Wilson, Visual Guide to Hedge Funds

Richard C. Wilson’s Visual Guide to Hedge Funds (Bloomberg/Wiley, 2014) is the ninth volume in the Bloomberg visual guide financial series. These guides follow a standard, if somewhat unusual format. They are 10” x 7” paperbacks printed on good stock with color illustrations and color-coded marginal notes divided into five categories: definition, key point, step-by-step, do it yourself, and smart investor tip.

Wilson’s book will have a captive audience because it is required reading for the Certified Hedge Fund Professional (CHP) designation that, as it turns out, the author and his team offer. (I must admit that I had never heard of this certificate program, but according to the book, over 1,400 people have participated in it globally.) Wilson is, perhaps more notably, the founder of the Hedge Fund Group, the largest hedge fund association with over 115,000 global members.

The book covers the most common hedge fund strategies: long/short equity, global macro, event-driven, fixed-income, convertible-arbitrage, and quantitative and algorithmic trading. In addition, it has chapters on managed futures, credit- and asset-based lending, multi-strategy hedge funds, and fund of hedge funds. As befits a basic text for a self-directed certification program, it includes tests after each chapter.

Readers who have some familiarity with hedge funds and with trading in general won’t learn much from this book. For instance, the chapter on quant and algo trading introduces a few chart patterns (head and shoulders, flags), the notion of momentum (as measured by MACD), and portfolio optimization. Perhaps the most useful information for the more sophisticated reader comes from the brief interviews at the end of each chapter. The quant hedge fund manager whom Wilson interviewed suggests (referencing the outsize and longstanding success of Renaissance Technologies) that “the way pure multi-strategy quant funds have been competing is by looking at ever smaller time slices.” (p. 128) That is, essentially by turning themselves into high frequency trading firms.

Do hedge funds provide investors with a decent return? Well, of course, that depends. But “according to data from Hedge Fund Research, Inc. (2013) over the past 14 years the Sharpe ratio on long/short equity strategies is approximately 1.12 compared to a Sharpe ratio of a long-only strategy targeting the S&P 500 index. Long/short equity strategies have a 71 percent correlation to U.S. stocks but produce a return profile that is much higher, 12.75 percent compared to an annualized return of 8.93 percent. The standard deviations of the returns are 9.18 percent for long/short equity while they are much higher at 14.97 percent for U.S. equities.” (p.43) I assume that returns are calculated before management and performance fees.

Wiedemer, Aftershock

The world may end in fire and brimstone; I may get mauled by a deer in my backyard. Quite frankly, I never give these possibilities a second thought. I can do nothing to avert apocalypses and I’m not going to stop going outside. There are, however, some negative events that are worth planning for in some way or another, either because they are likely (with consequences ranging from minor to major) or because, although unlikely, I would take a huge hit if they happened. For instance, it is highly likely that I will be stung by one or more wasps this summer; since I don’t have a life-threatening allergy to wasps, it is sufficient to keep a topical ointment on hand to minimize the localized reaction. Similarly, it is highly likely that not all of my investments will have positive returns, so it is wise to take some appropriate preemptive steps (diversifying, hedging, etc.) Or, like most homeowners, I have an insurance policy that will compensate me in the unlikely but devastating event that my house burns down.

David Wiedemer, Robert A. Wiedemer, and Cindy Spitzer, authors of the revised and substantially (30%) updated third edition of Aftershock: Protect Yourself and Profit in the Next Global Financial Meltdown (Wiley, 2014), believe that more financial pain is inevitable, that its consequences will be huge, and that investors must act now, or at least soon, to protect themselves.

The authors gained fame when their first book, America’s Bubble Economy (2006), highlighted the housing bubble and called attention to four other bubbles: a stock market bubble, a dollar bubble, a consumer debt bubble, and a U.S. debt bubble. They predicted that when the five collided in a “bubblequake,” we would see a deflation in American assets and people’s standard of living.

