hedge fund managers now owning their own firms were talented traders and investors.  We had started working as hedge fund managers because we were passionate about trading. This passion translated to dedication to our work which did not make us the best teachers. This dedication to be the best was also lacking in our new employees. They really wanted to work for us just for the money.  They are smart, academically brillant but lacked the market savvy to deal with a changing market environment. This can clearly be seen when you look at hedge fund returns at the end of 2012. Firms where the experienced hedge fund managers who dominates risk taking at heir firms have outperformed. Take Dan Loeb at Third Point. Here is a manager that is a perfect example to show the passion of the old school hedge fund manager. Even though many criticize his style, he is a hands on leader, so when you invest in Third Point, you pay your management fee for one of the best researchers and portfolio managers around. However be aware not all old school managers are like that. Some firms really show the weaknesses where the founder has stepped aside to let others run their business. Izzy Englander's Millennium are a prime example of this. Izzy set up Millennium to be a quasi fund of hedge funds. Thankfully he does not charge a management fee but makes money from volume rebates and performance. Izzy was great at spotting trading talent and then putting a sensible risk structure around this talent. However Izzy is not hands on any more and his senior staff who run business lack the talent, knowledge and hubris to spot talent. If fact if ever there was example of how arrogance hides incompetency, the Millennium senior staff are that. This is an international problem: both New York and London have the same attributes (in fact in my analysis I think the London office is worse, where the head of finding new trading talent is so inept I think the only place he could survive is Millennium which thankfully still has a common sense risk management infrastructure that Izzy originally developed).  However if a Millennium, whose business is spotting new talent, cannot even staff itself with quality at a senior level, then this obviously reflects on the talent in the whole industry. Another key factor in finding the next generation of hedge fund manager is background. Unfortunately there seems to be belief that Physics or Mathematics from a top university means that an individual will be a great trader because of new technology of electronic execution. In fact the investment banks are partially to blame, but maybe this was there only choice given the lack of senior trading experience. While these individuals are extremely smart they unfortunately tend to have similar academic foundations. This is why the Flash Crash of 2010 and the quant problem driven by Goldman's hedge fund products of August 2007 exist, basically the models trade the same. One of my most successful trading hires in the last few years was a gentleman that was educated at the best university, did not get the highest mark, but the was someone through university traded his own account to make some money. He was passionate about the markets and became a great employee and trader. However as he often said to me, he would have never been considered as a trader in an investment bank or as trader with another hedge fund. If he ever has a desire to set up his own hedge fund I would back him. Of course I have not told him that but he does have that passion for trading, he is not just trading to earn lots of money, he enjoys it and he is dedicated. So there is hope. Unfortunately though finding him is like finding a needle in a haystack.

Sorry - we are greedy but we are stupid...

I apologize. I apologize on behalf of all top hedge fund managers and private equity managers. Even if most would probably would not want me to apologize for them or even feel they owe anyone an apology. Personally I do not care. When the latest fiscal cliff deal was signed, once again my industry ended up paying less tax than teachers, doctors, nurses firemen. For those who are knowledgeable on tax law, I am referring to the carried interest tax rule that both Democrats or Republicans guard with the same passion and intensity. This rule is not only anti-social, it is actually offensive given how much tax-payers money has been spent on bailing out the financial industry. The fact is that even some of the most intelligent investment professionals, leaders of their industry, blessed with a great ability to see into the future,  can be absolutely blind and stupid when they have to confront their own emotion of greed. You see these great men can not see that their happiness is not just created by accumulating wealth for themselves and their families but also involves the happiness of the environment they live in, beyond their front door and street. The wealth gap between the middle class and ultra rich has widened to an enormous level over the last 10 years. What is even more worrying is that this rate has increased since the financial crisis. Basically as the world had to did deep in their  pockets, the elite few made sure they were not digging as deep. Prima facie you might think this to be smart. But it is not true. They can not see they are building a level of resentment amongst the masses. This resentment is justified. It is not driven by pure envy, it driven by anger. And this anger is well founded, the super-rich in the financial industry are not paying their fair share, especially after benefitting so much in the good times. The resentment if not addressed will escalate and ultimately it will be the super-riches next generation that suffer. The problem is power and greed are dangerous drugs, highly addictive and as a hedge fund manager for over 20 years one that I confront on a daily basis. But the reality is true wealth is not having isolated power, its enjoying life amongst others who are also enjoying life, so they don't even notice you. The financial industry owes it to everyone including themselves to readdress this issue now. All we have to do is pay our fair amount. It does not mean that the tax rate needs to be so stringent that it strangles growth and investment, but we should contribute to the general welfare state to ensure the foundations of the next growth period (which there will be one) are built as quick as possible. I ask all hedge fund managers, private equity managers to contact me and maybe as a combined force we can beat this greed. However I doubt I will receive one contact. The problem is it just to easy. the elite control. The present system of party donations means there is no end to this selfishness. All I can do is apologize to the rest of you..

SAC - The Real Issue

Apologies its been too long but these markets have been tricky and I had to prioritize my investors. Thankfully this paid off and I pleased to have delivered nearly a 20% return for them in these markets. Ok lets talk insider trading and hedge funds. Of course as SAC and Steve Cohen come under scrutiny its worth thinking about exactly what the hedge fund industry has become. I started as a hedge fund manager at a similar time to Steve Cohen. He was one of the most gifted equity traders there was. He could have a positive view on a company and yet on a daily basis be short that company make money  and then go back to being long. But SAC today is a billion dollar hedge fund and Steve's style cannot run that size money. So he had to bring in other managers and traders. as SAC success grew so did their asset base and Steve became a smaller percentage of the capital. He made a conscious decision to build SAC into a large asset management firm and by doing this he made the decision to focus on management fee and not performance fee. I took a different route, always running a small amount of money for a select group of investors but my income is driven my income performance. Is Steve more wealthy than me? In pure money terms yes. We occasionally cross paths in the art world and he has more buying power than myself for sure ( I believe he is in the top 3 art buyers in the world. An unregulated market where insider trading, and cornering a market is legal!). But wealth is not just measured by money. I provide a service where my investors are my friends (this probably has a lot to do with the fact I make them money rather than my personality). I do not employ anyone else and have no operational headaches focussing on investing. Steve has to run his firm, which involves a lot personnel issues and ultimately has led him to getting the negative press he is receiving. Do I think Steve is an insider trader..No. He was always looked after by the street (Wall Street), was one of the first calls on breaking news but this is all legal and he had the knack to take advantage of it.  However this skill is only privy to a few and the vast majority of Steve's employees are no where near as good as him. This then leads them to the temptation to cheat. Unfortunately SAC only crime may well be that they did not have the infrastructure operationally to identify and prevent this. It basically comes down to a simple fact: hedge funds should not be that big. I often think how I would create a large hedge fund and I have come up with one solution. Get together a small group of experienced and talented managers and create a super hedge fund. I thought of calling up Bruce Kovener, Louis Bacon, Paul Tudor Jones and Steve Cohen and suggesting it to them. But I would imagine that ego might be a preventive factor and in truth we all are in control of own lives so why? I would do it as a showcase, to show there is still trading talent in the hedge fund world. However this talent sits with a few. I feel sorry for all those institutional investors: pension funds, insurance companies etc who believe large hedge funds provide them alpha. Let me tell you they don't, they can not, they are far to big not to be Beta. Anyway I guess that is human nature..Alfred Winslow Jones created a great vehicle, for approximately 50 years it delivered excessive returns but now greed has destroyed this product. I hope Steve Cohen does not suffer too much from this, he is someone to respect. He probably needs a good succession plan at SAC but that a discussion for another time....