Now that we’ve had the major quake, we can expect an aftershock which will, in fact, be worse than the quake itself. The current so-called recovery, the authors contend, is 100% fake, and we are slowly working our way toward the market cliff (stage 4). Right now we are in stage 2, poised to enter early stage 3, characterized by “an oscillating stock market and continued money printing that will at first keep the market from falling significantly.”(p. 91) In general, stage 3 is marked by increasing instability where “the stock market falls gradually in spite of intervention,” “interest rates rise in spite of actions by the Fed,” we see “more government stimulus by foreign countries, as well as interventions in foreign currencies and foreign economies,” “gold prices increase significantly,” “people increasingly begin to see the connection between money printing and inflation, which radically decreases the positive impacts of money printing,” and the U.S. experiences “foreign capital outflow.” (pp. 91-92)

In stage 4 we have a rapid collapse. “Gold prices soar,” “intervention in the stock market fails,” “the bond market falls,” “the real estate market falls,” and “the dollar falls.” And, the authors add in Armageddon boldface, “The Aftershock begins.” (p. 93)

Although it’s well nigh impossible to time these stages, the authors advise investors to get out of the stock market now: “don’t play chicken with the approaching crash, even though it may mean missing out on some additional upside.” (p. 96) Actually, they write, the best time to have gotten out of the stock market and bought gold instead would have been 1999, but the second best time is “any time before we go over the Market Cliff.”(p. 97)

If we assume that their doomsday scenario is correct (and that’s a very big assumption, although they vigorously defend their position), what should an investor do pre- and post-Aftershock? By way of preparation, an investor should exit stocks, stay away from real estate, and avoid bonds and most fixed-rate investments. If he follows that advice, he’ll be sitting on a pile of cash. Short of putting it under the mattress, where should he keep it? For the time being, anything short term is pretty safe. “But when the Aftershock hits, even short-term U.S. government debt will be problematic, which means you should be moving heavily toward precious metals, such as gold and silver … , and similar inflation-driven investments, such as some foreign short-term debt instruments, as pressure on the dollar and government debt increases.” (p. 222)

Oh well, think on what is, I guess, one bright side to the impending financial collapse. “[I]f your credit card debt is quite high relative to your income and assets, you might want to consider not paying your credit cards at all. When the bubbles pop, many credit card companies will go out of business. … you will likely still owe your credit card debt balance to the government but at that point, who knows when they will get around to collecting it, and in any case, high inflation will rapidly destroy the debt. … Not paying your credit card debts will significantly harm your credit score, but after all the bubbles pop, credit scores are going to be pretty lousy all around, and few people will have the need for a high credit score. … Even the U.S. federal government will have a very poor credit score!” (pp. 226-27)

Call me a Pollyanna, but I will continue to pay my bills, continue to hold onto financial assets (though, as always, on a relatively short leash--here and there I even get the timing right), and continue to coexist peaceably with the local wild life.

Fox, The Myth of the Rational Market

Justin Fox’s The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street (Harriman House, 2009) isn’t exactly hot off the press, but I discovered it only recently. It’s a fast-paced history, replete with interesting (sometimes chatty/catty) details, of theories about the financial markets from Irving Fisher to Robert Shiller.

The cast of characters is huge. I list them here to give a sense of the scope of the just shy of 400-page book: Kenneth Arrow, Roger Babson, Louis Bachelier, Fischer Black, John Bogle, Warren Buffett, Alfred Cowles III, Eugene Fama, Irving Fisher, Milton Friedman, William Peter Hamilton, Friedrich Hayek, Benjamin Graham, Alan Greenspan, Michael Jensen, Daniel Kahneman, John Maynard Keynes, Hayne Leland, Robert Lucas, Frederick Macaulay, Burton Malkiel, Benoit Mandelbrot, Harry Markowitz, Jacob Marschak, Robert Merton, Merton Miller, Wesley Mitchell, Franco Modigliani, Oskar Morgenstern, M.F.M. Osborne, Harry Roberts, Richard Roll, Barr Rosenberg, Stephen Ross, Mark Rubinstein, Paul Samuelson, Leonard “Jimmy” Savage, Myron Scholes, William F. Sharpe, Robert Shiller, Andrei Shleifer, Herbert Simon, Joseph Stiglitz, Lawrence Summers, Richard Thaler, Edward Thorp, Jack Treynor, Amos Tversky, John von Neumann, and Holbrook Working.

The unifying theme of the book is the rational market hypothesis, but don’t worry if you’ve read more about efficient and inefficient markets than you yourself can rationally justify. Don’t worry if you’re bored with CAPM or option pricing or if you can, practically in your sleep, recount the demise of LTCM in all its gory details. You won’t be able to put Fox’s book down. He combines journalistic prowess with academic rigor to tell a captivating, and important, tale—one that investors and traders ignore at their peril.

Cooper, Money, Blood and Revolution

George Cooper’s Money, Blood and Revolution: How Darwin and the Doctor of King Charles I Could Turn Economics into a Science (Harriman House, 2014) is a quick read but a much longer think. I’m still in the thinking process.

Thomas Kuhn’s landmark work, The Structure of Scientific Revolutions (1962), provides the theoretical underpinning to Cooper’s book. In Part I Cooper recaps Kuhn’s hypothesis and illustrates it (as well as the paradigm shift he proposes in economics) with the work of four scientific revolutionaries: Copernicus, Harvey, Darwin, and Wegener. “In all cases, the path to scientific progress required overturning the equilibrium paradigm and moving to a dynamic, usually circulatory, paradigm. Copernicus made the earth circulate around the sun. Harvey made blood circulate around the body. Darwin made species evolve and Wegener made continents move, pushed by circulating currents within the earth’s core.” (p. 76)

Economics, Cooper argues, is not yet a science; instead, it “exhibits all of the symptoms of being in one of Thomas Kuhn’s states of pre-revolutionary scientific crisis.” (p. 81) For instance, it has fractured into too many incompatible schools of thought with incommensurable paradigms. Cooper analyzes—and criticizes—the most widely recognized of these schools: classical, neoclassical, libertarian, monetarist, Keynesian, Austrian, Marxist, institutional, and behavioral. Moreover, although the mathematical models of economics are proliferating and their complexity growing, “their predictive ability is not obviously improving.” (p. 82) Economics, in brief, is ripe for revolution.

The first ingredient of economics, if it is to be truly scientific, must be Darwin’s notion of competition. Unfortunately, if human beings are Darwinian competitors rather than neoclassical optimizers, the basic tenets of neoclassical economics (individualism, maximization, and equilibrium) crumble. People do not make their decisions based on their own self-interest, independently of one another, and these decisions are not always designed to maximize their own welfare. Once the first two principles fall, the principle of equilibrium—that “the result of all of these individual optimizing decisions is a stable system in optimal equilibrium”—falls as well.

As Cooper recapitulates: “If human decision-making is fundamentally a competitive process, then decisions of individuals become dependent upon those of their peers. This implies that behaviour at the aggregate level of the economy cannot be reliably modelled as the sum of individual behaviours. Nor can it be safely assumed that the behaviours of individuals in competition will lead to an equilibrium situation. Indeed it is likely that competitive actors will always seek to disturb any equilibrium.” (p. 133)

The second element in Cooper’s paradigm shift, with a nod to William Harvey, is a circulatory model of economic growth. This model comes from marrying the competitive Darwinian economic system with the democratic political system. Capitalism pushes wealth up the social pyramid while democracy, with its progressive taxation, acts in the opposite direction to push it back down, “causing a vigorous circulatory flow of wealth throughout the economy.” (p. 152) This model, sure to rile people on both sides of the political aisle, suggests that income inequality is essential for economic growth and that taxation and government spending are contributors to economic progress. That is, “economic progress is associated with both income inequality and large government.” (p. 157)

Cooper concludes by using the circulatory growth model to help explain the causes of the financial crisis and “why the policy mix applied after the crisis has failed to restore normal levels of economic growth.” (p. 169) He offers three suggestions for dealing with the current economic stagnation: “1. Stop the policies designed to promote further private-sector debt-accumulation” such as student debt, “2. Shift from monetary to Keynesian stimulus” because quantitative easing “puts the money into the wrong position within the circulatory system,” and “3. Rebalance the burden of taxation between labour and capital—less tax on labour, more tax on capital.” (p. 191)

Cooper may not be the Darwin of economics, but I suspect that he (and the many researchers who are exploring complex adaptive systems) will help point the way.

By way of a footnote, readers who are interested in learning more about complex systems science might want to check out Melanie Mitchell’s course, Introduction to Complexity, part of a project being developed by the Santa Fe Institute and funded by a grant from the John Templeton Foundation.

Friedman, Fortune Tellers

I just finished reading Walter A. Friedman’s Fortune Tellers: The Story of America’s First Economic Forecasters (Princeton University Press, 2014), which I highly recommend. Readers will probably be familiar with some of the main characters, but in a depersonalized form—for instance, Babson action/reaction lines and Moody’s Investors Service. Other characters, such as Herbert Hoover and Irving Fisher, are rescued from the one-sided simplifications of history—failed president during the Great Depression, false prophet who claimed just prior to the 1929 crash that the stock market had reached “a permanently high plateau.”

Friedman accomplishes two main tasks in this book. First, he brings his characters to life, recounting their personal, intellectual, and entrepreneurial successes and travails, their pet social and political ideas—some that now seem appalling, and the battles they did with one another. Second, he describes the dominant styles of forecasting (and, by extension, investing) of the period, which remain with us today—“historical patterns, mathematical models, expectations, and empirical analogies.” (p. 210)

The book is a darned good read and belongs in the library of every investor and trader. After all, despite all protestations to the contrary, we are fortune tellers too.

Sandford, Goals to Gold

Lee Sandford left school at the age of sixteen to become a footballer—or, more precisely, an apprentice footballer. He turned pro the next year. When he was in his mid-thirties he retired from the game and decided to focus on trading, in which he had dabbled, along with real estate, for a number of years. He recounts this journey in the first part of Goals to Gold: Trading the Football Pitch for the Financial Markets (Harriman House, 2014).

The second part of the book deals with trading basics. Sandford’s preferred trading method is spread betting, legal in the U.K. but not in the U.S. (Spread betting firms bear an uncanny resemblance to bucket shops, which flourished in the U.S. from the 1870s until the 1920s.) For those unfamiliar with spread betting, Sandford explains: “you are betting a certain amount of money per point or pip that a product moves up or down. … we’re not buying anything, we are just betting on the movement of the price of something. … You never own anything, so there is no capital gains tax, and it is not seen as income so it is not taxable. The government still classes it as betting.” (p. 114) The spread bet has an expiration date; for instance, the wager may specify that the price of a stock will rise over a period of three months. Since spread betting firms don’t charge commissions, spreads on these trades are normally wide, the farther in the future the wider.

Spread bets are often levered; you need deposit only a small fraction of a trade’s total value in advance and you can potentially reap much higher returns than in the stock market proper. Let’s say, to use the author’s example, you firmly believe that shares in Lee’s Boots will rise and you are willing to wager $10 per point. When the stock is trading at $10 per share, you place your bet at the offer price of $9.98 and set a stop loss at $9.90. If the stock price goes up to $11 per share, you make $1000; if it falls, you lose $100. Sounds good, doesn’t it?

Well, spread betting firms make money not only because they normally demand wide spreads but because most of their customers lose money. (Some firms trade against their own customers.) Sandford describes basic technical analysis techniques, such as MACD divergence, and positioning guidelines that are designed to change these odds. He also takes the reader through a series of illustrative trades, many drawn from the forex market.

The final part of the book is entitled “Trading in Football Terms.” I must admit that I, who don’t follow soccer, didn’t quite connect with “play like you’re not going down” (and hence get out of the relegation zone). But most of Sandford’s analogies could have been drawn from practically any sport, or from life in general—for example, be patient and match your tactics to the situation.